Could today’s increase in “add-on” transactions mean that valuation multiples are on the rise?
Over the past few years, PE firms have been heavily involved with add-on acquisitions, rather than platform companies. (In 2012, add-on acquisitions represented approximately one half of all PE buyout activity.) With the economy on more solid footing, more businesses — including large and small privately held companies — are returning to the M&A marketplace. That means more opportunities for acquiring platforms, and broader possibilities for supporting add-ons.
At the core, these new platform/add-on dynamics are causing a shift in the art of performing business valuations, as value can differ significantly based on the viewpoint of the deal participant. This means it is more important than ever for a company to have a holistic understanding of the market.
What are platform companies? What are add-ons?
The key characteristic of platform investments and add-ons are summarized as follows:
- Platform investments typically include companies in high-growth industries that command significant market share. They often are well managed, are reasonably capitalized and have broad distribution and market exposure. These companies likely have multiple avenues of growth and clear opportunities to leverage their position in the market. They typically command a premium price when sold.
- Add-on companies often aren’t viewed as industry leaders and might suffer from issues with management, undercapitalization, lack of broad distribution or limited exposure to their industry.
Combining platform companies and add-ons through acquisitions can leverage the value of both, considering the built-in efficiencies of combination and the realization of economies of scale.
What are the “buy and build” benefits?
PE players seek the perfect balance between acquisitions of platform companies and value-boosting, incremental add-ons. When fleshing out an offering in one industry — let’s say the grocery business — it makes sense to use a key company’s established name, infrastructure and management capabilities to maintain a stable presence in the market, then leverage the increases in overall value as add-on companies are acquired.
For example, the platform acquisition of Whole Foods, currently valued at $13.9 billion, has rolled in a number of smaller add-ons, including independent grocers, a coffee maker, a vitamin brand and more. These add-ons take advantage of the platform and create synergies that help increase the sales penetration and/or decrease the operating costs for other add-ons. These synergies make both the platform and add-ons more valuable.
Keep in mind, a company might represent a platform to one buyer and an add-on to another. For example, as of the publication date, there were rumors that Whole Foods itself might be acquired by the Florida-based Publix grocery chain, valued at $24.1 billion.
What’s the value of a business that has different values to different buyers?
The simple answer: It’s worth what someone is willing to pay for it.
Platforms and add-ons don’t require different valuation techniques. The valuations of both types of companies use common approaches such as discounting projected cash flows at an industry rate of return, and the market approach, which compares one business to the sale of similarly sized businesses in the same industry. The difference in valuations comes in the art of estimation of the future cash flows, or the level of comparability to sales of similar companies.
It’s critical to clearly understand the companies and the internal factors impacting their attractiveness to the broader market. These include sales, distribution, cost structure, management and capitalization — and the many detailed facets within each of these categories.
Synergies and snags: What’s important to watch?
Analyzing possible synergies makes a critical difference when valuing add-ons. The most desirable add-ons can bring benefits like:
- Lowering costs by merging sales staff with similar expertise
- Expanding sales into regions not currently served, either domestically or internationally
- Increasing product offerings
- Cross-selling/upselling opportunities for existing products
- Eliminating duplicate management
- Consolidating financial functions, such as treasury and tax
- Eliminating idle manufacturing capacity
- Boosting buying power
In recent years, most add-on transactions have involved target companies within the lower-middle market classification, with valuations between $5 million and $50 million. The sluggish economy from 2010 to 2012 presented opportunities to a number of “smaller” companies that traditionally might have been overlooked by big PE firms without the benefits of an add-on. The PE firms’ desire to put capital to work, along with prior platform acquisitions, made these acquisitions logical during this time period.
But generally, lower-middle market businesses haven’t always had the access to capital or professional management to help them intrinsically grow. The benefits afforded by selling to a PE firm help to correct a number of issues. However, the additional costs required to repair a stagnant or troubled company can lower valuations. Some common drawbacks that affect add-on valuations include the following:
- Lack of sales distribution
- Management gaps
- IT fragmentation
- Less detailed accounting and understanding of cost structure
- HR issues, such as increased costs when merging benefit platforms
- Cost of merging operational logistics
The cost and time to fix these common issues affects the desirability and price paid for an add-on.
Since the synergies of a transaction and the associated projected cash flows may vary from buyer to buyer, the resulting valuation by a specific buyer can be different than a market consensus projection. When capitalizing a buyer-specific cash flow analysis, the results of the valuation are often referred to as the “investment value” rather than the “market value” of the business. In today’s fast-paced environment, these variations in perceived “value” are part of what buyers have to deal with when competing for the purchase of a business.
What’s the new art of negotiating?
The right platform companies generally command a premium. Competition sets the price for these companies. With growth in the M&A market and more prominent companies entering the playing field, there’s no doubt we’ll see more deal making — sometimes with hefty multiples paid — for major platforms. In late June, the aluminum company Alcoa announced a nearly $3 billion acquisition of Firth Rixson (owned by Oak Hill Capital Partners), a manufacturer of jet components; Alcoa is attempting to increase its presence in the aerospace market. This is one of numerous examples of the desire to expand market share.
But valuing add-ons gets more complex, particularly when PE firms need to put capital to work and grow acquisition categories. They’re able to offer higher prices, in terms of EBITDA multiples, but that doesn’t always mean they will.
Imagine a lower-middle market grocer. As a standalone company, let’s say the business, which generates $6 million of EBITDA when considering all of its standalone benefits and issues, might receive a five times EBITDA multiple, or a $30 million valuation. However, a prospective PE firm plans to roll up this company into a larger platform, so when considering the combined, projected EBITDA, that’s now $8 million. This might result in a sale that appears to be a multiple of eight times current EBITDA, increasing the value based on the trailing EBITDA and market perception of value by 33 percent.
That’s where negotiating skills come into play. If there’s competition to buy this grocer, then the PE firm might be forced to pay a higher multiple relative to recent transactions for similar stand-alone businesses. This converts some roll-up synergies of the buyer back to the seller, and puts more pressure on the PE firm to intrinsically grow post-merger to justify the premium.
If the PE firm chooses to pass on the deal due to the seller’s request for a higher valuation, then this might mean the benefits of synergy of this potential acquisition will accrue to another PE firm that elects to complete the transaction. Ultimately, the fit with the platform and opportunity for post-merger synergistic growth represent key factors in negotiating the final value between the buyer and the seller.
Where are the big opportunities?
Industries considered “recession-proof” are commanding heavy interest. Oil and gas. Medical and pharmaceutical. Food. Software. Most commonly, deals are sourced by investment bankers working on the buy or sell side, looking for ideal targets to maximize value.
Some PE firms search for complementary companies shortly after platform acquisitions, if there’s not much work needed to stabilize the platform company. For other platform deals, the process is longer and more complex and thus delays the process of finding add-on candidates.
As for businesses, is it better to be acquired as a platform or add-on? It’s situational. Platforms traditionally command a premium. But the right add-ons, though they might be smaller, may negotiate similar, higher multiples in the right circumstances.
What does this mean for PE firms?
Negotiations are rarely straightforward, and calculations based on synergies and costs are only becoming more complex. Is there a simple formula for choosing the right valuation for a platform or add-on? No. But understanding the total picture and the benefits of combination is key to increasing the leverage of acquisitions and overall value.