Creating Shareholder Value through a Roll-Up
In years past, there have been a number of consolidations or “Roll-ups” in which participating companies have created significant shareholder value through a combination of multiple companies in the same industry. Recently, these consolidations have been driven by the recession, outside factors over which business owners have little control and “baby boomers” desiring to retire. Participation in a Roll-up provides an attractive exit alternative for many business owners.
Examples of industries that have been particularly active in consolidation are financial services, food and beverage distribution/manufacturing, logistics companies, auto retailing, commercial banking, and waste hauling. Recent changes and declining margins in the U.S. health care industry are also driving consolidation in that industry.
Introduction to Roll-ups
In simple terms, a Roll-up involves the merger and integration of a number of businesses in the same industry to create one larger company. They are generally best suited for highly fragmented, mature industries with predictable, sustainable cash flows but without a dominant player(s).
Usually a “Sponsor” (an established or new larger company backed by funding from a lender or by a private equity fund) acquires the assets of other companies for cash and/or equity (“bolt-ons”) with the objective of generating economies of scale and reducing costs through elimination of duplicative expenses, etc. The non-Sponsor participants (“Founders”) often become owners and remain active as managers in the surviving entity.
Benefits of Roll-ups
The primary benefit of consolidation is the opportunity to arbitrage the difference in valuation (based on earnings multiples) between smaller vs larger private companies. Small private companies normally can be acquired for a lower earnings multiple than a larger company. A Sponsor can generally acquire a number of small companies for 2 or 3 times EBITDA and then sell for a higher multiple of 5 or 6 times.
If the Sponsor ultimately becomes a public entity, the valuation multiple may be 9 or 10 times EBITDA or more.
As a result of the valuation arbitrage, many owners of smaller companies have created substantial value for themselves by electing to take equity in the consolidated entity as opposed to selling for cash.
Consolidation may generate other benefits as well:
• Cost synergies – examples are cheaper insurance, merchant fees and buying power;
• Revenue Growth – cross-selling of products / services and access to larger customers and new markets;
• Brand Building – Allows for faster brand recognition across multiple market locations or sales channels;
• Capital – Capital is more accessible to larger, strong entities;
• Leveraging fixed costs – spreading fixed costs (such as HQ or sales /marketing and occupancy costs) over a larger revenue base;
• Centralized administration – access to more sophisticated IT and accounting systems.
Is my industry suitable for a Roll-up?
• If customer interface represents a high percentage of the costs of doing business, the opportunity for economies of scale is limited. Also, businesses in some industries benefit from being small, innovative, and local – values which are not always enhanced by size (and hence less suitable for consolidation). Trying to bring together a large number of equally small and unsophisticated companies is not likely to succeed.
It is easier to integrate a large number of relatively smaller distribution or service businesses than larger, more complex businesses (such as IT and manufacturing).
• Does the Sponsor have the right stuff?
• An experienced and committed management team with the ability to take the business to the next level
• A long term perspective and the patience required to create value
• Sound proven business model with a history of earnings
• Well developed and scalable systems and infrastructure
• How difficult is integration? Do the Founders have as a common goal the creation of value? Do they have reasonable valuation expectations? Are the cultures of the businesses similar? Will key managers sign on? Do the participants have good information including financials?
• Is the size of the industry large enough to generate economies of scale? For example, can enhanced earnings be generated through centralized bulk purchasing of products and services?
• Are there third party suppliers, manufacturers, customers, etc. that are encouraging consolidation? Will customers see the consolidation as beneficial? How will competitors react to the aggregation? Will the consolidation open new opportunities in new markets or territories with larger customers?
• Can the addition of new technology to the combined companies create standardization of operating and pricing policies?
• How many bolt-ons should be acquired?
Too much, too soon may exceed the ability of management to integrate the add-ons (both operationally and culturally). Too few participants may not provide the scale needed to fully utilize synergies/buying power.
• Are some Founders willing to “roll” a portion of their equity in their current business into ownership in the Sponsor? A significant percentage of the equity in the Sponsor Company should come from Founders.
• What are the costs associated with a Roll-up?
A successful Roll-up requires extensive research, preparation and cooperation. The cost of retaining professionals experienced in these matters, including investment bankers, legal, accounting, and tax experts can be significant. Businesses with a high risk of contingent liabilities, complex financial histories, uncertain/unstable forecasts can make the cost of due diligence prohibitively expensive.
What are the risks of Roll-ups?
• Consolidation can present integration challenges, clashes of culture/ego, and execution risk;
• Geographical differences can be hard to overcome;
• It can be difficult to integrate smaller businesses with varying information and accounting systems, management styles and business philosophies;
• Sometimes the cost savings don’t exceed the expense of a head office (executive salaries, etc.);
• If Founders receive a large cash payout as part of the Roll-up they sometimes lose focus rather than driving the business forward. It is important that most participants (including management) have “skin in the game”, particularly if there is the risk a key member will leave the group to start a new competing business;
• Under new ownership, Founders will inevitably be forced to deal with a more formalized culture with far stricter reporting requirements and governance with all strategic decisions being dictated at the Board level.
• The greater the number of parties means the greater the risk that one stakeholder seeks to hold up the consolidation or the eventual exit by being greedy or relying on some technical right (in other words refusing to sign the relevant acquisition or sale documents) in order to get a special deal.
The risks of a Roll-up can be mitigated through the careful implementation of several strategies:
• A governance model that is Sponsor/Founder centric (e.g. the Sponsor/Founders retain a majority of the equity, the CEO is appointed and the majority of the Board is appointed by the Founders). This governance model is an important driver of success.
• Use a “push” rather than “pull” strategy for some policies and procedures. In other words, it is up to each Founder whether they accept changes rather than it being forced upon them.
• Consider whether a decentralized 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.
• Offer incentives for Founders to stay involved with the business into the future. These can include options for additional equity or cash bonuses based on the performance of their original business (not just the group).