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Looking Ahead – Which Way Do We Grow?

“Behold the turtle. He only makes progress when he sticks his neck out.”
– James Bryant Conant

This year our team has spent a healthy amount of time interacting and consulting with A/E and environmental owners, executive teams and boards of all shapes and sizes on evaluating various strategic alternatives and ways to enhance shareholder value. Like a football coach drawing plays on the chalkboard, every option potentially looks like a touchdown until you actually have to play the game.

For some organizations, it’s been another year of frustratingly slow progress, of gains that come in fits and starts and the breakout momentum that rarely happens due to a never ending list of “almosts” and “shoulda beens” (e.g., fewer mega projects to pursue, key contracts still on hold, etc.). However, other firms are having a banner year of record top and bottom line performance despite a 2% GDP climate, a moribund single family housing market, federal and state budget blues, and a tougher competitive environment than anyone can remember.

Talk to leaders in the latter group and what leaps out at you is that there is no one ideal model to consistent, profitable growth. Some have grown through organic means and tighter organizational and project discipline, some via acquisitions and bold ventures, while others have benefitted from cyclical market timing and just plain luck. However, these organizations are also embracing something that has been seriously lacking over the last few years – taking risks! I’m not talking about the “bet the house” type of risk with win big/lose big ramifications, but the steadfast courage and leadership to not become paralyzed by inaction and watching competitors pass you by.

Fortunately, the A/E industry is in a healthier financial position today. Cost cutting exercises are mostly in the past and many firms are well capitalized and possess strong cash positions. Leaders seem more eager than ever to reinvigorate or maintain their growth pace. Getting your firm from here to there in this environment takes planning (of course), communication, execution, as well as a certain (healthy!) paranoia to not become complacent when things seem to be going their best.

Here are some of the growth alternatives firms are utilizing:

  • Hiring Outside Talent – For the majority of A/E firms, it’s common for management to home-grow their technical and business development talent. It creates and diffuses a culture, process and legacy for successful client relationships and project execution. Unfortunately, leadership succession is becoming a huge structural challenge for our industry and many firms will simply not have younger principals with the skills and business acumen ready and available to lead in the future. Boards are increasingly tapping seasoned outsiders to lead at the executive levels to bring new perspectives on organizational structure, marketing, and overall strategic direction.
  • Adding new service lines/market sectors – One of the biggest challenges for A/E firms is to “change your stripes” and enter completely new markets or service lines. During the height of the recession, land development firms tried to become municipal engineering experts, companies of all disciplines rushed into the federal sector, and architecture firms morphed into sustainability consultants. While much of this was done for pure survivability, adding a new service line or entering a market sector ultimately takes a much longer horizon. The risk to this diversification is that core clients can become confused, thinking you were an expert for one aspect and now you are serving a completely different base and needs. Another risk is that are you jumping into a hot sector (yesterday’s residential development could be today’s shale play?) that will inevitably cool. However, based on larger market trends or emerging client demands, certain prospects and market opportunities may appear too good to pass up. Look before you leap.
  • Opening new offices – The reality is that it has become increasingly harder to cold start new offices today. New branches are initially expensive and bring high opportunity costs without a solid client or prospects to make an easy transition. Younger principals are often reluctant to relocate to help launch an office, given that many home values are still underwater. However, the truth is that in order to grow you must have a local presence with certain types of clients, and those are hard to cultivate and service two time zones away.
  • Acquiring other firms – Of course, the alternative to the “build” approach is to buy, and many firms are ramping up their M&A initiatives, seeking targets that will help them expand quicker into new regions, markets or client bases. From our perspective, it continues to be a “buyer’s market” as demographic patterns alone have the number of net sellers of shares outnumbering either the internal or external demand for them. And while integration risk and cultural and operational differences always have to be managed, when properly executed M&A remains a powerful tool for strategic growth.
  • Revamping business development models – The glory days of the 2000s where phones would ring off the hook seem to be a quaint reminder of headier times. As the overall “pie” has shrunk for many firms, there is a premium today on taking market share away from others and that has often involved a top-to-bottom review of marketing practices for a challenging new era. Leadership teams are becoming more proactive with social media channels and outreach, undergoing new branding initiatives, and training principals and project managers on developing valuable communication and sales capabilities.
  • Implementing new ownership and incentive compensation models – Maximizing performance for some organizations has also involved a critical assessment of their ownership models and incentive compensation practices. Getting shares in the next generation’s hands either directly or through phantom stock, synthetic equity or stock options is critical to linking efforts to rewards for the firm’s top performers.
  • Selling the firm – While selling one’s A/E firm is often done primarily for ownership transition purposes, it is also viewed by many as a growth strategy. Larger firms often have deeper managerial, marketing, recruiting and financial resources to help a smaller firm grow, while leveraging cross-selling potential and other organizational synergies together.

