Transforming AEC Firms into Private Equity Magnets

And , kp , there was one that you posted on LinkedIn it's about a week ago as we record this but you were talking about AEC executives and private equity and everything that's thinking about growth in the industry . So let me just read the post and then we can go back and unpack this . It says I really enjoy the conversations that I have with AEC executives .

Today I was having a conversation with the CEO of an engineering firm . I was giving my views of private equity and how . Ceo of an engineering firm , I was giving my views of private equity and how , for many firms that sell to the private equity , they may be doing so for a liquid event and that they don't see their firm growing .

Essentially , they're selling their interest in the firm and then likely allocating to the public markets . It could mean that , on a risk-adjusted basis , they have more confidence in the stock market than their own company . And you go on after that to kind of unpack your ideas around that .

So , first of all , from my point of view , as I look around maybe more the AE market because that's more my background I see a lot of this . I see a lot of private equity coming in . I see owners transitioning out this . I see a lot of private equity coming in . I see owners transitioning out , so to speak .

There's a session plan turning into hey , let's talk to private equity , but you're out there talking all across the ENR 500 , all across the AEC world , and obviously this came from a specific conversation with the CEO of an engineering firm . So when you had this conversation , maybe what's the context of that conversation ?

And then , do you think about the hybrid approach that you described ? What's going on there ?

And I think the example I brought up was , you know , the idea of , like , you look at a medical practice and you see , you see what's happening there , right ? So you have a medical practice . Your limitation to a medical practice is the doctor . Right , the doctor can see only so many patients . Everybody wants to see , you know , Dr Ready .

Everybody's got to see Dr Ready . Everybody's got to see Dr Ready .

Like that's who they have a relationship with , even though a nurse might take your blood pressure and weigh you and a PA might come and swab the back of your throat , whatever , but at the end of the day , it's a boutique relationship with a physician , and that's why you've seen the advent of executive medicine , right .

So you know you have a doctor , that's your doctor and you see that doctor . You know that's the deal , but I'll pay a premium for that , right . So those are the premium boutique services .

But if you look at most doctor's offices , so much of it is like the sniffles business doctor's offices , so much of it is like the sniffles business , the sprained ankle business , right .

And so what the medical industry has figured out is if I keep my physician practice separate and I spin out or create urgent care centers , urgent care centers don't require doctors , you can have nurses and PAs . So that limitation of a physician , of that boutique person , doesn't matter , right ?

So the urgent care centers are never you know ready's physician group , it's , you know , urgent well , or like they're all branded , like they're heavily brand oriented and heavily technology oriented .

So what the industry has done is like let's bifurcate kind of the high value out and then take the low value , highly repetitive , very predictable business , and put it over here . And so urgent care is almost like a retail business , more than a physician's business . And what private equity wants is they want highly predictable revenue and cash flow .

They don't like the ups and downs . It's essentially an annuity business , in other words , they have a guaranteed income every month after month , with some modest growth . The problem with things that are of high value is they tend to be high margin , but they also tend to be high risk and not that predictable .

So when I look at what the AEC firms are doing , when they talk about innovation , right , for example , the high value things they want to do private equity doesn't actually want those . Private equity wants timesheets , utilization . They want the commodity business . They may say otherwise oh yeah , no , we really value your innovation .

They don't value your innovation , right . And so what you look at , what's happening in private equity , is the firms that are being sold . Some of them are circumstances , right , ownership , succession , planning , issues . However , one would argue that the businesses that are most attractive to private equity are the ones that are most commoditized .

So , like you talk about in your advisory practice and your content , you're always talking about commoditization . So , like you talk about , you know , in your advisory practice and your content . You're always talking about commoditization , right . So one could say you know , become highly commoditized and you're a great candidate for private equity .

The thing that I kind of is a little bit of a little bit irksome for me is when people like , oh , we're value and we're this and we're not a commodity , and then they sell the private equity . It's like a lie , right . It's like they're lying to themselves .

If you are a great candidate for private equity , you are therefore a commodity business full stop , and I think these people know this because they're selling it . I'm talking to civil engineering friends that are walking away with $50 million selling their firms . They didn't even know what $50 million ever looked like .

They're civil engineers like me , and then they're taking that money and what are they doing ? They're taking liquidity out of their business and then they're putting in the stock market , in real estate , right ? So what they figured out is having ownership in a private company . There's no liquidity , so there's a risk there , right , and the growth probably isn't there .

When you have an S&P 500 that's now up 23% this year , their profits aren't growing 23% . Their balance sheet's not growing 23% in a year , right ? So what it is , it's a reallocation . You have to think about it as a reallocation of capital to the low risk , low return , very predictable world of private equity , and I think that's the issue right .

I think that's where people aren't really tuning in .

