Here's the car-market play for investors now

The auto industry recovery has been widely celebrated, from Detroit to the White House. It also has created a lesser known but perhaps more durable success story in the market for the products and services that keep all of those cars running.

A Pep Boys Auto Service location in Lakewood, California.
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A Pep Boys Auto Service location in Lakewood, California.

The automotive aftermarket grew 3.6 percent in 2014 to annual revenue of $328 billion, according to the industry group Autocare Association.

Private equity investors have been attracted by this size and growth, with the latest reports focusing on private-equity firms expressing an interest in buying auto-parts and services company Pep Boys. Also this month, Ohio-based private-equity firm Linsalata Capital Partners acquired a majority interest in RWA Holding and its subsidiary, Ring & Pinion Service, which makes automotive aftermarket components under the Yukon and USA Standard brands.

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Both the new car market and the aftermarket have benefited from macroeconomic trends: record low interest rates, increasing employment, growing consumer confidence, and car-maker and dealer incentives. Further, record low oil prices have helped shift demand to higher price-point, gas-guzzling SUVs.

But any investor in any segment of the autos sector needs to ask: What happens when rates go up? The Federal Reserve has hinted multiple times that it will raise short-term interest rates beginning as early as this summer.

Rate increases will have wide-ranging implications for consumers: loans for everything from homes to new and used cars will grow more expensive; employment growth may be tempered; and headline-grabbing equity indexes like the Dow Jones Industrial Average and the S&P 500 could be in for a wild ride.

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Further, baby boomers are buying fewer cars as they retire in increasing numbers and millennials are not making up the difference. All of this adds up to the forecast for a sluggish new car market. This, coupled with growing average car prices (for both new and used vehicles), could lead consumers to defer new car purchases.

But for any investor who worries about the potential for rising interest rates to slow growth in the new car sector, the aftermarket could perhaps provide a somewhat counter-cyclical investment opportunity. Currently, the U.S. automotive aftermarket is projected to grow 3.4 percent annually until 2017, based on data from the Automotive Aftermarket Suppliers Association and Auto Care Association.

It is the total number of cars on the road that drives sales in the aftermarket. That number reached a record 257 million in 2015, with projections for an even higher number in 2016. And all of the new cars on the road that have been purchased in the recent auto-industry resurgence are certainly going to be put to heavy use, with oil prices at a record low and car quality as high as its ever been.

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Also, Americans have learned to drive their cars longer, extending the life of their vehicles with a range of products that make up the automotive aftermarket. On average, the average age of a car on the road today is more than 11 years, up from less than 10 years in 2002.

There are an estimated 500,000 individual businesses in the U.S. that manufacture, distribute and sell everything from car batteries to oil change services. Because of this high degree of fragmentation, the aftermarket is attractive to private equity players. There were 159 private equity transactions in the sector in 2014, up from 140 in 2012. More private equity activity is likely, as buyers add companies to existing platforms and form new ones.

For instance, Spectrum Brands last month agreed to acquire Armored AutoGroup from Avista Capital Partners for $1.4 billion in cash and assumed debt. And Audax Private Equity recently acquired Wheel Pros, a designer of specialty wheels.

The distribution side of the aftermarket has seen a spate of mergers and acquisition activity, too. Last year, retail giant Advance Auto Parts acquired B.W.P. Distributors and completed a $2 billion acquisition of General Parts International, extending its reach beyond North America.

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Where are the safest bets in the sector? For investors, the winners in will be those parts and services vendors with strong brands, high quality offerings and well-established distribution.

Of course, if interest rates remain suppressed or rise too high too quickly, the picture — for investors and the aftermarket companies — could change radically. At a minimum, everyone should prepare for a speed bump.

Commentary by Vincent Carey, managing director at MHT MidSpan, an investment bank in San Francisco serving middle-market companies. 

Disclosure: Neither Vincent Carey nor MHT MidSpan owns any shares of the companies in this article nor do they have any other business relationships with them.