By Atul Vyas and Alessandro Carleo
Increasing the value of portfolio companies is crucial for the success of a private equity firm. As Gompers, Kaplan, and Mukharlyamov (2015) have found, PE investors “target returns that exceed CAPM-based returns”. The bulk of excess return, or alpha, is gained through value creation in the portfolio firms that a PE fund manages. This value enhancement is usually attributable to financial engineering, governance engineering, and/or operational engineering. Increasing leverage and improving sources of financing are some examples of the strategies used to generate value through financial engineering. To accrue value through governance engineering, PE firms can align incentive programs for top management, increase active ownership, provide industry expertise through the board etc. Operational improvements also drive value through improved productivity from cost cutting and margin expansions, decreased working capital and capital expenditures and changes to the business model.
Apart from these conventional approaches of delivering value growth, a fourth strategy has been gaining traction in the PE industry. The Buy-and-Build (B&B) method has experienced burgeoning popularity over the last decade which continues into the present. From 20% in 2000, the share of PE deals with add-on acquisitions trended toward 53% in 2012.
The B&B model of value enhancement
In a Buy-and-Build (B&B) strategy, a PE firm purchases a company as a “platform” and subsequently builds upon it with add-on acquisitions. This strategy can both accelerate revenue growth and drive margin expansion by realizing synergies – these benefits translate into higher exit valuations. This strategy is also useful for PE firms attempting to penetrate a market with no clear frontrunners; through the B&B method, an industry leader can be built by adding small players together.
According to the Boston Consulting Group (2016), the B&B strategy is exceptionally successful when the portfolio company fulfills the following conditions:
- It is small or medium-sized
- It has a PE sponsor with operational and buy-and-build experience (not solely a financial restructuring player)
- It offers an operationally efficient and scalable platform
- It is in a long-growth, low-profitability and highly fragmented industry
- It engages only one or two add-on acquisitions
- It targets add-ons in its core industry
- It enacts cross-border acquisitions to expand internationally
A simple reason explaining the recent increasing interest in B&B deals is the high return these strategies offer. In 2016, B&Bs generated an average IRR of 31.6% upon exit, widely outperforming standalone deals which posted average IRRs of 23.1%.
As seen in Exhibit 1, the overall frequency in the employment of the B&B strategy is positive and grew by 165% between 2000 and 2012. B&B was the prevailing strategy among other PE schemes composing 53% of overall PE investments in 2012 where 62% of such deals include 1 or 2 add-ons and the remaining 38% include more than 2 add-ons. The average number of add-on acquisitions per investment rose from 1.3 in 2000 to 2.7 in 2012. To be successful in a B&B, PE funds must be increasingly focused and selective when performing due diligence and closing an add-on acquisition. On the back-end, PE firms can extract more value from the sale of a platform investment if there is already a vetted pipeline of add-on targets in place for a new owner to pursue.
It is remarkable that even during the financial crisis in 2008, the number of B&B transactions persisted. In fact, according to Stanford Graduate School of Business, PE-backed companies decreased investments relatively less than the control group during the financial crisis. This result can be explained by the ability of PE-backed companies to use resources and relationships of their PE sponsors to raise equity and debt funding during illiquid periods and to lower their cost of capital. Furthermore, the positive investment effect of PE was particularly large in companies more likely to be financially constrained at the time of the crisis and when the sponsors had more resources. The increase in investment during the crisis led to increased asset growth and higher market shares.
According to Investcorp, the paramount factor that cannot be overlooked by a PE firm is creative operational value strategies, especially if the firm is seeking to deliver excess returns. Subsequent buy-and-build strategies form a crucial element in this regard. If done properly, the combination of financial resources, expertise and entrepreneurship can add significant value, creating strong and synergetic teamwork between PE sponsors and management teams generating high returns for investors. Exhibit 2 shows the growing trend of top-line growth and margin expansion strategies becoming the most popular value creation strategy of choice.
A noteworthy example:
The recent ongoing consolidation of the western European dental market is a pronounced example of this rising trend of B&B deals across the market and is a testament to the success of the B&B strategy in value creation. The dental health market in Europe is very segmented which prevents the market from realizing economies of scale. Germany, for example, has the biggest dental market in western Europe, with total consumer spending of $28 Billion in 2015; however, 99% of the industry functions through small, standalone dentistry practices.
Realizing the industry’s potential, many PE firms have entered the market to reap the benefits of consolidation. Mydentist, the UK’s largest dental chain, is jointly owned by The Carlyle Group and Capital Partners since 2011. It currently operates over 650 practices and continues to acquire more small practices throughout the UK. This trend of PE firms consolidating the dental industry is particularly prominent in the UK. Exhibit 3 aptly demonstrates the benefits of the B&B strategy applied to the dentistry industry in the UK. The EBITDA multiples have almost always increased in most regions of the UK where smaller practices were consolidated to form larger chains, predominantly owned by major PE firms.
Despite the fact that Buy-and-Build strategies are becoming more and more common within the private equity business, there are several risk factors that could lead to failures and bankruptcy, which PE funds should consider when planning such ventures.
Besides diverging from the previously listed criteria that make a successful B&B, the most significant unique risk factors include unrealistic or indefinite business plans and insufficient due diligence. The due diligence is necessary to understand how potential targets add value in meaningful ways and what their shortcomings might be while a robust strategy maps how add-ons will jointly operate with the platform company.
Best M&A practices must be observed as well and add-ons should have explicit strategic rationale falling into either the vertical, horizontal or conglomerate expansion categories. For instance, overlap acquisitions, or the capture of minimal market share in a horizontal acquisition, can be dilutive. The other extreme, venturing into opportunities further removed from the platform company’s market, can be equally dangerous. An example of the latter is the case of “Aurora Foods” which filed for bankruptcy in 2003. In 1998 the PE-backed company began to acquire budget brands specialized in frozen foods after having already bought up some premium brands two years before. The primary reason for Aurora’s bankruptcy (aside from adverse market conditions) was the overly excessive diversification of their brand portfolio straying too far from its core business to the point where capital was spread thin and synergies failed.
Editor: Eric Peghini
Authors: Atul Vyas, Alessandro Carleo