As we're recording this , I'm getting ready to jump on a plane to come down to you and we're going to host our one day mastermind event tomorrow . Ready to jump on a plane to come down to you and we're going to host our one day mastermind event tomorrow . There's going to be a lot of discussion of emerging technology and data , etc .

Uh , amongst other things . But is there anything to the idea that we're headed to a point again in terms of of valve , in terms of the through the lens lens of the private equity , the value and the predictability , the value and the commoditization ?

Is there anything to the idea that the data that these firms are collecting let's see , maybe it's performance data . Whatever it is Is that also a value proposition for the private equity or is that outside of this conversation ?

Think of it as buying power , right ? It's not value add , it is buy more commodities . And if you buy more commodity firms , you only need one CFO , you only need one CEO , right ? So you squeeze your , your , your GNA and overheads , you're squeezing the crap out of that . You're turning out more cash , right , that's all they care about .

You know , it's put a quarter in , get a cookie out . That's all they care about . They're not trying to do anything , anything different , which is fine . That's a business model . It's not a negative , right ? And so , if you think about that , they need to be out in five years

. So let's say , you have some data , you're on a path to be a data business . If you can't monetize it ie , I'm going to invest $5 million in my data business and you can't generate profits that exceed within five years . The answer is no .

It's a short-term game , and I don't think without , realistically , millions of dollars of investment to build a data business . Let's forget about whether there's a market for it and just putting that aside , we know we're not starting a data business with 10 bucks . It's a dedicated team . It's probably $5 million a year in spend .

So you're going to spend , let's say , $15 million over three years just to get going , which means you need to deliver like $100 million . I sold my BIM company , my BIM tech company . I sold it to a Reprographics company and everyone on my team made like $200,000 a year because they're all technology people . Right , we're in the Bay Area .

Even then , everybody was making a lot of money . Well , reprographics firm the people in those little print shops are making like minimum wage , right ? They're printing companies and a great financial crisis happened and the COO was , like you understand , on every blueprint that we print , we make and profit a nickel .

So when you go off and you hire these people making all this money , do you know how many sheets of paper we have to print to make up for it , right ? So if you think about $5 million of spend to invest in innovation , right ? How many billable hours does the firm have to create to offset that ?

It's a lot and you're not going to get that payback necessarily in five years and there's too much risk to it . So the private equity people are like no , let's not do that , let's just do more of the same . I think the worst job right now for me . Everybody has their preferences .

I would hate to be a chief innovation officer for a private equity backed company , because all of your innovation is going to be cost mentality . How do we use ai to reduce the number of people ? How do we which is fine , there's a market for that . It's just not what I want to do with my life .

Right , I want to invest money and create value add , and so it's the same thing . Why private equity and a lot of the firms ? When they look at the venture capital side of the business , they can't understand .

Like KP , you write $2 million checks to 10 companies each , so you deploy $20 million against 10 firms and you only expect one to survive and pay back everything . They can't even fathom it . The private equity people can't fathom it . No , yeah , or a lot of this , firms , firm executives can't understand my support .

But the reason , or and the reason that I've focused so heavily on decommoditization over the years , is that mentality right . They don't understand firm leaders don't necessarily understand how to create value that's not commoditized and , as you're talking about it , you know , private equity , that's a business model . Going in that direction is a business model .

So if we look at this , and maybe in two different directions , if I'm a firm leader and , for whatever reason , I decide that I want to go down the private equity road , what do I need to prepare myself for that ?

You should be able to easily acquire a 25-person architecture firm , bolt them in , plug them in , integrate marketing , integrate ops , integrate accounting all the operational stuff . Kind of ignore the fact that they're an architecture firm . It's a staffing business , right . Treat it as a staffing business , right .

So you're going to go through both them on and try to reduce as many operational costs as possible to keep your EBITDA going right , to keep your cashflow at least at pace , if not better , right , because you should be .

So the question is , if you're a 100-person architecture firm and you look at your overheads , you look at your fixed overheads accounting , it , whatever can you hire a 25-person company ? acquire them and get rid of all their fixed overheads , because that's the goal . So it's all about being operationally excellent .

In fact , I would argue , if you're advising a firm , this is the idea of having the end in mind . If you talk to a 100-person firm and you're advising them , they said , hey , we want to sell to private equity . Your strategy should be the re-commoditization of the business . In other words hey , all those value add things that you're doing , nobody cares .

It's about getting as many architects on staff , it's about churning as many billable hours as possible , keeping your costs low and generating and going after K through 12 . You can't go after that new stadium because that's not a commodity , Because a private equity guy says , how many stadiums do you work on a year ?

And you're like , well , we get one every five years . Well , that's not predictable . Whereas if you say , oh , we do 20 school K through 12 a year and we're on the budget for this new SPLOST for the next five years ding ding ding , they're very excited . Don't do award winning , don't do any of those things .

It's firehouses , firehouses , schools , maybe a few airports in there , right , things that are very programmatic and predictable is what people want to see .

