Strategy for our time: ‘buy and build’ steps up
July 2019 | FEATURE | PRIVATE EQUITY
Financier Worldwide Magazine
July 2019 Issue
Uptake of the ‘buy and build’ strategy by private equity (PE) houses has increased significantly in recent times – an uptick generated by rising competition for assets and record-high valuations.
Essentially, investors in pursuit of value are eschewing traditional strategies such as ‘buy and improve’ in favour of the buy and build concept – wherein PE buys a platform company with established management and systems, and leverages off this company to acquire subsequent tuck-in acquisitions which, they believe, will deliver the value and returns they crave amid an increasingly competitive PE landscape.
According to Bain & Company’s ‘Global Private Equity Report 2019’, buy and build has become so popular that approximately one in five transactions today is executed as part of a broader buy and build strategy. Indeed, the report states that, while the strategy has been around as long as PE, it has never been more important than it is now.
So, given the extent of its popularity, what is driving the uptick of buy and build as a desirable investment strategy? “More than anything, the rise in purchase price multiples has encouraged the increase in buy and build activity,” opines Christophe De Vusser, a partner at Bain & Company. “The strategy gives PE investors a way to take advantage of the market’s tendency to assign big companies higher valuations than smaller ones.
“This allows a firm 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,” he continues. “This multiple arbitrage brings down the firm’s average cost of acquisition. At the same time, serial acquisitions allow investors to build value through synergies that reduce costs or add to the top line.”
In the view of Michael B. Schwerdtfeger, a principal at NewCap Partners, PE firms are interested in buy and build for three reasons: pricing arbitrage, synergies and cash flow growth. “Larger companies command higher multiples, so tucking small, lower priced add-ons into larger, more valuable companies offers a good way to arbitrage the difference in pricing,” he says. “These tuck-in acquisitions often have redundant infrastructure or management, offering the buyer a chance to capture these synergies and drop additional dollars to the bottom line.
“Firms often only have a short investment horizon to grow their portfolio companies – adding revenue and earnings before interest, tax, depreciation and amortisation (EBITDA) by acquisition can be faster than growing organically,” continues Mr Schwerdtfeger. “The buy and build approach is a relatively straightforward path toward value creation through purchase price multiple arbitrage and capturing synergies between similar companies.”
Facilitating buy and build
In order to facilitate a value-creating buy and build strategy, a number of determinants need to be in place, such as healthy sector dynamics, stable platforms and infrastructure, and strong management teams.
“Sector dynamics can have a huge impact on the success or failure of a given buy and build strategy,” says Mr De Vusser. “We have seen buy and builds – where the platform is investing more capital and taking on more leverage – fail in sectors with underlying market decline.
“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,” he continues. “Importantly, the platform company usually makes add-on acquisitions – not the PE fund – so it is critical that the company generates consistent free cash flow to finance deals in succession.”
Me De Vusser also notes that it is critical that the platform is stable enough to support what the PE fund wants to do with it. “To pursue an efficient acquisition strategy, the buyer needs the right foundational infrastructure – such as robust IT systems, a strong balance sheet and repeatable financial and operational models – and assets like distribution and sales networks that are set up for expansion,” he adds.
Another key aspect is the role that strong management has to play. “Finding and making add-on acquisitions is relatively easy,” says Mr Schwerdtfeger. “However, the acquiring firm needs to be able to successfully digest and integrate the acquisitions in order to create additional value. With a good management team, there are many opportunities for value creation through add-on acquisitions.”
With a strong management team clearly a key component of the buy and build strategy, how that team is put together and then integrated into the acquisition process are crucial steps, requiring a measured approach.
“Experience matters when picking a leadership team for buy and build,” suggests Mr De Vusser. “It is critical for the PE fund and platform company leadership to have a clear-eyed view on the leadership team’s capabilities and ability to execute. Understanding upfront what capability or resource gaps need to be filled by the fund or external parties, such as advisers or consultants, can ensure that execution goes well.”
For Dr Benjamin Hammer, executive director of the Centre for Corporate Transactions & Private Equity (CCTPE) at Leipzig Graduate School of Management, a management team needs to be a combination of ‘rainmaker-type’ lead partners well-versed in M&A execution and operations-oriented lead partners with specific industry experience. “The first type of lead partner usually sources and closes the deal, whereas the second type is responsible for monitoring and advising the portfolio company during the holding period,” he explains. “For the latter, it is often important that you find lead partners that share a common background with the portfolio firm managers and who ‘speak the same language’.
“If the buy and build strategy includes cross-border acquisitions, it is also important to have a local office or subsidiary to operate from in order to ensure that PE managers have similar cultural background, which eases communication and interaction, and can closely advise and monitor the portfolio company,” he continues. “However, our 2017 research – ‘Inorganic growth strategies and the evolution of the private equity business model’ – shows that not many PE firms have these distinct skill sets and human capital.”
Challenges and benefits
Once the key determinants that help facilitate the strategy are in place and an experienced management team is secured and integrated, the benefits of buy and build can be reaped, but not without overcoming significant challenges.
In the opinion of Mr Schwerdtfeger, the challenges are twofold: one market driven and one operational. “On the market front, PE firms can have a little bit of a herd mentality,” he suggests. “Consequently, there can often be many firms chasing the same buy and build strategy, limiting the upside of the ultimate strategy. Operationally, integrating numerous acquisitions over a short period of time is a lot more difficult than it looks. If firms are not careful in their integration, an initially attractive add-on investment can end up being disastrous.”
An additional challenge that can arise stems from the complex and lengthy nature of M&A processes. “This is especially so when it comes to the organisational integration of add-ons,” says Dr Hammer. “There is a risk that buy and build extends the holding period to more than the three to five year target. Also, buy and build is a human capital intensive strategy and requires a lot of coverage by the lead partners. Buy and build is thus a costly strategy for the PE firm.”
To overcome complexity and extended timelines, Mr De Vusser suggests a focus on two key factors: excellence in due diligence and execution. “Deep, holistic diligence is critical,” he asserts. “In buy and build, due diligence does not 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,” he continues. “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? Questions such as these are a necessary prerequisite to evaluating the real potential of a buy and build thesis.”
Moreover, positive answers to these queries can lead to considerable benefits. “Buy and build often has the advantage over organic growth in that it creates growth faster,” adds Dr Hammer. “This can be important given the illiquid nature of the PE industry, with funds having a limited lifetime of around 10 years and individual firms typically being exited after three to five years.”
Building on buy and build
The appeal of buy and build as a value creation strategy for PE houses is beyond doubt, with some suggesting that it may be on a par with traditional organic growth in certain sectors and industries in the years ahead.
“Buy and build will continue to be a popular strategy,” states Mr De Vusser. “However, the sectors the strategy is being executed in will change as opportunities for buy and build are exhausted in some areas, and PE investors turn their attention to pockets of industries that are still ripe. For example, buy and build in roofing distribution in the US has already played out, while retail healthcare, business services and software in the US and Europe still present ample opportunity for consolidation.”
Likewise, Mr Schwerdtfeger believes that buy and build will continue to be important for PE groups, though not at the expense of traditional organic growth. “Nothing will ever replace the fundamental value proposition of owning a strong business that can generate continued growth,” he says. “For traditional firms, investments that cannot generate strong growth are not going to be interesting. However, to the extent that a PE group can extract additional value by making a series of add-on acquisitions, that will also continue to be attractive.”
In the end, while the buy and build is not foolproof, as great successes are often offset by those that badly underperform, what cannot be denied is its strength and durability – a progressive and value-creating investment methodology that could well be considered the strategy for our time.
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