Buy-and-Build: A Powerful Private Equity Strategy
While buy-and-build strategies like this one have been around as long as private equity has, they’ve never been as popular as they are right now. The reason is simple: Buy-and-build can offer a clear path to value at a time when deal multiples are at record levels and GPs are under heavy pressure to find strategies that don’t rely on traditional tailwinds like falling interest rates and stable GDP growth. Buying a strong platform company and building value rapidly through well-executed add-ons can generate impressive returns. As the strategy becomes more and more popular, however, GPs are discovering that doing it well is not as easy as it looks.
What is the definition of Buy and Build?
When we talk about buy-and-build, we don’t mean portfolio companies that pick up one or two acquisitions over the course of a holding period. We also aren’t referring to onetime mergers meant to build scale or scope in a single stroke.
We define buy-and-build as an explicit strategy for building value by using a well-positioned platform company to make at least four sequential add-on acquisitions of smaller companies.
Why PE uses this buy-and-build strategy?
Buy-and-build strategies are popular because they offer a powerful antidote to soaring deal multiples. They give GPs a way to take advantage of the market’s tendency to assign big companies higher valuations than smaller ones. A buy-and-build strategy allows a GP to justify the initial acquisition of a relatively expensive platform company by offering the opportunity to tuck in smaller add-ons that can be acquired for lower multiples later on. This multiple arbitrage brings down the firm’s average cost of acquisition, while putting capital to work and building additional asset value through scale and scope.
At the same time, serial acquisitions allow GPs to build value through synergies that reduce costs or add to the top line. The objective is to assemble a powerful new business such that the whole is worth significantly more than the parts.
Having coinvested in or advised on hundreds of buy-and-build deals over the past 20 years, we’ve learned that sponsors tend to underestimate what it takes to win. We’ve seen buy-and-build strategies offer firms a number of compelling paths to value creation, but we’ve also seen these approaches badly underperform other strategies. Every deal is different, of course, but there are patterns to success.
The most effective buy-and-build strategies share several important characteristics. These are:
1. A sector with room to run
Sector dynamics can have a huge impact on the success or failure of a given buy-and-build strategy. Value creation depends on a steady cadence of acquisitions, which means a sector has to provide an ample supply of targets and a stable environment in which to pursue them. Importantly, the platform company usually makes the add-on acquisitions—not the Private Equity fund—so it’s critical that the company generates consistent free cash flow to finance deals in succession.
Sector issues can disrupt cash flow in a number of ways—cyclicality being the most obvious. In an industry like oil and gas, for instance, ping-ponging demand can wreak havoc on free cash flow, crimping a platform’s ability to do deals. The potential for large-scale technological disruption is another factor. Buy-and-build was a brilliant strategy in the magazine business until the Internet plundered print advertising and completely changed the industry’s economics. Supplier or customer consolidation can also upset the best-laid plans. Buy-and-build depends in part on creating scale advantages. But if suppliers or customers are combining in parallel, a business plan that relies on increased purchasing leverage or pricing power can fall apart quickly.
Following the stability imperative, the most effective buy-and-build strategies target sectors with predictable secular growth and a low risk of disruption (unless, of course, the platform company is the disrupter). They also target fragmented industries with sufficient acquisition targets of the right size. This raises two questions in diligence: First, will potential add-ons have lower valuations than the platform company, so that buying them presents a true multiple-arbitrage opportunity? Second, will potential add-ons be meaningfully accretive? In other words, does the sector offer plenty of targets that are smaller than the platform company, but not so small that acquiring them doesn’t add value?
2. Plenty of white space
The sector’s “white space” is a function of supply and demand. On the supply side, how many businesses are there in the sector that might naturally transact? Are a lot of founders reaching retirement age, or are macro pressures making it difficult to remain independent? On the demand side, how many other consolidators or strategic buyers are already at work in the industry picking off the ripest fruit, and what are their cumulative plans? These questions add up to a bigger one that guides due diligence: Does the potential for acquisitions in this sector provide enough runway for the buy-and-build strategy to create meaningful value? Too much demand for too few targets will drive up prices and compete away the multiple-arbitrage opportunity. But dynamics can change quickly as capital and consolidators pile in. For anyone getting in now, a fresh look at the white space will be essential.
Coming in late or following the herd can spell trouble. A good example is the funeral home industry. As macabre as it sounds, PE-backed buy-and-build strategies thrived in the US death business for years. Eventually, a crowd of consolidators picked off all the attractive midsize targets, bid up asset prices and eroded the multiple-arbitrage opportunity. In essence, the sector had “barbelled,” meaning companies were either too big or too small, with nothing left in the middle to support a buy-and-build strategy.
GPs can avoid getting caught by focusing on their exit strategy from day one. If the sector continues to offer buy-and-build opportunity, it leaves runway for the next buyer to continue the consolidation, which should improve exit value. If buy-and-build is largely exhausted, the exit story needs to reflect a clear shift in strategy. Often the opportunity graduates from buy-and-build to scale M&A, where a consolidator starts buying up other consolidators. Alternatively, the most logical next owner might be a strategic buyer that is looking to expand in the sector and sees value in a newly scaled-up platform company.
