The perks and perils of private equity

Editor’s note: This article is for general educational purposes only and does not constitute legal advice.

Recently, private equity investments in roofing companies have become more common. If you are curious about how they could affect you and your business or have already been contacted by a private equity firm, there are several factors you should consider.

What is it?

Private equity is an investment tool that infuses funds into businesses, usually with the goal of acquiring a stake in ownership or increasing growth. Private equity firms collect funds from various investors, pool the resources and invest in companies. This practice is widely accepted in myriad industries and becoming more prominent in the construction industry.

Private equity often is used to finance property development, providing the necessary funds to create and complete building projects. Private equity firms find numerous investment opportunities in the construction industry, including residential and commercial projects, renewable energy and infrastructure.

Why roofing is appealing

The construction industry has potential for consistent, productive returns and long-term growth. Real estate projects, urban development and other initiatives strengthen demand for construction services. Investors perceive construction can offer steady cash flow followed by increased value through operational efficiencies and expansion. Generally, there are lower barriers to entering roofing than other construction trades, which makes the industry attractive to investors.

Knowing your worth

If pursuing private equity intrigues you, you must fully understand your company’s value. There are several ways to calculate that value, but here are three common ones:

• EBITDA multiples. EBITDA stands for earnings before interest, taxes, depreciation and amortization. An EBITDA multiple is determined by dividing a company’s market value of equity by EBITDA from the past 12 months. That multiple then can be used to compare a company’s value to similar businesses. (A company’s market value of equity also is known as its market capitalization, and that number can be found on a balance sheet.) For example, say a company has a market equity of $120 million and an EBITDA of $20 million; its EBITDA multiple would be 6. Generally, companies with lower multiples may be perceived as more favorable acquisitions. Those with higher multiples may be overvalued. Some investors prefer this calculation method because it is simple. However, it does not consider a company’s growth potential or profitability.
• Net asset value. With this method, a company’s value is determined by totaling its assets and then subtracting its liabilities. That number is then multiplied by a predetermined ratio, which often is derived by using the industry average or researching what multiplier other roofing companies have used. For example, perhaps the industry average multiplier is 4. If a company’s assets are $200,000 and its liabilities are $50,000, its net worth is $150,000. When multiplied by 4, the company’s net asset value is $600,000. This approach is straightforward, but it does not consider future growth potential.
• Discounted cash flow. This method considers a company’s future cash flow. It estimates how much a company will earn in the future and then discounts that number to its present value. The discount rate usually is the company’s weighted average cost of capital. That is then multiplied by a given number, usually between 4 and 6, to determine the company’s value. For example, say a company is expected to generate $50 million in cash flow during the next five years, and its discount rate is 12%. Its present value would be about $29.6 million. If that is multiplied by 5, the value of the company would be $148 million. The challenge with this method is accurately predicting future cash flow and using the correct discount rate.

Given the variety of calculation methods, it is essential to consider all factors and determine which approach is most accurate for your company. All parties associated with the deal can benefit from discussing these options with accountants to accurately understand a company’s worth.

Benefits

There are several reasons business owners might welcome private equity interest:

• Growth. When a private equity firm focuses on roofing companies, it often acquires specific contractors or specialties. This strategy allows the firm, in a short amount of time, to create a regional or national specialty contractor. For example, an investor might purchase a roofing company in one state and then proceed to purchase similar companies in that state and surrounding states. Doing so quickly establishes a sizeable regional roofing contracting company. This kind of acquisition differs significantly from the organic growth a single contractor typically would experience. By combining purchased contractors, individual companies will not need to build relationships and hire more staff. Instead, they can share resources. This approach can be beneficial for smaller subcontractors, as well.
• Networking. Quite often, private equity firms will provide access to extensive professional networks, which can mean more partners, suppliers and customers. That level of support is invaluable.
• Funding. Contractors sometimes struggle financially, so private equity firms can offer capital to help them expand their reach, invest in new materials or technology, and take on more significant projects.
• Operational support. Private equity firms can offer operational assistance and expertise, help companies implement best practices and streamline processes.
• Exit options. Many contractors have not considered an exit plan they may require in upcoming years. However, with a private equity firm, you can easily phase out your role in your company without having to close the company. Investors can help with a succession plan to effectively transition ownership and leadership without losing momentum.

Concerns

Although private equity relationships can offer several benefits, you should be aware of the following risks and challenges:

• Profit expectations. Although every company wants to turn a profit, private equity firms are under increased pressure to deliver solid financials. To meet investor expectations, they might be required to cut costs and speed up schedules. That approach may be much different from your current operational environment.
• Safety and quality. When smaller companies suddenly begin working in tandem, there can be inconsistencies. Safety and quality standards may vary, so it is critical the parent company mandates the use of specific safety equipment and controls work quality. It may take time, but all workers must adopt the same best practices and have equitable quality expectations.
• Loss of control. You probably are used to calling all the shots, but if you sell to a private equity firm, you may be held accountable to investors. You may regret losing the authority to make decisions and have operational control. This lack of authority can affect daily functions, workers and customers.
• Company culture. Most long-term roofing companies have accepted and valued company cultures. If a roofing company culture clashes with the culture of the private equity firm, morale may suffer, which could lead to employee dissatisfaction and turnover.

