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On the Challenges and Opportunities we see When Investing in Rollups

By : Ziad K. Abdelnour| 1 May 2010
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For all those not familiar with rollups….. A rollup is a technique used by investors where multiple small companies in the same market are acquired and merged. The principal aim of a rollup is to reduce costs through economies of scale. Rollups also have the effect of increasing the valuation multiples the business can command as it acquires greater scale. Rollups may also have the effect of rationalizing competition in crowded and fragmented markets, where there are often many small participants but room for only a few to succeed.

An investor faced with an opportunity to invest in two competing companies may reduce risk by simply investing in both and merging them. Rollups are often part of the shakeout and consolidation process during an economic downturn or as new market sectors begin to mature.

Rollups of complementary or unrelated companies are also done to:

• Build a full-capability company, when it would be too costly or time consuming to develop the missing pieces through internal expansion.
• Blending companies have different financial metrics, often to make the combined company attractive for investment, mergers and acquisitions, or an initial public offering.

In general, and although a number of rollups don’t have a great track record, we believe going this route can yield much better returns at large than acquiring an established business or funding a startup. It is a fact that you can achieve an operational multiple and see an uptick in market multiples when going for a roll up while for an established business or a startup you could have to do quite a bit just to get to a significant multiple.

While Primedia, for example, is probably better remembered for the acquisitions that failed — such as About.com — than the deals that built the company — and while its divestitures left more of a mark, as the company had to sell such titles as Seventeen and New York Magazine, when it ran into credit issues early last decade, the number of successful rollups such as Riordan, Lewis & Haden’s initiative in the consumer durables space, Fonezone, ABC Learning Centres, etc…. don’t necessarily generate the headlines in the Wall Street Journal that KKR’s efforts seem to produce. Also, and while in Primedia, one of the largest roll-up plays out there, KKR tried to build a leveraged company from scratch, we believe this was a monumental mistake for the idea of a rollup for us isn’t an option of last resort or a response to weakened credit markets. It all rather goes back to the theory that strong management actually trumps the quality of assets when it comes to achieving returns. Would you rather in an ‘A’ business with a ‘B’ CEO, or an ‘A’ CEO and a ‘B’ business?’ For us at Blackhawk the latter scenario always wins out.

So the Key issues we look at when structuring industry roll-ups and to maximize the likelihood of our success and for you to consider are issues such as:

1. Is the industry suitable for consolidation ?

It is important to consider industry dynamics both pre and post consolidation. The implementation of your roll-up is likely to change the competitive landscape, sometimes dramatically. How will other competitors react to the aggregation? Will customers see the consolidation as beneficial? Hence, when determining whether an industry is suitable for consolidation you should consider:

Is the total size of the industry big enough to generate economies of scale ? For example, with funeral homes, economies could be generated through centralized bulk purchasing of caskets or flowers.

Will consolidation generate cost synergies ? For example with veterinary services, standardized operating and pricing policies amplify procedures and reduce customer uncertainty.

For example, if the customer interface represents a high percentage of the costs, the opportunity for economies of scale is limited (e.g., dry cleaning).

Some businesses benefit from being small, innovative, localized – values which are not always enhanced by size (and hence less suitable for consolidation). For example, a boutique hotel attracts customers by being “unique” not commoditized….and so on and so forth.

2. Have you determined the ease and cost of acquisitions ?

Another important element of a successful roll-up is the ease and cost of acquisitions. As you know, the professional costs of acquisition, including legal, accounting, tax and strategic due diligence can be significant.

Hence, if you are seeking to buy businesses with a high risk of contingent liabilities, complex financial histories, uncertain/unstable forecasts then due diligence might be prohibitively expensive. Something to watch out carefully.

3. Do you have a strong platform ?

A key criteria of success would appear to be that the “host” or “platform” has:

• An experienced management team;
• Sound proven business model; and
• Well developed and scalable systems and infrastructure.

