First published in the Financial Times on 13th November 2012.
Making a series of horizontal acquisitions in a fragmented industry can be lucrative
Roll up! Roll up! Welcome to the buy-and-build circus!
One of the ways financiers make money is doing a “roll-up”: a series of horizontal acquisitions in a fragmented industry. Typically these are industrial sectors that are obscure, unloved and overlooked.
I first saw this technique in action among various listed companies I researched as a stockbroking analyst in the 1980s. For example, a series of companies sprang up that consolidated funeral homes, including Kenyon Securities, Hodgson Holdings and Great Southern Group. They rationalised the use of hearses and crematoria, saved money on administration and marketing, and arbitraged the different earnings multiples between private and public companies.
I have been involved as a principal in roll-ups in healthcare, recruitment, food distribution, financial and marketing services. All did well for investors, which is fairly remarkable in itself. Of course, not every transaction worked – after all, between the various companies we probably executed more than 50 mergers. I haven’t performed a rigorous analysis, but I suspect at least one in eight deals destroyed rather than generated value. But there were decent returns overall.
A roll-up should possess certain features if it is to succeed. First, the industry in question should not be consolidated; there must be plenty of small family-run companies to buy. The sector must not be so niche that monopoly concerns arise. Second, the businesses to be acquired should be available cheaply – ideally on profit multiples of three or four. Third, the buying vehicle should develop an effective formula for finding, negotiating and integrating acquisitions. Fourth, the acquirer must have the wherewithal to carry out the deals – cash and/or shares that vendors will accept. Finally, the enlarged group should be able to achieve savings and economies of scale, be it through buying, distribution or administration.
There are plenty of pitfalls, because buying companies is a risky undertaking. One can simply pay too much, or rush deals and do insufficient due diligence. Other cases suffer from culture clashes, or earn-out structures that unravel badly. Frequently the purchased companies are not amalgamated, so the supposed advantages of the whole exercise are lost. And if the cash for acquisitions is borrowed and the acquired companies don’t deliver, the buyer can breach covenants with the bank and end up bust.
I once made the mistake of buying into a roll-up that had gone wrong. It looked cheap. In fact it was a wasteland of debt, disgruntled ex-owners, litigation, subsidiaries that had not been integrated and vendors limbering up to compete with their old businesses. Unlike an organically grown business, it was a jumble of hastily assembled operations with little logic and even less direction or soul. Purely financial constructs like that rarely succeed: there needs to be an underlying coherence and rationale.
The American master of roll-ups is probably the Floridian entrepreneur Wayne Huizenga. He co-founded Waste Management, Blockbuster Video and AutoNation. By targeting garbage collection, video rental and car retailing, he found three unglamorous industries with no dominant businesses. He was able to use highly rated quoted paper to absorb smaller rivals on lower multiples, thereby enhancing earnings. But he appears to have lost his magic touch: the shares of Swisher Hygiene, his latest vehicle, have slumped by more than 75 per cent in the past two years.
There have been fewer buy-and-build ventures in recent years. Many markets are now dominated by a handful of big organisations, with little opportunity to acquire family companies at fair prices. Many of the public companies using this strategy failed, so private equity firms have taken the lead. They initially back a “platform” company and then add bolt-on acquisitions. However, it is much harder to find immature sectors where the right improvements are to be found from merger sprees.
Roll-ups work if there is a genuine operational formula that can be applied to the acquired companies, and duplicate overhead costs that can be eliminated. Accomplishing this requires expert leaders who focus on identifying the right partner companies, merging them properly, while resisting the temptation to get carried away.