Tax implications

When buying or selling a company, there always are state and federal tax issues that must be addressed. For example, a private equity firm could experience a taxable gain if the tax basis of assets acquired is lower than the assets’ fair market value. If the tax basis is higher than fair market value, the firm will experience a taxable loss. Private equity firms will be required to pay taxes on gains, but they can use losses to offset other taxable profits.

In addition, if the company being sold has a high net operating loss, the loss may be carried forward by the purchaser and used to offset future taxes. However, under certain circumstances, losses do not transfer and will not be available for future tax deductions.

In most cases, the private equity firm will take on the tax credits of the roofing company, but this is not true if the transaction is an asset purchase.

As with any acquisition, tax considerations are a significant factor. It is critical to seek the advice of a tax expert to negotiate the terms, lessen tax liabilities and protect the transaction’s value.

Legal issues

Similar to taxes, in every business deal, legal ramifications affect all involved parties.

If you choose to work with a private equity firm, ensure your management structure, including board members and decision-makers, remains intact. Otherwise, you may find yourself in a power struggle.

Before doing business with a private equity firm, research the investors’ legal history and note any transgressions. You should review and evaluate existing contracts, regulatory compliance, intellectual property rights, environmental concerns, ongoing litigation and employment-related matters. Avoid trusting firms that have made dubious decisions in the past, and review the private equity firm’s preview projects and investment philosophy. By conducting due diligence, you can help ensure your working relationship will be compatible.

In some real estate development situations, a developer might form a limited partnership that acts as project owner and a special purpose entity to serve as general partner. Usually, these two parties work seamlessly, with general partners carrying out fiduciary duties and offering investment expertise while the limited partnership provides most of the funding.

But there are times when conflicts can occur, such as when a partnership defaults on its obligations or investments fail to perform. In these cases, it is critical construction lawyers understand which party they represent, maneuver divergent legal or financial interests, and manage any implied representation and conflicting responsibilities.

In many regards, the legal implications of a deal can be as critical as financial ones, and, frequently, the two are tightly intertwined.

The workforce

When any company is sold, retaining employees is a significant challenge. Often, dealmakers focus on keeping executives but may overlook the technical and functional employees who keep a company operational daily. Before any deal is finalized, it is vital all parties look beyond leadership positions and determine which groups and roles are essential for the company’s future health.

Once key roles are identified, a human resources team should review those employees’ compensation and benefits, analyze internal pay equity and set retention priorities. As the deal progresses, the human resources team can create retention plans that address compensation, benefits, career advancement, remote work options and other factors. In general, companies should determine what issues are most important to employees and whether they can accommodate them.

In addition, leadership must take the time to get employee input about the transaction; listen to their concerns; and implement positive, reasonable policies. If the purchase has the characteristics of a merger, it will be critical to consider contrasts between company cultures and assist employees as they adjust.

Even the most profitable deals can be seen as a failure if employees are overlooked in the transaction. Critical operations could suffer, and morale may plummet, which eventually will affect the bottom line. Therefore, dealmakers must make an effort to identify talent and ensure those employees have a place in the new business environment.

Helpful strategies

If you are considering working with a private equity firm, you can benefit from adhering to the following checklist:

• Communicate. From the outset, communicate with investors openly and often. Be transparent in your expectations, and provide regular updates. Make it known you require transparency from them, as well.
• Ask questions. If you have concerns about the investors’ objectives or goals, be sure to inquire. The more information you have, the better your chances of creating a profitable arrangement. Making assumptions is never a successful strategy.
• Remember your people. As you consider your company’s overall success, also understand your employees’ needs. Many have been with you through triumphs and adversity, so you do not want to undervalue them. Do everything you can to secure their place after the deal is finalized.
• Secure professional guidance. Working with a private equity firm can be beneficial to you, but do not attempt to complete any deal on your own. If you do not have an accountant, hire one and get insights into your company’s financials, its overall value and the inevitable tax implications of a sale. Also, enlist the services of a construction or real estate lawyer. An experienced attorney can help you negotiate terms, review the contract and anticipate disputes.

Private equity investors are likely a mainstay in the roofing industry, and working with them can be attractive and daunting. If you are considering an agreement with a private equity firm, make sure you consider all the ramifications. Ask the right questions, do your research and acquire the professional support you need.

TRENT COTNEY is a partner and practice group leader at the law firm Adams and Reese LLP, Tampa, Fla., and NRCA’s general counsel.