In the pursuit of attractive equity returns, private equity firms have developed numerous innovative strategies beyond typical leveraged buyouts and take-private transactions. One of these “new” strategies that has grown in popularity over the past decade is the concept of “roll-ups” (also sometimes called “platform acquisition strategies”).
In a roll-up strategy, a private equity firm will attempt to consolidate a large number of smaller firms into a single, professionalized company with numerous benefits, including economies of scale and fixed cost leverage, valuation uplift (so-called “multiple arbitrage”), and acquisition expertise, among others. Let us examine each of these in detail:
Economies of Scale and Fixed Cost Leverage
To illustrate the benefits of economies of scale and fixed-cost leverage, let us consider the example of veterinary medicine. As it happens, this is an industry that has experienced a significant amount of private equity-backed roll-up activity. For example, relevant platforms in this space include AmeriVet (owned by AEA and ADIA) and VetCor (owned by Oak Hill). In this industry, owning 50 to 100 or more veterinary centers gives you procurement advantages in that you can buy much higher volumes of suppliers (syringes, medical equipment, etc.) and thus receive volume discounts with better pricing. Further, you can centralize many non-veterinary functions in a corporate office to drive fixed-cost leverage. For example, whereas 10 independent veterinary clinics might each have their own human resources and accounting functions, a roll-up platform will have centralized functions that can be shared across multiple clinics. Further, the more professionalized centralized capabilities in a roll-up platform can often operate more efficiently – veterinarians are not trained in human resources or accounting and certainly did not enter the field to spend time focused on those areas. As a result of all these factors, acquired companies can achieve substantial margin uplift upon being acquired (even before considering other benefits from sharing best operating practices across a large group of acquired companies).
Valuation Uplift and Multiple Arbitrage
Apart from the margin uplift and cost benefits described above, roll-ups can create equity value simply through their scale alone. Small, independent businesses are often available at lower multiples when compared to the market valuations for scaled businesses with more diversified operations. To illustrate this point, let us consider the landscaping industry. As one example, BrightView, now a publicly-traded company, developed as a roll-up of smaller landscaping businesses and has been owned at various times in the past by private equity firms including KKR, MDS, and Leonard Green, among others. Let us assume smaller landscaping firms trade for 4-6x EBITDA and a larger landscaping platform trade for 8-10x EBITDA (these numbers are illustrative but serve to make the point). If a large platform acquires a small business doing $5 million of EBITDA for $25 million (i.e., 5x EBITDA), this incremental $5 million of EBITDA could be worth $40 million or more – creating an instant gain of $15+ million.
It is important to consider that this gain is before even considering the fact that the roll-up should be able to increase the acquired company’s EBITDA for some of the reasons mentioned earlier including economics of scale, fixed cost leverage, and accelerating revenue growth. If the larger roll-up acquirer has the ability to finance these acquisitions with incremental debt capacity, the equity value uplift may be even greater (although the reasons for this are beyond the scope of this article). This begs an important question: why do roll-ups receive a higher value than smaller acquisition targets? There are a few reasons. First, roll-up platforms often grow faster than independent businesses, in part because of their substantial inorganic growth. Second, roll-up platforms often have built-in M&A value (they are more likely to be acquired at a premium valuation by even larger strategic players or conglomerates). Third, the reality is that sellers of these businesses may often be less sophisticated counterparties or motivated to sell for non-financial reasons (want to retire, do not have a family member interested in continuing to run the business, etc.). Finally, roll-up players are likely to have a cost of capital advantage through the clever use of debt financing or other “financial engineering” tactics in which private equity firms specialize.
At their core, private equity firms are mergers and acquisitions specialists. This is a large part of the reason why private equity firms recruit so heavily from investment banking, where they are able to find professionals with extensive M&A experience. This expertise is a key function in executing a roll-up strategy, where a large portion of the value creation stems from acquisition expertise. In a roll-up, the private equity acquirer can leverage this skillset to ensure acquisitions are structured in a way that maximizes value to the private equity firm and its investors. More specifically, this might entail negotiating transaction features such as earn-outs, deferred consideration, or seller financing, just to name a few. Further, private equity firms may offer the seller flexibility in how their deal is structured, such as by offering a joint venture structure with shared ownership and residual economic participation in the acquired entity by the seller. Alternatively, deals may be structured in such a way that the seller is able to receive a small amount of equity in the actual platform itself. In many cases, private equity professionals will leave private equity and play this role (often labeled “corporate development”) for platform acquisition companies.
At this point, you now have familiarity with how roll-up strategies work and why private equity firms use them to create equity value. This phenomenon is becoming extremely widespread, and has gained prominence in the following industries (although to be clear, this list is not exhaustive by any means): personal financial advisory, HVAC (heating, ventilation, air conditioning), dental medicine, veterinary medicine, car washes, automotive aftermarket and repairs, and many more. As this strategy has gained popularity, competition has increased and this has driven up the prices for acquisition targets. As a result, private equity firms must look at more and more new industries and assess their consolidation potential. As an aspiring private equity investor, you should be familiar with this trend and always be on the lookout for whatever industry may be next.
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