Certainly there are other growth avenues A/E firms are pursuing. However, keep in mind that all of these initiatives require a foundation of sound firm and project management discipline, such as open book management, timely cash collection, effective client communication, and investments in new information technology. As organizations look ahead to 2013, it helps to have an “everything on the table” mindset in terms of growth possibilities in your playbook. Happy New Year indeed!

The Vanishing Mid-Sized A/E Firm

“We’re too big to be little, and we’re too little to be big.” – Burt Hill’s CEO Pete Moriarty on his board’s decision to sell to Stantec in 2010

Being stuck in the middle can be hard. In my mind, no one personified that dilemma better than Jan Brady, the perpetually awkward and insecure middle child on the classic TV series The Brady Bunch. On one hand, Jan was always jealous of her pretty and popular older sister Marcia, leading to unfair comparisons and inferiority complexes. And on the other, the family seemed to shower more affection on little Cindy, the sweet and talented youngest daughter, complete with her pigtails and cute lisp. If Jan wasn’t battling freckles, she was nervous about wearing glasses. As best as she tried to make a name for herself or form her own identity, Jan struggled to fit in.

You could draw similar comparisons to many mid-sized A/E and environmental consulting firms in this climate. From our vantage point, more of these “in-between” firms are struggling to fit in (and survive!) as well, leading to increasing numbers selling to larger national and international players (see table). While many leaders have sensed and observed this trend over the years, the underlying factors driving this phenomenon are unlikely to subside anytime soon.

The Middle Class
The initial question is just what exactly constitutes a “mid-sized” A/E firm, and in talking to industry leaders and experts you’ll find no shortage of opinions. Given the fragmented nature of an industry with thousands of niche practices, some define firms as “mid-sized” if they have 25 to 50 employees, particularly those that are single-discipline or dominate a particular city or region. Other companies, such as Halcrow (6,000 staff) and PBS&J (3,900), lamented their underwhelming size as motivation in selling out to industry titans CH2M HILL and Atkins, respectively. That’s a big range!

For simplicity’s sake, we’re going to define mid-sized firms as those with staff sizes between 150 and 1,500 employees. This would cover those organizations that comprise the ENR 500 up to approximately number 50. At a minimum, these firms have the following general characteristics:

  • Multi-disciplined service offerings, typically including some combination of engineering, architecture, planning and/or environmental consulting
  • Mix of public and private sector clients
  • Anywhere from 5 to 50+ office locations, with activities often dominated in one state or several regional footprints
  • Privately held, with ownership profiles ranging from sole owner to 100% ESOP
  • Formal management structures, governance policies, and IT/financial reporting systems

A/E firms above 1,500 employees tend to get exponentially larger, are often publicly owned, focus on the largest building or infrastructure projects, and have national and international franchises. Those below 150 typically tend to focus on several cities/counties in a particular geography, have higher client concentrations, fewer owners, and simpler organizational matrices.

