Previously we talked about the state of the industry. Wall Street has arrived in the collision industry. And Wall Street doesn’t play nice when it comes to money.
The insurance companies we do business with every day are some of the most powerful financial institutions in the world. Even the small ones wield huge influence. Their campaign contribution dollars get favorable politicians elected. Their lobby dollars get favorable laws passed (Obamacare anyone?)
In other words, they get a great return on their investment.
For a relatively small investment, they earn massive amounts of dollars in return.
Wall Street buys companies the same way. They call them Leveraged Buy Out’s, or LBO’s for short. Private Equity Groups (PEG’s – pronounced like peg board, not individual letters) gather capital, cash in other words, to invest. But they also use debt to generate what’s called leverage.
At the risk of oversimplification, it’s like buying a house. The buyer puts up 20% and the bank the other 80%. This way the PEG only puts only a small percentage of its capital at risk. The debt is the lever that turns a small investment into a large ownership stake.
Why does this matter to you, dear collision repair operator? Using leverage allows a company to do a few things that regular folks can’t do.
First, it allows larger companies to super size their growth rates. With a relatively small investment, a larger company can grow much more rapidly than a smaller company.
It also creates what’s called a tax efficient capital structure. Since interest is tax deductible, companies using leverage to grow have a lower effective tax rate. Imagine your business is growing at 25% or more a year and you’re paying next to no taxes.
It also allows these companies to engage in capitalization. Capitalization, rather than expensing, is a legitimate accounting strategy where the costs to acquire an asset added to the value of an asset and then depreciated over time. I’ll explain more about the benefits of capitalization in another post.
For the investing classes of the world, leverage allows investors to realize investment gains that are measured in multiples rather than percentages of return. In other words, investors are earning 3 times, 4 times, or maybe even 10 times their initial investments.
Meanwhile you and I are happy if we earn 15 percent.
The LBO model is a tried and true method to grow rapidly in a fragmented industry (sound familiar?). If you think that consolidation is going to slow down consider the following: in a $30 billion collision industry, there is still about $25 billion of unconsolidated territory.
There’s a lot more to discuss about LBO’s in future letters because it WILL reshape how the industry does business.