This article is sponsored by PwC
Buy-and-build has become one of the most popular strategies for creating value in portfolio companies. PitchBook data suggest that add-ons account for around 70 percent of US buyout activity today.
That is up markedly from 2006, when less than half – just 46 percent – of deals done by US private equity houses were acquisitions by portfolio companies.
While the strategy has been around for a long time, the rise of technology and digitisation has made buy-and-builds an even more attractive option for private equity houses as industries seek to create new business and operational models.
A recent PwC survey, Private Equity Trend Report 2019, found, for example, that digitisation was among the top three most important influences on equity stories for acquisitions this year.
We caught up with PwC’s Friederich von Hurter, M&A integration partner, and Filip Debevc, senior manager, deals, to explore how M&A in the digital era is driving value in private equity portfolios.
What are the key trends you are seeing in buy-and-builds today?
Friederich von Hurter: One of the most important trends we have seen over recent years is that the old way of doing things – the pay and pray strategy – does not work anymore in private equity. Firms are having to be highly creative in identifying value-creation opportunities.
Buy-and-builds are one of these opportunities and have really come to the fore recently as industries and markets are being transformed by the arrival of technologies such as big data and digitisation tools. Many investors are looking to create value out of two or more legacy companies by combining them to create a greater momentum in growth and scale through the deployment of these tools, while also building on classic cost synergies.
This is also a strategy being used to mitigate against the high valuations we see in the market today. Firms are having to create strong equity stories and the buy-and-build is a familiar and tried and tested vehicle for value creation.
In addition, we are increasingly seeing private equity players team up with strategic buyers, which can bring not only financial power to the table, but also deep industry and market knowledge. They are able to provide a real boost to companies already in the portfolio.
Why do you think private equity firms are looking to strategic buyers as partners?
Filip Debevc: Dry powder among private equity firms has increased and so, therefore, have competition for deals and multiples paid for businesses. Attractive targets have become rarer. Bringing together the different points of view of strategics – with their ability to implement new processes and their in-depth knowledge of industries – with private equity’s value creation mindset creates a good equity story.
How does that play out when it comes to exit?
FvH: The fact that you are creating businesses of scale through buy-and-builds provides good opportunities at exit.
If you are putting together enterprises, you can not only achieve a higher value, but you can often create businesses of the size that attract the attention of public markets. IPOs or other floating exit strategies come into play and that in itself creates value for investors.
And so how are big data and digitisation being used to create value in buy-and-builds?
FvH: These are mega-trends that all industries are getting to grips with. Companies are trying to create new business models from heritage or legacy organisations. Business owners, including private equity firms, need to use big data and digitisation as a toolkit for this shift in any case, but when you add in buy-and-build strategies, the potential is much greater.
Big data and digital tools are clearly very different from bricks and mortar – they can be used and reused across structures, legal entities, channels, geographies and so on and they can be deployed quickly. They are very good tools to create value quickly across a combined entity and build modern operating models.
In terms of how that can create top line value, you have data that can be used to share customer insights, predict their needs and requirements and you can combine products and services to increase customer convenience.
There is real value to be created by adding new capabilities, services and products through buy-and-build acquisitions to serve customers better, based on these insights. You can create vertically integrated organisations around customers.
Can you provide an example?
FD: One recent example of a deal we worked on had a significant effect on the cost-line. Digitisation allows companies to virtually outsource processes that are not strategically important.
In this deal, we helped combine a company that was outsourcing using the cloud with an existing portfolio company, which hooked into this virtual outsourcing. The cost line improved by 16 percent and the value increased significantly – you can create value immediately this way.
How can buy-and-builds today help optimise working capital?
FvH: When you are combining two businesses, working capital can become a synergy-creating opportunity in itself – it is the way many CEOs see it. So, you can share exposure to customers and suppliers and if you can virtualise this, you are unlocking synergies.
For example, you can create a virtual warehouse by sharing information gleaned through data-mining around what products and services you need in stock to meet customer requirements. This opens the synergy bucket in a way you simply could not do 20 years ago.
This has an effect on capital expenditure. If a company invests in a certain methodology and its infrastructure, when you combine the businesses, they can share the cost of periodic refurbishment. By creating vertically integrated organisations, you are adding value by reducing the amount of capex needed for each part of the business.
You mentioned modern operating models. What do these look like?
FvH: Under a modern operating model, you do not think along functional lines anymore. Companies are concentrating their value chain around the customer, where the value chain is the product or service that the customer pays for. The operating model therefore goes across countries and beyond pricing optimisation, for example.
Processes are not only improved end-to-end or digitalised by shifting manual workforce to automatised processes like RPA. A modern process on a digital operating model happens simultaneously.
Also, there are no longer cost centre buckets. Instead, you have people working together across functions to create something a customer will buy. By employing a modern operating model, you can avoid certain exposures and cost friction.
If we take the example of Amazon, when you buy something, it will often come directly from the product site, it is not touched by Amazon or even the trader – it may not even touch the balance sheet of the trader. It is the operating model for a connected and integrated world.
That is quite a transformation for many businesses. How can private equity firms create such organisations within their holding periods?
FvH: One of the biggest shifts is in due diligence. The legacy way of doing this is to look at the past and try to reduce risk, praying that the business will develop well in the future. We do not think that is appropriate in today’s world. You cannot just look at the past; you have to invest in and investigate what will be possible for the future.
As a result, value creation has to start at due diligence phase, embracing the whole gamut of financial, operational, tax, legal and structuring and looking out to future potential. You need to create a single, sophisticated equity story rather than conduct silo-based due diligence.
To what extent is this enhanced due diligence a feature of deals today?
FvH: Most sophisticated firms are now taking their time ahead of investing to work out what immediate benefits they can generate from being proactive.
They are spending less effort on pure financial reports than was the case in the past – the work we do now centres around helping clients see how they can take an integrated approach to value creation across the strands of operations, strategy and commercial improvements.
The new way of a due diligence process also includes more and more a big data analysis, not only to better understand the past but also to initiate a data driven future strategy and operations. In a best-case scenario the seller has prepared sufficient data extracts for the confirmatory phase. A potential buyer will conduct a first big data analysis on, for example, detailed sales and customer data or detailed procurement data down to the purchase order level.
In any case, auctions are so tight these days, you do not have time to write books anymore, so you need to work fast to create an integrated view of what you can achieve with the company. Hence, value creation starts with the due diligence processes.
How do you see these trends developing further?
FvH: We will see further digitisation and virtualisation of business processes as companies and industries focus here to drive efficiency, create new opportunities and increase revenues. We will see new business models run in parallel with legacy organisations at first, but eventually, companies will no longer be product companies or trading businesses – they will go across the value chain to meet customers’ needs and this will move companies to the modern operating model.
Buy-and-build is an enabler for this: instead of taking time to develop a new capability within – for example – your logistic team in-house, acquisitions speed up the transformation and the improvement of your value chain functions or of your support processes.
We will see more buy-and-builds as a result, in particular as the scale achieved by buy-and-builds offers more exit routes for private equity firms, with dual track processes more achievable. In addition, private equity is proving increasingly attractive for investors and capital will continue to flow towards the asset class. Firms will need to build bigger and more equity stories to deliver for their investors.