3. Building on a solid platform company
As we noted earlier, the most effective buy-and-build strategies assume that the platform company’s free cash flow will fuel acquisitions. The PE fund is theoretically a backstop if the platform asset starts to sputter, but few GPs are willing to throw good money after bad if the well runs dry at the platform level. It’s also critical to determine if the platform is stable enough to support what the fund wants to do with it. To pursue an efficient acquisition strategy, the buyer needs, or as a startposition or after the integration is finalised, the right foundational infrastructure—robust IT systems, a strong balance sheet, repeatable financial and operational models, and assets like distribution and sales networks that are set up for expansion.
It’s an enormous benefit to start with a strong existing management team that has already demonstrated its ability to pull off acquisitions. It’s not always that easy. A central question in diligence is how much work the platform company needs in order to spearhead the strategy. If the answer is a lot, it can drastically affect the timing of value creation. Private Equity firms are often buying someone else’s starting point. The company might already have made acquisitions that are poorly integrated. IT systems may look like spaghetti, go-to-market strategies may be at odds, one unit’s delivery trucks might be driving past another’s distribution centers. Fixing issues like these takes both time and investment, which may pay off if the opportunity is big enough. The key, however, is going in with eyes wide open as to what the up-front costs really are. A years-long reclamation process can cut deeply into Return on Investment.
4. Targets that add value
While vetting the right targets for buy-and-build involves all the normal M&A diligence questions, the key factors are strategic: How does an add-on or group of add-ons increase value? More is not simply better; an acquisition has to fit into a strategic logic that assumes the whole is worth more than the sum of its parts. For this reason, successful buy-and-build strategies target acquisitions that are close to the core, rolling up a set of highly related companies to achieve the benefits of scale. Moving into adjacencies can make sense, but it is critical to understand the risk. The further a company strays from its core, the greater the chance that something goes wrong.
Bain defines a company’s core as the clients, products and services that:
- drive the majority of its profits and profitable growth
- provide its key competitive advantage.
Defining a company’s core is the heart of strategic planning and an essential element in ensuring that each acquisition adds value to the platform. Each step away from the core creates distance between the acquisition and what the company does best. The question becomes, how much overlap is there between the two companies’ customers, costs, channels, capabilities and competition? A rollup strategy assumes significant, if not total, overlap. Close-in adjacencies have less overlap, and two-step adjacencies have significant differences. Looking at potential acquisitions—or the entire strategy—through this lens prevents firms from trying to knit together related businesses that are further from the core than they seem.
A company’s core and adjacencies aren’t always obvious. The buy-and-build strategies that outperform typically rely on multiple paths to value creation. They take full advantage of multiple arbitrage, they identify, integrate, and capture cost and revenue synergies and operational improvements. In this way they generate top-line growth by improving commercial capabilities and implementing smarter go-to-market strategies at each company acquired. Spotting these opportunities has to be the explicit target of due diligence, so that the fund can begin pulling each of these levers from day one of ownership.
5. A winning approach
Too many attempts at creating value through buy-and-build founder on the shoals of bad planning. What looks like a slam-dunk strategy rarely is. Winning involves assessing the dynamics at work in a given sector and using those insights to weave together the right set of assets. The firms that get it right understand three things going in:
- Deep, holistic diligence is critical. In buy-and-build, due diligence doesn’t start with the first acquisition. The most effective practitioners diligence the whole opportunity, not just the component parts. That means understanding how the strategy will create value in a given sector using a specific platform company to acquire a well-defined type of add-on. Are there enough targets in the sector, and is it stable enough to support growth? Does the platform already have the right infrastructure to make acquisitions, or will you need to build those capabilities? Who are the potential targets, and what do they add? Deep answers to questions like these are a necessary prerequisite to evaluating the real potential of a buy-and-build thesis.
- Execution is as important as the investment. Great diligence leads to a great playbook. The best firms have a clear plan for what to buy, how to integrate it, and what roles fund management and platform company leadership will play. This starts with building a leadership team that is fit for purpose. It also means identifying bottlenecks (e.g., IT systems, integration team) and addressing them quickly. There are multiple models that can work—some rely on extensive involvement from deal teams, while others assume strong platform management will take the wheel. But given the PE time frame, the imperative is to have a clear plan up front and to accelerate acquisition activity during what inevitably feels like a very short holding period.
- Pattern recognition counts. Being able to see what works comes with time and experience. Learning, however, relies on a conscious effort to diagnose what worked well (or didn’t) with past deals. This forensic analysis should include the choice of targets, as well as how decisions along each link of the investment value chain (either by fund management or platform company management) created or destroyed value. Outcomes improve only when leaders use insights from past deals to make better choices the next time.
At a time when soaring asset prices are dialing up the need for GPs to create value any way they can, an increasing number of firms are turning to buy-and-build strategies. The potential for value creation is there; capturing it requires sophisticated due diligence, a quick holistic based integration, a clear playbook, and strong, experienced leadership.
This article is a synopsis from an article published in feb-2019 by Bain&Company. Some US examples and some graphics are excluded from the text.
See the full article here.