While rising interest rates might be squeezing private equity firms, they’re continuing to look to the pest control industry for investment opportunities.
Editor’s note: This feature originally appeared in May 2023 PCT under the headline “Invest Quest.”
The initial investment is usually large and called a “platform.” Typically, a firm spends the next few years operating the new business, growing it, and then the last few years they are focused on exiting (or selling) the business and returning a profit to their investors.
A PE HISTORY. Private equity firms are nothing new in the pest control industry, nor are their financial tactics. Wayne Huizenga, the former owner of the Miami Dolphins, Florida Panthers and Florida Marlins, is credited with what we now call “roll ups.” He began in the recycling/garbage industries by buying a series of companies and aggregating them into what is now Waste Management. For those of us that remember VHS tapes, he did the same with Blockbuster. Unlike the investment icons of the 1980s, such as Carl Icahn, who made their money buying conglomerates and selling of their pieces, the roll ups starting in the 1990s are the reverse of a leveraged buyout, because they leverage equity and access to debt markets to finance the aggregation of businesses. Huizenga combined or acquired businesses to form empires in sports, waste and media.
Since the ’90s, we have seen hundreds of roll ups across industries from banking, funeral homes, pet cremation, bus lines, car wash, medical services and pest control. PE firms can capture market share because these industries are highly fragmented. In the early 2000s, Royal Palm (a PE firm) entered the pest control industry by purchasing Middleton Lawn & Pest Control in Florida. At the time, Middleton was generating an estimated $8 million a year in revenue.
The plan, according to Kemp Anderson, who led the acquisition at Middleton for Royal Palm, was to go public. “After closing the platform acquisition (Middleton), we took control of a failing penny stock: SNE (Sunair Electronics). Selling their core electronic assets, we rebranded the SNE business as a pest-related services business and proceeded to close at least one deal per month,” said Anderson. “The heavy acquisition activity at a lower P/E (price to earnings) multiple created an arbitrage opportunity. We did an initial offering around $2 a share and drove the stock to approximately $12 a share.”
After a few years, the assets were sold for over $50 million.
A PE PRESENT. Today, the market is rich with companies trying to replicate that same formula; purchase a platform company, grow the business, then sell the larger company for a premium price. Access Holdings Principal Josh Finifter describes the reason his firm is focusing on pest control.
“With pest management, our team identified market trends like high fragmentation, a shifting consumer sentiment toward a ‘Do-It-For-Me’ model, a recurring revenue model and an opportunity to enhance both the customer and technician experience through contemporary technology, service excellence and training and development,” he said.
All these trends point to an opportunity to build an enduring business that can help transform the category. The private equity formula relies on a couple of key factors, and as we continue to see firms enter the market, those factors might have begun to get squeezed.
The first factor is a pipeline of available deals at an attractive price. As private equity firms enter a new market, they tend to make a platform acquisition: a larger company with substantial revenue that comes with a solid management team and brand they can grow. After making this initial investment, PE firms seek to buy smaller companies in overlapping geographies. These are called tuck-ins. The PE firm will “tuck” the smaller business into the larger. Usually, these firms are smaller, and the deals are negotiated off-market and outside of an auction process where a firm could maximize value at the point of sale. These cheaper deals dilute the higher cost of the initial platform investment. With more firms entering the market, competition for deals get higher, increasing the transaction multiples at which deals are performed.
The second factor contributing to the efficacy of the private equity strategy is the availability of a profitable exit strategy. As discussed previously, PE firms deploy capital by buying and aggregating (collecting and combining) various businesses. The rise in interest rates has had a clear negative effect on the PE industry; we saw a sharp decline in the volume of deals in the second half of 2022. Since PE firms tend to use debt to finance part of their investment, higher rates are squeezing the margin on deals.
The good news for PE firms is that major strategic players in the market are still trading at record high price-to- earnings multiples, suggesting there is still an opportunity to sell a premium asset at a high price.
PCOs should keep in mind the observations from accounting firm Cherry Bekaert: “From 2021 to 2022, total private equity capital raised dropped almost $20 billion year-over-year, according to Pitchbook’s 2022 Annual U.S. PE Breakdown.
“Declines in public equity markets may mean many LPs are either fully allocated or overallocated to the alternative investment asset class. Given these dynamics, it is not surprising to see the duration to close a new fund ticked up to 15.4 months from the 13.8-month average seen in 2021.” On the other hand, the average time between funds continues to tick lower and reached three years in 2022, down from 3.2 years in 2021, the report said.
PCO PERSPECTIVE. If you are a pest control operator, here are some things to keep in mind.
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- PE firms are incentivized to negotiate outside of a formal auction process. Less competition generally means a better price and terms for the buyer. Don’t be surprised if PE firms are reaching out via LinkedIn or other methods to ask for a meeting. PE firms prefer to meet and buy companies that are alone and not represented.
- Private equity firms are in one way or another beholden to their investors, and these investors want to see a return on their investment. To see a return on their capital, a firm needs to monetize their newly created asset. While holding times (how long a firm will hold onto the asset, aggregated companies in this case) have increased to a little over five years, it should be no surprise that your company and team will almost always go through a second sale farther down the line. Some firms are rumored to be going public, but this is the exception more than the rule.
A large portion of the leadership team tends to be tied up in common equity or stock options, usually behind the private equity firm’s ownership in payout. It is critical to understand the terms of any options or restrictions on equity in a deal that you make, because they can substantially impact the value of the leaderships team’s equity.
Private equity firms can be great for companies whose owners want to seek aggressive growth strategies and big change ups. Generally, for platforms, we see the buyer offer a large percentage of the transaction in cash up front with a complete ownership transfer with the potential for a second bite of the apple if you are willing to stay on and steer the company successfully.
But there are advantages of selling to a private equity firm:
- Private equity firms can be willing to use creative financial structures to reward owners who are willing to stay on and continue to grow the business.
- Private equity firms looking to get into the industry can be willing to pay a high premium to make their initial investment.
- Some business partners desire to remain partial investors, shedding off some managerial roles. They become rollover investors.
- The business lacks the financial muscle and stamina to finance growth and expansion. It requires an external capital injection to oil its business growth.
- PE firms typically have abundant resources including cash to support the business.
WHAT TO DO. When engaging with a PE firm who is interested in your business, here are some questions to keep in mind:
- How many investments have you made in your fund?
- How many investments are you intending to make in your fund?
- How do you structure capital?
- Do you use preferred equity or any types of debt?
- After close, what decisions are delegated to the board versus the business leadership team?
- What percentage of your last LOIs (letters of intent) have closed?
- Can you explain why any of your past deals didn’t close?
- If I hold a note (or paper), what are my guarantees to be paid in full?
- How long will you (the PE firm) hold my company before it is sold again as part of a larger entity?
PE firms are viable buyers for our industry, and while the macroeconomic environment may be pulling down the parameters that make investments profitable, the additional competition and deal creativity offer sellers additional paths and opportunities when it is time to sell.
As a seller, it is important to remember that private equity firms operate differently than traditional industry buyers, and whether you are selling to a regional, national, international or private equity firm, you should do extensive research on potential candidates and more. Odds are your pest control company is your largest asset and the transaction process can be complicated.