Are add-on acquisitions the best way to create value in portfolio companies? This was among the topics discussed at a recent breakfast roundtable around value creation in portfolio companies. The event was co-hosted by Axial and Strategex and included attendees from private equity firms, family offices, search funds, and investment banks. (See upcoming Axial events here).
Buy-and-build strategies continue to gain popularity in today’s market. Add-ons now encompass more than two-thirds of total deal count in the US middle market, accounting for $111.3 billion through 1H 2019, according to Pitchbook. Middle market add-ons accounted for $245.8 billion in 2018, the highest volume in 10 years and a year-over-year increase of 26.4 percent, Pitchbook says.
According to Bain and Company’s 2019 Global Private Equity report, “Buy-and-build can offer a clear path to value at a time when deal multiples are at record levels and GPs are under heavy pressure to find strategies that don’t rely on traditional tailwinds like falling interest rates and stable GDP growth.”
Inorganic growth has also become an important component of the playbook for many private equity firms as institutional LPs put more pressure on producing returns quickly. “The LPs we work with really value velocity and inorganic growth is one way to try to create value quickly,” said one private equity investor at the breakfast.
At the same time, integrating and growing multiple acquisitions requires a lot of work; the difficulty shouldn’t be underestimated. “Acquisitions are a great way to grow but they come with a lot of risk,” noted another investor at the event. “Cultural fit in particular can be hard to manage.”
For those who do prioritize inorganic growth, keeping a steady focus on integration is crucial. “Successful acquirers embrace the process of integration as the single-most powerful value creation tool available, and view their investment in integration as one of the elemental costs of doing a deal. And they understand that integrating and operating are two different processes, with unique objectives and requiring separate attention and separate skills,” writes Douglas Yorke, Managing Principal at Rumson Acquisitions.
Organic and inorganic growth ideally go hand in hand, another investor noted at the event. “If you start to try to bolt on companies to an inefficient business it’s not going to work. You want to have an organic growth engine that’s working side by side even as you acquire new businesses.”
The timing also needs to be right, cautioned another investor. “A lot of success comes down to sequencing. You’re not going to make a big add-on a year before the exit.”
In their report, Bain notes a few characteristics common among successful build-and-buy strategies, which they define as “an explicit strategy for building value by using a well-positioned platform company to make at least four sequential add-on acquisitions of smaller companies.” These characteristics include:
- The right sector dynamics: “Value creation depends on a steady cadence of acquisitions, which means a sector has to provide an ample supply of targets and a stable environment in which to pursue them.” The ideal scenario is a fragmented industry where there are opportunities to acquire add-ons with lower valuations than the platform company — but of substantial enough size that they are “meaningfully accretive” for the firm.
- Enough white space: This means both enough supply (e.g., retiring founders) and the right level of demand (i.e., not too much competition from other acquirers). “Too much demand for too few targets will drive up prices and compete away the multiple-arbitrage opportunity.” The veterinary space is one example of a sector primed for build-and-buy strategies, Bain notes.
- A stable platform: As noted earlier, the right platform is just as important as the right target. A management team with acquisition experience is helpful, as is systems that run smoothly and efficiently — e.g., IT systems, sustainable financial models, robust sales networks, and more.
- Targets that are close to the core: Bain notes that while it’s possible to add value by moving into adjacencies, the “further a company strays from its core, the greater the chance that something goes wrong.” To minimize risk, look for targets with overlap in customers, costs, channels, capabilities, and competitions — “a rollup strategy assumes significant, if not total, overlap,” notes Bain.