General partners may insist that buy and build has always been popular, and is indeed central to the industry’s value creation proposition, but the level of recent activity has been particularly robust.
In the third quarter of 2015, platform companies executed 125 add-on transactions in Europe, the highest in a quarter since Q2 2008, and 404 add-ons over the year, up on 2014, according to Silverfleet Capital’s report European Buy & Build in 2015.
The reason is clear: performance. A Boston Consulting Group (BCG) study, which describes buy and build as the “PE value creation strategy of choice”, shows investments in which a portfolio company acts as a platform for further add-on acquisitions outperform standalone deals. Buy and build transactions generate an average internal rate of return of 31.6 percent from entry to exit compared to 23.1 percent for standalone deals, according to BCG.
Among value drivers, consolidating a fragmented sector through M&A promotes cost and revenue synergies, accelerates scale and operational improvements – including the acquisition of new capabilities, products or technology – grabs market share, and facilitates rapid geographical expansion, with the additional promise of growth through future acquisitions.
And the price impact of add-ons is appealing. The potential for favourable post-synergy adjustments on the entry multiple is always attractive to investors. In the current high price environment and abundance of dry powder, add-ons provide GPs with a route to deploy capital into smaller businesses, typically through a proprietary process and at more competitive values than bidding on larger targets in an auction.
Add-ons are usually less risky than a standalone deal, notes one European GP. “You have a management team you’re already comfortable with [at the platform company] who can help you with the strategic rationale for the add-on, in an industry where you’ve already conducted due diligence because you own [the platform]. The decision is much more likely to be focused in the right areas than if you’re buying a platform.”
Developing a relationship with the management team executing the investment thesis is critical. “Management can usually do a pretty deep dive on what the synergies might be, which ones make more strategic sense, which are operated in a way that will be complementary rather than destructive to their own structure,” says the GP. “If you have a bad relationship with management, then doing M&A and allowing them to stay in charge is quite risky. It’s very important for them to think you bring something. If they begrudge you as an annoying shareholder who just analyses their performance, that relationship doesn’t work.”
With many add-on targets too small to be sourced by advisors, firms are typically dependent on management to generate deal flow. “Buying through your portfolio company, you rely quite heavily on management to have the connections within that sector and bring the transactions,” says Ashurst partner Nick Rainsford. “It’s important that they are well-known in the market and alert to the opportunities.”
Management teams with an acquisition track record are therefore very appealing. “If the CEO and CFO of a portfolio company have already done an acquisition or two, got it under their belt, and had the experience of integrating it, that is very positive because it’s no longer idle chat,” says Silverfleet Capital managing partner Neil MacDougall. “If you’re a regular acquirer of businesses, you are more likely to get them right because you’ll have learnt the key things to look for and you would have adopted some of the disciplines that stop you doing things that are too difficult or too dangerous.”
One way to ensure management engages with the strategy is to give them ownership of the M&A process, he says. “That means the CEO, CFO and whoever is in charge of production and sales absolutely need to be completely involved and the deal has to be theirs. It is one of the things some corporates get wrong, the idea that there is a strategy and you [simply] delegate it to management to make it happen. It rarely works.”
But, the European GP warns, the private equity firm needs to monitor the process and ensure management does not get “starry-eyed” at the prospect of running an enlarged business and misjudge opportunities.
In the face of other tasks competing for attention, the GP’s role is to ensure the management team stick with the M&A strategy in line with the value creation vision.
“When we review portfolio progress on a quarterly basis, one of the key questions is: where are you getting to in terms of implementing your value creation strategy, which in many cases means those bolt-ons you wrote about in the investment paper, and have we made any progress in making them happen,” says MacDougall.
He adds: “You have to remain disciplined and when due diligence [of a target] turns out to reveal things you didn’t expect to find, you need to be able to walk away.”
Beyond picking the right targets, the post-acquisition integration of businesses – including of management teams – will determine the success of a buy and build strategy and the possibility of value creation, GPs say. Management inexperience, lack of bandwidth and a clash of business cultures are all elements that can sabotage the integration process.
“Whether or not your management team can deal with all the social issues around managing a larger organisation post-acquisition is a risk that belongs to the GP rather than management,” says the European GP. “Management come in different shapes and sizes. Some can be unused to buying smaller companies and bolting them on, and sometimes they can adopt an attitude that alienates people. You have to make sure you keep them on a straight and narrow.”
Losing key talent can be hazardous and is likely to be value destructive unless accounted for in the business plan. “The thing you’re after is the people,” says MacDougall. “It’s their know-how, their contacts, their experience, their track record, their customer relationships. As long as you remember that’s really why you bought the company and you go out of your way to make sure you hang on to it, then you’re likely to make a successful acquisition.”
To skilfully manage the relationship with senior executives, GPs emphasise the advantage of having a buy and build track record themselves. What firms know intuitively is supported by data. Frequently acquiring firms generate average IRRs of 36.6 percent on deals, compared with infrequent acquirers with IRRs of 27.3 percent, according to BCG.
Experience, in this case, creates value.