By Carmelo Spallino and Federico Sanvito
Buy-and-build strategies are acquiring an increasing role in the private equity market, principally in Italy where they accounted for 25%, on average, of private equity investments made between 2011 and 2015.
The term refers to multiple acquisition made by the same private equity operator in order to create value thanks to the merge of two or more companies. The first company bought is called platform and through it one or more targets are acquired.
A recent report from Silverfleet Capital, which monitors the Buy & Build activity, shows an increase of about 30% in the number of add-ons in Europe from H2 2015 to H1 2016, achieving 325 add-ons in this last semester and reaching the highest level since 2008. Historically, the Buy & Build volume has shown a strong positive correlation with the number of PE buyouts and has followed the trend of the M&A index. As we can see from the graph below, there has been a divergence in trends, with the out-performance of add-ons relatively to the other type of transactions.
Figure 1. Annual volume of add-ons. Source: Silverfleet Capital
Value levers on Private Equity Investments
Before properly define what a buy-and-build strategy implies and what are the main reasons behind it, we briefly summarize the value drivers in a PE investment, making reference to our previous articles for further details.
The final aim of a private equity operator is the divestment of the participation realizing a capital gain. This characteristic makes a distinction between the industrial investor and the financial one such as the private equity fund which operates on a mid-run horizon aiming at an operating and financial improve of the company in order to achieve the required return on the investment.
Private equity funds increase the value of the company acting on three levers:
Exploiting the positive differential between enter and exit multiple (arbitrage on multiples)
Increase of the venture-backed company debt (exploiting the benefits of leverage)
Increase the operating efficiency (performance arbitrage).
The figure below better summarises this concept.
Figure 2. Value Levers. Value creation on a private equity investment
In an economic slowdown as the one that characterized the years after the 2007/8 financial crisis, new ways to achieve the planned financial return on the investments had to be found. In fact, the difficulties to obtain interesting and profitable exits for the investments, that are reflected in the increased holding period of participations after the crisis, push private equity operators to look for alternative ways to enhance the value of the target companies in order to maintain a reasonable holding period, avoid the value dilution of the investment throughout time and meet the planned return. Thus, add-on strategies through synergies creation, know-how sharing, size and negotiation power increase and the fastest external growth linked to them became a natural solution in such a context.
Value levers on private equity investments introducing add-ons
In principle, add-on value creation process could exploit each of the three levers presented before. In fact, the arbitrage on multiples mainly is linked to the increased size (based on an accretive strategy) of the conglomerate and, consequently, its higher negotiation power. Also the financial arbitrage seems to leave room to important opportunities. Indeed, the target should be usually able to raise new debt with advantages mainly represented by the fiscal benefits linked to the accounting for interest expenses on debt and the greater final return with respect to the same capital thanks to the use of leverage.
However, as the research of SDA Bocconi Private Equity Lab demonstrates for add-ons carried out between 2007 and 2012 in the Italian market, the performance arbitrage is the main driver perceived and exploited following such a strategy. Following this, let’s look better at all the reasons behind a buy-and-build strategy.
Figure 3. How Add-ons act on the Value Drivers of a private equity investment
Market context and reasons behind Buy-and-Build investments
In order to better understand the importance of such a strategy and its characterization in the Italian context, here we summarize some of the reasons underlined before as well as the market context, adding comments and further details.
Market characterized by an economic slowdown resulting in reduced possibilities of internal growth. Furthermore, as already explained, the faster external growth made possible to contrast the problem of an increasing holding period.
An M&A context characterized by an increased competition that made harder for private equity operators to realize favorable arbitrages on multiples.
The willingness to undertake a further investment in a known sector together with the reliable corporate management of the platform.
A better positioning of the company following three main drivers:
Horizontal Growth and increase in the market share. Strengthening of the core business;
Internationalization through the acquisition of a foreign target company in order to gain a better access to that market.
Add-on acquisitions, if carried out properly, can generate an immediate accretive effect. This is possible since the EBITDA of the acquired company gets automatically written up to the value of the platform that absorbed it, implying a multiple expansion.
They show also a positive effect related to the mitigation of the impact of frothy valuations. This is useful since multiples for companies in hot sectors are high now, hence commanding high valuations.
There is another interesting trend that is arising: firms are planning to pursue add-on acquisitions earlier in the investment cycle. Some sponsors are including add-on opportunities evaluation inside the due diligence process to identify possible targets moving forward to the next step post acquisition. Related to this phenomenon, there is also a change in the financing structure of the deals. As a matter of fact, some sponsors are including delayed-draw term loans in the financing of the platform acquisition in order to already have access to a credit facility to complete the strategy of acquiring an add-on at the same term of the initial transaction.
The characteristics of this credit feature make it a difficult choice for both private equity owners as well as for lenders. For the latter, they have to reserve capital on which they gain a small margin until the borrower decides to draw the funds, while the sponsor has to pay fees. These costs are split in an up-front fee when closing the loan agreement and in a fee, that has to be paid until the loan is drawn. Therefore, delayed-draw term loans are utilised when there is high probability that the amount made available will be drawn before the expiration.
The Italian experience
The theoretical explanations underlined above seem to be confirmed in the Italian experience but, referring to the 4th reason, it seems clear the prevalence of the horizontal growth as main driver behind the buy-and-build strategies. This is in line with researches undertaken by SDA Bocconi Private Equity Lab as well as several testimonials of main operators that report an Italian context characterized by small-medium excellent enterprises with local advantages due to established relations with local customers that can obtain large advantages from the integration and the resulting increased market share, strengthening their core business.
Buy-and-build strategies represent one of the hottest topic in the private equity environment. Their increasing trend, the potentiality of such a strategy and the market context underlined above bring them to the center of private equity discussions for the coming years.