Trying to bring together a large number of equally small and unsophisticated companies is far less likely though to succeed.

If on the other hand you have a strong host business with a proven track record it will not only serve as the “hub” of your operations, but also demonstrates to other targets what can be achieved with the right systems and forms a yard stick for assessing targets.

Typical “platform” we at Blackhawk use has an EBITDA of at least $5 million over the last twelve months as we believe it is way safer to build the foundation of our enterprise with a real healthy platform than a shaky one.

4. How many bolt-ons should be acquired?

The issue of how many bolt-ons should be acquired will depend on a number of factors:

• Growing too quickly restricts the ability of management to integrate the existing bolt-ons (both operationally and culturally);
• Not enough, may not give you the scale you need to utilize the costs synergies/buying power;
• To achieve exit through an IPO requires a minimum market capitalization of $100m (to justify costs of listing, shareholder spread and analyst coverage etc);
• It will be easier to integrate a large number of small retail outlets or service businesses than large/more complex businesses (such as manufacturing).

Another great benefit we find in roll-ups v/s buying a standalone business or funding a start-up is basically the ability to arbitrage the difference in earnings multiples between private and public companies.

Small private companies as we all know can be usually acquired for a lower earnings multiple than a publicly listed company. The sponsor can generally acquire a number of small companies for say 3.5 or 4 times EBITDA and then undertake a public offering at 7 or 8 times EBITDA. The higher multiple is achievable due to the liquidity and transparency (due to audited accounts and continuous disclosure) of public markets. In addition to the earnings multiple arbitrage, some of the benefits that consolidation may generate include:

• Cost synergies such as cheaper insurance, merchant fees and buying power for stock;
• Revenue synergies: including cross-selling of products / services and introducing large clients into other regions;
• Brand: superior brand recognition;
• Capital: access to (cheaper) capital which is an ancillary benefit of not only the scale of the consolidated group but private equity backing;
• Leveraging fixed costs: spreading fixed costs (such as HQ or sales /marketing costs) over a large revenue base;
• Corporatization: such as the introduction of a head office with access to more sophisticated IT systems and accounting systems. A key benefit of this is freeing up the time of the founders to get on with their business (rather than spending all their time doing administration, chasing bad debtors or paying bills);
• Succession: many small business owners lack natural succession plans and the roll-up provides them with a future retirement plan.

On the downside it is clear that consolidation usually brings enormous integration difficulties, clashes of culture/ego, and other risks such as:

• Integration risk: It will be difficult to integrate the different businesses acquired as they will all have different systems (including IT, accounting and business systems), management styles and cultures. The more companies acquired the greater the integration risk;
• Increased costs: sometimes the cost synergies don’t outweigh the additional costs of a head office (salaries and lease expenses);
• Non-alignment of incentives: once the founders have received a large cash payout as part of the rollup they lose focus and become distracted by their new found wealth (decisions about which super fund to invest in and what holiday house to buy) rather than driving their business forward. In some recent deals, there are numerous cases where the founder actually leaves the group to start a new competing business;
• Cultural issues: often the bolt-ons are run very informally with little or no corporate governance mechanisms in place and with limited finance/reporting systems. Under the new regime they will inevitably be forced to deal with a more formalized culture with far stricter reporting requirements and governance;
• Execution risk: should not be underestimated and applies at both the acquisition stage and eventual exit stage. The greater the number of counterparties to be negotiated with, means the greater the risk that the deal will not go ahead and also increases the risk of “green mailing” where one stakeholder seeks to hold up the consolidation or the eventual exit by relying on some technical right (in other words refusing to sign the relevant acquisition or sale documents) to get a special deal.

