Buy/sell activity remained very robust in 2018 – the fifth consecutive year of over 200 transactions. Underlying today’s robust buy/sell market is the growing U.S. economy. GDP increased 4.5% in the third quarter and wages rose at 2.9%, the highest level since 2009. With the unemployment rate at 3.7% (the lowest level since 1969), consumer confidence hit an 18-year high in October. The strength of the U.S. economy is sustaining auto retail’s high sales levels and today’s active buy/sell market.
With this strong backdrop, below are the key trends my firm sees shaping the 2019 buy/sell market.
Generational Transfers Increase the Number of Sellers Coming to Market
The auto retail industry is primarily a family business. For decades, dealers have passed their businesses onto the next generation with great success. This transition from generation to generation defied the family business odds. Only 30% of family businesses are expected to transition to the second generation. By contrast, Kerrigan Advisors estimates the majority of today’s dealers are second generation or greater. Auto retail’s succession record is a statistical aberration.
The challenge today comes as a growing number of third and fourth generation dealers are aging into the succession plan. Kerrigan Advisors believe most dealers are currently in the process of transitioning a portion of management and ownership from one generation to the next, with a significant number in the third and fourth generations. These generations have a much lower likelihood of successfully taking over the family business. Only 12% of family businesses transition to the third generation and only 3% to the fourth. (See Chart I)
As an increasing percentage of the dealer body fits this generational make-up, it is not surprising to see more sellers coming to market. As the number of dealers continues to decline and the store count required for success rises, many of these families realize the skillset required to run a handful of dealerships is quite different for a large multi-dealership group. This is particularly true for the third and fourth generations who are in their 20s and 30s. These up-and-comers see an industry that will transform significantly over the next 20 years, making their careers more volatile and challenging. Some are concerned that the value of their inherited family enterprise will decline, rather than appreciate. These risks, coupled with the challenges associated with transitioning to higher generations will continue to be a driving force for further industry consolidation. (See Chart II)
A Growing Pool of Financial Investors Support Consolidation
With all the change expected in auto retail over the next two decades, it may seem surprising that financial investors are eager to support dealers’ expansion plans. The volume and interest of equity and debt investors in auto retail continue to rise, despite the much-discussed risk to the industry’s future. For the same reason some dealers feel the time is right to sell, an increasing number of sophisticated investors believe the time is right to invest. These well-funded investors see a tremendous opportunity to support growing auto retail groups who are seeking to capitalize on consolidation and the inevitable opportunities industry disruption will create.
The make-up of these investors is broad and diverse, from high net worth individuals to institutional investors. On the equity side, family offices are the most common because their long-term investment strategies are aligned with those of the OEMs and thus approvable in a buy/sell. In addition, OEMs are more comfortable with the family office structure/governance because it is very similar to that of the large family-owned dealership groups. In fact, many of the largest auto retailers have their own family offices for investment purposes.
On the debt side, the largest U.S. banking institutions continue to finance sizable acquisitions for growing dealership groups. These lenders focus on identifying the dealers who will drive industry consolidation and want to ensure they are part of the tremendous financing opportunity consolidation will provide. They also feel a sense of urgency to develop relationships with buyers, rather than sellers, to retain market share in the long term.
In addition to traditional lenders, bond investors have shown a willingness to finance private group expansion and buyouts. Most recently, the Ken Garff Automotive Group, one of the largest private dealership groups in the U.S. with over $4.5 billion in revenue, successfully sold $375 million worth of bonds to finance the buyout of its equity partner, Leucadia. Garff’s buyout of Leucadia, which is the largest transaction of 2018, resulted in an enterprise value for Garcadia of $675 million. Garff likely chose to finance the buyout with debt, rather than equity due to the lower cost of capital charged in the bond markets. Garff’s bonds pay a 7.5% interest rate, which may seem high relative to traditional bank financing; however, it is very low relative to private equity which usually requires at least a 20% return (as can be seen in Leucadia’s high returns noted in Chart III).
As auto retail continues to consolidate, Kerrigan Advisors expects the pool of capital available to growing dealership groups with well-conceived expansion plans will increase, providing multiple financing options for growth.
To Achieve Pricing Goals, Sellers Increasingly Accept Structured Transactions
Blue sky multiples have remained relatively consistent in 2018, despite the industry’s sales plateau. Seller’s understand their blue sky may have declined due to lower earnings; however, they still expect a strong blue sky multiple in order to complete a sale. This can be tricky for buyers in a rising interest rate environment where their cost of capital is also increasing.
Kerrigan Advisors finds the most innovative buyers are meeting seller’s pricing expectations and their own return on investment requirements through structured transactions. These transactions usually include some form of seller financing and/or the retention of a minority ownership stake by the seller (also known as “rollover equity”). In both cases, these structures reduce the equity capital required of the buyer and thus increase the buyer’s return on equity, while still meeting the seller’s pricing expectations.
In the case of rollover equity, the seller usually retains a minority ownership position in the dealership post-transaction. Unlike traditional buy/sells, which are typically asset sales, these transactions are usually stock transactions and subject to increased government oversight, particularly as the transaction increases in size and complexity. In most of these transactions, the seller contributes their business’ assets to a new legal entity which then sells stock to the buyer. It should be noted that only brokers who are licensed with FINRA and regulated by the SEC are legally permitted to sell stocks or securities in a private company with few exceptions. A buyer could rescind the transaction after closing if it is found that the seller is not represented by a licensed broker.