Consolidation has become a driving force for M&A in the U.S. car dealership space, with autonomous vehicles, ride-sharing and other influences contributing as well. An estimated 1,080 car dealerships were sold to 612 buyers between 2014 and 2017, reports Kerrigan Advisors, an Irvine, California, sell-side advisor to auto dealers. The number of U.S. dealership groups with more than 10 dealers rose to 141 in 2017, up from 90 in 2011. We asked Stephen Dietrich, a Denver-based Holland & Knight attorney with an auto dealer M&A practice, for his thoughts on trends in the space and what middle-market private equity firms should consider when looking at potential deals for car dealerships.
What is driving M&A in car dealerships?
Several factors are pushing current activity. There is a growing number of current dealers who are looking to exit the space either because of succession issues or from a desire to not have to work through the coming changes in retail automotive. There is an aging dealership owner body and many of these owners either do not have family to take over the business or there is not the talent available to pass the dealerships to the next generation. In addition, there is tremendous innovation and change occurring in the industry and when that occurs there are usually two camps, folks who see change as obstacles and others who view change as a significant opportunity to enter markets and industries. This dynamic is creating anxious sellers and aggressive buyers. Finally, there is a reality in the industry that the traditional one- or two-dealership operation is struggling or will be struggling soon in many markets. Consolidation has always been a factor in auto retail, but there is a significant increase in the market view that consolidation will be necessary in many markets to survive and thrive.
Why are car dealerships attractive to private equity firms?
There are several businesses involved with the operation of a new vehicle dealership--new vehicles, used vehicles, service, financing and insurance, at a minimum--so there is a diversified revenue and profit model, which helps to combat cyclicality. A well-run dealership can provide high returns on invested capital and free cash flow from operations. So, there is a potential double benefit to the investment because the asset itself can appreciate, but while that is occurring, the business is also generating annual cash flow that can either be reinvested or harvested. In addition, there is a natural barrier to entry through the original equipment manufacturer (OEM) approval process, so deciding to get into the industry is not a decision as easily undertaken as with many other industries. The process to obtain approval is thorough and potentially requires thoughtful modification of typical investment models or operational models, but the benefit of being in an industry that is not fully fluid and profitable can be very attractive to the correct investor.
What are the notable middle-market car dealership deals in recent months?
- Day Automotive Group in Pittsburgh purchased by Lithia Motors Inc. (NYSE: LAD)
- Grossinger Auto Group in Chicago purchased by AutoCanada (TXS: ACQ)
- Six Prestige Motors dealerships in New Jersey and New York purchased by Lithia Motors
- A majority stake in Prime Motor Group, based in Westwood, Massachusetts, acquired by Capstone Automotive Group, now Prime Automotive Group, a GPB Capital company
What advice do you have for PE firms considering investing in car dealerships?
Take the time to learn the industry and what makes a dealership profitable. I realize this sounds like generic advice that anyone should take for any industry, but the dealership space is unique in both its operations and in how M&A deals get done. The accounting methods and conventions are unique to the industry partly due to the different businesses being run under the dealership and partly due to the manner in which revenue is received and recognized from different sources. All of this results in a need to understand the operations in detail to fully comprehend the financial statements and operations. With respect to the M&A process, there is a break with what we see in many other industries relating to documentation, diligence and process. In many other industries full diligence is completed as the main transaction documents are drafted and negotiated, with final execution of the definitive agreements occurring after all diligence is complete. In the auto retail space there is often initial financial diligence done, but then the main acquisition documents are often negotiated and executed with confirmatory financial and operational diligence and real estate diligence to follow. This is historically driven because the OEM needs to approve the transaction, and under most state laws that approval process takes at least 60 days. So, the convention in this industry developed to move to an executed document so that the OEM would be able to begin its process and the diligence would proceed after execution so that the deal time frame would be reduced as much as possible.
The other significant aspect of an M&A deal in this space is the OEM approval. This is not only an approval based upon financial considerations, but also a review of how the relationship between the capital partners and operators works. The OEMs in this industry are highly focused on ensuring that an individual person who understands the business has day-to-day operational control. This aspect of the approval is something any private equity investor will want to understand and internalize. I have seen this create significant stress with some investors because the level of control provided to the operator is significant. It is possible to have investment protections, but they are more nuanced in this industry so the PE investor will want to understand the requirements and how those will interact with investment and operational models.
What other trends are affecting deals in the auto sector?
Autonomous vehicles will affect what kinds of cars are purchased and who actually owns the vehicles. We are starting to see subscription services from the OEMs and some dealer groups, which will affect if a vehicle is purchased, and related financing and warranty work that dealerships often rely upon. Ride-sharing services such as Uber and Lyft will impact dealerships, from who may be purchasing the vehicles to opportunities for steady-stream service arrangements. Dealerships are needing to shift from a focus on the buying, selling, financing and servicing of cars to a focus on being a transportation solution, which requires a much broader world view and will necessitate significant change in the industry. The question is how long will the changes take, and in most markets, which changes will actually come to fruition. For example, it is more likely that a subscription or shared-ride service develops in certain metro areas more quickly than in rural areas of the United States.