Roll-Up Strategy: How To Create Value

Succeeding Where Over Two-Thirds of Roll-Ups Fail

A roll-up strategy involves the acquisition of multiple smaller companies in a fragmented industry with the intent to develop a company that creates value for its shareholders. But, in a Harvard Business Review piece by Paul Carroll and Chunka Mui entitled “Seven Ways to Fail Big,” one of the seven is “Roll-Ups of Any Kind.” According to the authors, research has shown that more than two-thirds of roll-ups fail to create any value for investors.

Yet, even with this high failure rate, when roll-ups are conceived, planned and executed properly there is considerable opportunity to create substantial value. However, for value to be created there are several components that must be present for a roll-up strategy to be successful. The remainder of this article offers some insight into these essential components.

Components Overview:

1. Right value creation thesis

2. Industry with right characteristics

3. Board and Management competencies

4. Acquisition Process — extremely detailed and highly disciplined — includes integration and post-acquisition performance management

5. Competent and cooperative legal counsel

Components Detail:

Value Creation Thesis

Value creation thesis must include both of the following value creation methodologies or the strategy will at best not create maximum value and at worst (as is common) fail.

1. Valuation Multiple Arbitrage — the multiple (EV/EBITDA) paid by the roll-up company must be considerably less than the one or more of the following depending on circumstances: a) Projected IPO valuation multiple or 2) If public from outset, less than average trading multiple or 3) Projected exit multiple if private with assumption that company will be sold to new owner as exit method. In other words, for example, you are in good shape if you buy for 5X EBITDA and sell at 9X EBITDA (or have a public valuation of 9X). This unfortunately, is the extent of the concept of value creation for many roll-up founders. They lack the sophistication to grasp that even if there is a potential multiple arbitrage, if the companies acquired are not improved, then the multiple arbitrage may also vanish.

2. Post-Acquisition Performance Maximization — for a roll-up to create maximum value, the roll-up company should be more sophisticated and superior in its ability to drive performance in the companies acquired than the incumbent owners. So, in addition to multiple arbitrage, there should also be value created by maximizing EBITDA post-acquisition. Any roll-up sponsor not having this as a part of the value creation thesis does not know what they are doing. There should be a playbook from the outset that delineates how diligence is undertaken and the generalized plan for quickly improving each acquired company. While integration is important, what is referenced here goes beyond integration to the levers that can be pulled for each company to maximize its performance over the short and longer-term. In so doing, the multiple arbitrage is enhanced as the EBITDA of each acquired company grows.

Industry

1. Higher the degree of industry fragmentation the better. If the universe of targets is not large enough it may be hard to gain scale quickly as many owners will not be interested in selling their business.

2. Low customer concentration and repeat sales without requiring heavy sales force activity

3. Preferably not dependent on a customer base that is loyal due to the company because it is the “local” or “hometown” business (there are workarounds with this but this situation increases the risk).

4. Stable and predictable EBITDA generation with low capital intensity

5. Products or services that are a necessity or near necessity for consumers

6. Companies not dependent upon current owner’s customer relationships to be viable. This goes beyond the “local” phenomenon noted above and includes the owner’s personal relationships with major customers. (My experience is that roll-ups work better when the owner is replaced as they typically have a difficult time adapting to the policies and processes of the roll-up company. There are exceptions but these are rare).

7. High barriers to entry (especially at scale) and/or opportunity to consolidate local/regional markets quickly after acquiring platform company in local or regional market area.

8. Not a requirement but a plus if the major customers of the industry are also in a phase of consolidation. When consolidation takes place, the consolidated entity usually seeks to have fewer and larger suppliers. The roll-up company can meet these requirements.

Board of Directors

1. Industry experience (recent) and track record

2. Roll-up experience and track record (good qualifications for the non-executive chairman)

3. General value creation experience and track record (think PE type individuals)

4. General M & A experience and track record (caveat: roll-ups are not the same as single, larger transactions so some caution here)

5. Specific to roll-up industry operations (not necessary to be from same industry but someone who brings a track record to one or more of the major performance improvement initiatives post acquisition)

Management

1. CEO — ideally has some M&A (even better if in a roll-up) and operational experience in the industry or one that is similar

2. CFO — also M&A experience with some experience in integration

3. Deal Person — this is the role that will be the internal “investment banker” who will oversee the entire acquisition process and execute certain key aspects of same (involvement with each company acquired stops once each deal is closed. The skills needed for deal-making are typically not the same skills needed for integration and post-acquisition performance improvement)

4. Integration — if starting from scratch there will be limited real integration until more companies are acquired. But at some point, someone will need to have responsibility for all aspects of integration.

5. COO — role may or may not have COO title but at some point in the growth of the company an executive will need to have full responsibility for the post-acquisition performance maximization process and the hands on responsibility for the company’s operations.

If company is starting from scratch or with only one or two companies, the corporate level staffing needs to be very lean. But, the CEO and CFO must have a detailed plan for scaling the corporate staff as the company grows. Successful roll-ups grow very rapidly which necessitates the need for a detailed plan. Without this, the company can outgrow the management which is a recipe for disaster.

Acquisition Process

Should be a core competency of any roll-up company and should function in many ways like a well-designed and executed manufacturing process.

This process should be spelled out in detail and should start at Identification of Target and cover everything all the way through the first year of the execution of the Performance Maximization Process.

I cannot stress too strongly that the absence of a process like this will result in less than full value maximization and potentially in failure. Also, it is critical that both Integration and Post-Acquisition Performance Maximization be fully developed and aggressively executed.

Highly Competent & Cooperative Legal Counsel

1. In-depth experience with mergers and acquisitions

2. Willingness to work at very fast pace to keep deals on track. For two reasons, roll-up acquisitions need to be closed quickly (I have always had a target for a closing within 30 days of signing a letter of intent). 1. If successful, many deals going on simultaneously and without moving quickly the entire process can bog down and 2. Typically dealing with business owners who consider their company their “baby” and as such can easily get seller’s remorse. The longer a closing drags out, the easier it is for seller’s remorse to set in and the deal dies.

It is important to have a discussion at the outset with potential law firms regarding what is expected as most will not be prepared to function at the pace required to successfully paper and close transactions at the speed required.

The failure rate of roll-ups is high due to the simple fact that all of these components were not embedded in the overall strategy and plan of those that failed. But, as noted previously, planned and executed properly, there can be significant value created via a roll-up strategy.