Checking Out?
So why sell? In discussions with dozens of leaders of mid-sized organizations who sold over the last few years, the reasons they offered were the following:

  • Higher valuation – it’s common to see mid-sized A/E firms sell stock internally at book value or other deeply discounted levels as a means of affordability and simplicity. Cash-rich publicly-traded buyers have the resources to offer much higher valuations, in many cases from 5 to 8 times operating earnings and 2 to 4 times book value. For baby boomer principals whose ownership stake is often the largest asset in their retirement portfolio, better to cash out sooner rather than later. Another factor for owners – future tax rates will be going in one direction – up!
  • Ownership transition failure – the reality today is a large percentage of mid-size A/E firms have ownership profiles that defy logic. Many are “top heavy” with principals in their 50s and 60s who own a large majority of the stock. There simply aren’t enough 30 and 40 year-olds ready, willing, and able to buy these senior owners out in a coordinated process that won’t result in a decade (or more) long sell down. With profitability levels down, using the firm as a conduit to fund buyouts via cash bonuses for equity or other transfer mechanisms is increasingly difficult. More ominously, in a low growth environment, cash used to pay down redemption liabilities means less available for firm reinvestment, incentive compensation, and growth capital.
  • Leadership succession failure – hand-in-hand with ownership transition challenges are leadership succession ones. Aging A/E leaders haven’t done nearly enough to prepare and groom their next generation. Many presidents and principals look around and readily admit they don’t have faith that the next tier of managers has the capacity and acumen to guide them into the 21st century.
  • Increasing client demands – the trend in A/E client delivery models has been towards more “one stop shopping” and offering end-to-end solutions from multi-discipline planning and design through construction and monitoring. Larger firms often have the geographic coverage, broader service offerings, and business development resources that many mid-sized firms lack.
  • Diminishing marginal returns – mid-sized firm leaders voiced their frustration with the steady creeping of corporate overhead, bureaucracy, fixed costs, branch offices, governance policies, and slower decision making, all of which served to produce lower shareholder returns! In contrast, small, niche firms had lower cost structures, were more operationally nimble, and can often focus on one discipline, market segment, or geographic area more effectively.

Fighting the Tide
Fortunately, many firms aren’t quite ready to accept the inevitability of their predicament and simply get swept away with the winds of change. There are hundreds of resilient mid-sized firms who have survived through booms and busts, leadership changes, new competitors, and management fads. Recessions have a powerful way of honing the senses, and today more than ever, savvy leadership teams are challenging the conventional wisdom of business as usual as well as shaking up their firm cultures. Some of the bolder initiatives they are undertaking include:

  • Regional combinations – mid-sized firms experiencing similar growth or ownership challenges are coming together to create larger regional engineering or architecture organizations for sustainability and growth. Good examples are H.W. Lochner and Bucher, Willis & Ratliff joining forces in the Midwest, and Pennoni linking with Patton Harris Rust in the Mid-Atlantic. Architecture firm “merger of equals” are developing around common urban centers as well.
  • New ownership models – faced with sizable redemption liabilities, some organizations with conventional owner/partner models are considering new avenues, including implementing Employee Stock Ownership Plans (ESOPs) or Employee Stock Purchase Plans (ESPPs). Studies have shown that broad-based employee ownership, combined with open book management and other participative measures, can be a strong impetus to growth and profitability. Private equity is another model, where growth-oriented financial investors can help with a partial exit strategy for owners while injecting capital and business expertise to accelerate growth.
  • Intentional shrinking – most A/E firms are smaller than they were five years ago, and many significantly so. Lower project volumes have led to a combination of layoffs, office closings, divestitures, and a strategic culling of clients. As a result, many leaders offer that they are “leaner and meaner” than they have been in years and are more focused at a reduced size.
  • Get growing – for all the hand wringing and tales of woe in the A/E industry, trust us that there are a number of great growth stories taking place every day. Mid-sized firms that are “bucking the trend” are doing it through taking a critical evaluation of their business development and marketing practices, aggressively pursuing new markets and client verticals, acquiring niche firms themselves, bringing in outside talent at all levels, and taking market share away in a lower growth environment. It’s refreshing to see!

Endgame
The A/E industry is going through some remarkable structural changes. The big keep getting bigger. Either displaced or just fed up, sole practitioners are putting out their own shingles in larger numbers. Design and consulting talent seems so readily available, yet so scarce. Unflinching clients are demanding more for less. The number of mid-sized firms is shrinking, but many are not going down without a fight.

Is your organization feeling a bit like Jan Brady today? Tell us what you think. ROG Partners brings years of seasoned financial and business experience in navigating A/E and environmental clients through strategic and ownership alternatives in an ever changing landscape.

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Table: Representative Mid-Sized A/E and Environmental Consulting Transactions, 2010-2011