So I think you have to think about the culture you want to build based on the exit strategy . If your exit strategy is not to sell the private equity , then who are you selling to ? Are your kids going to inherit it ? Maybe Some businesses ?

You see that in the construction world a good bit and the professional service is a lot less because , that requires you forcing your kids to get engineering degrees or whatnot . They can't be an English major and be the head of an architecture firm . It's very tough . They have to kind of grow up in the business . Or is it going to be employee-owned ?

And if it's employee-owned , it has to be more about a culture .

But I'll say the challenge with employee-owned companies you have to build a culture that attracts young people and indoctrinates them into wanting to be owners and not employees , because otherwise you run into the problem that we've seen with a lot of firms that their Gen Z and millennials were never interested in being partners and now , as the senior people are aging

out , they don't have anyone to sell their stock to Right . In many ways , employee ownership's a massive Ponzi scheme .

All right , well , to bring it back around , you started out this post on LinkedIn and you said you had this conversation with an AEC exec , a CEO of an engineering firm , and you're talking about private equity . And so this whole conversation , as we've been unpacking that LinkedIn post , we've been basically picking your brain on what is private equity ?

What is private equity interested in ? Again , a business model . You know , I know that there are people that will listen to this or watch this and say , yeah , that that's , that's not why I'm in it .

Fine , right , not your business model , but we've been talking about the business model of private equity , investing in AEC firms and maybe the re-commoditization , which is a little bit of a different spin than I'm usually focused on . So this is really interesting .

Any closing thoughts on ?

They kept the real estate and signed 20-year leases with the private equity firm to rent the space because they didn't care about the real estate . And then they took that money and they plowed that into these med spa businesses that are not very predictable . They're high value . You know it's amazing what people .

The margin on Botox is very high and they reallocated capital into the hype .

So I think if you look at your business as pieces and parts right , and you say this is a commodity , this is value add , and put them in their appropriate buckets and operate them that way , them in their appropriate buckets and operate them that way , then if a private equity event happens , maybe you're selling your K through 12 studio off to private equity and

guess what ? They don't care about keeping you as the architect right . It's not important as long as there's registered architects to do the work right , so you might sell off your K through 12 , take that money and maybe you're into stadium . You know stadiums and you want to keep a 10 person firm and only do stadiums do one stadium every five years .

Plow that money into your stadium practice and then the founders stick around . They can only work on the high value product projects , right . There's this idea that you know you can split the baby is my point , but it takes a very finance and analytical approach to how you operate them .

In fact , we did drilling for other engineering firms and then we ended up selling it to a drilling company , right , we ? It was a commodity , for we didn't need drill rigs as an engineer firm . Why do we have drill rigs ? You've seen that with surveying , right . It used to be in civil engineering .

Surveying was part of civil engineering , and then surveying started to get commoditized , and so that was the advent of surveying companies .

So , as someone who's listening to this , a CEO of an engineering firm , an architecture firm , an AE construction firm , whatever it is that they're leading , whatever their organization is , who do they need to talk to , how do they learn more about the strategies and who do they get to help them with these strategies ?

We're not going to do door details . So , like there's other commodity firms , like we'll send that off to Genzer , right . Like the bottleneck of production and deadlines . That's not what , who we are , let's sell that business off and just outsource it , right .

So I think you know those are the type of things that I think you and I think you and I talk about a lot having , um , you know , being the old guys in this industry .

Um , you're six months older , so you're the old guy , but uh , but generally I think we've seen enough cycles and I think , since we've kind of got we're industry adjacent now a little bit , I think we see it . We just have that bird's eye view and we're like what the hell are these people doing ?

Like we just see it right , they don't see it , they don't see it .

I'm I'm headed to the airport here very , very shortly and I'll see you for dinner tonight and we'll do our one day mastermind event tomorrow and then the following day , which is Wednesday , as we record , this is our AEC Summit 2024 . And a lot of the information that's going to be shared at Summit this year is from outside it's industry adjacent , certainly .

It's absolutely applicable , certainly , but it's points of view from other industries from outside the AEC , in hopes that somebody will hear this and say , oh right , I see that and I can think of how that can be applied here in the industry . About our now industry adjacency is really important .

It's like listen , there are other ways that this is being done in other areas that can actually be applied here in the AEC world 100% . Yeah , all right .

I want to know more . And hopefully you've been sticking around . You've been , uh , you've been sticking around . You've been listening to , uh , these , these podcast episodes and also following along kp on linkedin . If you're not , you're missing out lots of great nuggets shared there .

Uh , just find them on on linkedin kp letter k , letter p ready r-e-d-d-y on linkedin . Go follow him there and then you can have a preview of what we'll talk about on the next KP Ready Unpacked . Thanks , kp , thanks to everybody that's out there listening and we'll see you somewhere sometime soon . Thanks , everybody .