The risks outlined above can be however mitigated through the careful implementation of the following strategies:

• Clash of personalities: Use a governance model that is founder centric (e.g. The founders retain a majority of the equity, the CEO is appointed by the founders and the majority of the board is appointed by the founders).
• Clash of culture: Use a “push” rather than “pull” strategy for new policies and procedures. In other words, it is up to each founder whether they accept certain policies rather than it being forced upon them.
• Execution risk: To minimize “deal risk”, if possible, use one lawyer for all vendors, use standardized set of legal documents for all vendors, and same acquisition model for all vendors.
• Integration risk: Consider whether a decentralized (or federation) model is appropriate rather than a centralized structure. While it makes sense to integrate/centralize certain aspects of the business (such as corporate governance, financial controls/reporting and management of future acquisitions) full integration is not always necessary.

Another issue is aligning incentives for vendors to stay involved with the business into the IPO and beyond. This will be combination of “carrot and stick”. The “carrot” will be options over additional equity or cash bonuses based on the performance of their original business (not just the group) and the “stick” will be:

• Long dated restraints of trade for say 3 to 5 years
• Deferred consideration conditional on meeting earnings targets
• Rights of set off for deferred consideration against warranty claims
• “Good / bad leaver” provisions
• Escrow over shares to apply during the restraint and also for a period post any IPO
• Minimize upfront cash payment to vendors (to say 20% of total)

Looking forward to doing business with you and to continue being your resource for deals, capital, relationships and advice.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Comments

  1. AndreiAndrei

    Ziad, Loved your roll-up review, and glad to hear that you are interested in them. I am in the process of preparing a technology led roll-up that will start the consolidation drive of a global industry which is very fragmented and characterised by medium sized privately owned companies (in the $50-$250 MM Revenues). The Platform leader is a relatively small company which developed and very successfully commercialised a new “world beater” technology in its sector. The new technology improves the value added to the Value chain, by a factor of 15! The company has as its clients some of the best names in its chosen target market. I anticipate that within 2-5 years we could accumulate at least 5-8 aquisitions for a pre-synergies and technological upgrade (to the “Platform” company superior tech) of $800 MM in Revenues, which should double for each of the group’s companies within 2-3 years. In addition there are opportunities for bolt-on aquisitions of complementary suppliers etc. Looking to create a $50-%150 MM SPV through which to execute the acquisitions/investments in the targets. Red-Herring should be ready by Mid September. Let me know how you would like to proceed.

  2. John FontanaJohn Fontana

    To Andrew’s point, and from a CEO’s perspective, it is critical these days to have both a solid operating business and a well funded PE sponsor. In these times both hick-ups in company performance and momentary gaps in PE fund cash availability can casue a great deal to be laid to the side. When that happens – and it may be inevitable when it does – the firm and the PE fund both share blame for missed opportunities.

  3. Enzo VillaniEnzo Villani

    Ziad, This thread is excellent in identifying the key areas. One comment that seems to work in “people” or businesses that have a consulting component to them is using earn-out structures and reinvestment by key managers into the parent entity. This reduces flight risk and aligns goals across the team of organizations. Within those goals, integration and “playing nice” goals should be built in also. The decentralized and centralized models can also be adapted based on the type of business you are in. From a business perspective having multiple organizations less centralized in brand and resources allows for each of the companies to retain clients that in an integrated company could create client retention issues due to a perceived conflict. This same company could migrate to a technology environment that is a “cloud” structure, allowing cost reduction synergies and systematic support of all companies in the holding organization.

  4. Steve HudsonSteve Hudson

    Ziad: I think you have hit most of the cautionary points. I would add that the business model should be able to be implemented at every acquisition, which assumes that you have a very good model at the platform company (especially cost reduction and growth strategies). And I agree that you need an experienced management team in place that knows the sector and how to extract more value from it. Geographical dispersion would also seem to be a given unless you can consolidate small regional players to create a regional share dominator. Best, Steve

  5. Andrew ErosAndrew Eros

    Ziad, Very good thread. There is one important addition to the considerations / risks you point out. It is just as critical for a roll-up group to find an insightful PE partner as it is for the PE to find a well managed roll-up group. Synergies at the top help lead synergies within.

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