Value Creation strategies: How successful is Buy and Build?

In 2021 the Private Equity market was characterised by cheap debt, inflated asset valuations, and a strong fundraising environment for investors and portfolio businesses. This led to massive amounts of capital being raised by GPs and a frenzy of deal activity as we experienced strong activity in relation to buyouts and exits. The focus for the past few years has been on top line growth (at times growth at all costs). As multiples were at an all time high, value creation was relatively easier. Asset holding periods were lower as exits took centre stage as the main driver of value creation.

Since the start of 2022 dark clouds started to emerge in the global economy, driven mainly by post covid inflationary challenges, rising interest rates, and economic uncertainty due to the war in Ukraine. This has led to a slowdown in buyouts and exits as investors grapple with an uncertain and changing macro economic environment. At a time when traditional exit options have dried up and asset prices are falling, the need for GPs to pivot away from their previous exit plans and navigate a new environment has become paramount to maintain and create value.

The focus has shifted to longer term value creation i.e. operational improvements as investors bide their time until the market for exits becomes favourable. Operational improvements are not the only option to create value though, especially as this strategy typically takes a longer time horizon to implement and realise the benefits. Over the years Buy and Build has become a popular strategy of realising operational improvements and furthering a credible narrative of future expansion and growth, thereby achieving multiple expansion (the key driver of value creation).

What is Buy and Build and how successful is it?

Buy and Build is where a Private Equity firm purchases a business with strong fundamentals which is then used as a platform to grow via additional acquisitions (add-ons or bolt-ons) as the aim is to create a combined business which is worth more than the sum of its parts.

This is a specific strategy where a platform business is acquired, and then at least 4 smaller add-ons are acquired by the platform. 1 or 2 acquisitions over the course of a holding period or one off mergers meant to build scale or scope, wouldn’t be classed as Buy and Build. According to empirical research by McKinsey, the strategy that is most likely to create the most value for businesses is “Programmatic M&A”. That is, carefully structuring a series of deals around a specific business case or M&A theme, rather than relying on one-time transactions, is far more likely than other approaches to lead to stronger performance and less risk (McKinsey, How one approach to M&A is more likely to create value than all others, 2021).

Over recent years there has been an increase in the number and size of Buy and Build deals, and there’s one key reason for this, they outperform standalone Private Equity deals. According to Silverfleet’s European Buy & Build 2019 index, the number of add-on acquisitions has increased by 120% during the period 2013-2019.

The 3 key benefits of this strategy are:

1. Synergies

The rationale for Buy and Build is to accelerate revenue growth and drive margin expansion by realising synergies. There are many ways to achieve this. Some common ways to achieve synergy include greater efficiency or scale, the benefits of combining talent, cross-selling opportunities and potential cost reduction.

2. Multiple expansion

In addition to near term operational improvements, it can also create market expectations of continued growth and margin improvements in the combined business, which can translate into higher exit valuations. It provides GPs a way to take advantage of the market’s tendency to assign larger businesses higher valuations than smaller ones (larger businesses tend to command higher multiples than smaller ones because they have more scale and resilience).

3. Multiple arbitrage

Buy and Build is also popular because it offers a powerful solution to combat rising deal multiples or an expensive platform investment. It allows a GP to justify the initial acquisition of a relatively expensive platform business by offering the opportunity to bolt on smaller add-ons that can be acquired for lower multiples later on. This brings down the firm’s average cost of acquisition, while putting capital to work and building additional asset value through scale and scope. Private Equity firms appreciate fast gains and want to turbo-charge their investment returns. Buy and Build can be a way to boost your business value over and above the effects of any cost savings and operational gains (Bain & Co, Buy and Build: A Powerful PE Strategy, But Hard To Pull Off, 2019).

Key questions for a GP

Buy and Build is a great strategy in order to create value but in order for it to work it is important the right type of business in the ideal industry is located, (which is no mean feat in the current environment), but with effective market research, investment modelling, and building a strong network, GP’s can find appropriate platform investments and add-ons.

1.      Does the potential for acquisitions in this sector provide enough runway for the strategy to create meaningful value?

2.      Does the platform already have the right infrastructure to make acquisitions, or will you need to build those capabilities?

3.      Will potential add-ons have lower valuations than the platform business, so that buying them presents a true multiple arbitrage opportunity?

4.      Will potential add-ons be meaningfully accretive? i.e. does the sector offer plenty of targets that are smaller than the platform business, but not so small that acquiring them doesn’t add value.

5.      How much work does the platform business need to perform in order to implement the strategy?

Deep answers to questions like these are a necessary prerequisite to evaluating the real potential of a buy-and-build thesis.

How do you implement a successful Buy Build?

Industry dynamics

Sector dynamics can have a significant impact on the success or failure of a Buy and Build. The ideal conditions need to exist for superior value creation. Ideal conditions are:

• highly fragmented
• low growth and low profitability
• low risk of disruption/stable environment
• ample supply of acquisition targets of the right size

The above conditions offer the optimum opportunity to merge existing players, achieve synergies and increase market power before others have a chance to catch-up. This drives EBITDA multiple expansion on top of margin expansion to deliver rapid value growth. Add-ons also outperform when they increase the platform business’s presence in a particular industry, as opposed to diversifying its business lines.

It is also critical to understand how quickly the remaining consolidation opportunity is being depleted away. Too much demand for too few targets will drive up prices and compete away the multiple arbitrage opportunity.

GPs can avoid getting caught by focusing on their exit strategy from the outset. If the sector continues to offer Buy and Build opportunity, it leaves room for the next buyer to continue the consolidation, which should improve exit value. If the opportunity is largely exhausted, the exit story needs to reflect a clear shift in strategy. Often the opportunity graduates from Buy and Build to either exit to a strategic buyer (looking to expand in the sector and sees value in a newly scaled-up platform business), or scale M&A (where a consolidator starts buying up other consolidators).

The ideal platform and add on investments

It is the platform business that usually makes the add-on acquisitions, not the GP, therefore it is critical that the business generates consistent free cash flow to finance deals in succession and offers an operationally efficient and scalable platform. The GP is theoretically a backstop if the platform asset experiences cashflow problems, 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 the GP’s strategy.

Ideal platform investment

• generates strong consistent cashflow.
• small or medium sized platforms, as they typically gain the most from add-on acquisitions.
• the right foundational infrastructure which provides an efficient and scalable platform to scale i.e. robust IT systems, a strong balance sheet, repeatable financial and operational models, and well developed distribution and sales networks.
• a strong existing management team that has already demonstrated its ability to execute Buy and Build.

Ideal add-on acquisition

• Successful strategies target acquisitions that are close to the core, rolling up a set of highly related businesses to achieve the benefits of synergies and increasing market power.
• Add-ons outperform when they increase the platform business’s presence in a particular industry, as opposed to diversifying its business lines (building depth rather than breadth generates higher returns).
• 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.

The highest performing outcomes tend to occur when the platform and add-ons are small or medium sized, some of the key findings are:

• Research shows Buy and Build activity increases with the size of the initial platform deal, but the deals of small platforms outperform those of medium sized and large platforms by sizable margins (BCG, How Private Equity Firms Fuel Next-Level Value Creation, 2016).
• The greatest multiple expansion occurs in businesses with relatively small enterprise values, this is mainly due to the valuation multiples of smaller businesses expanding at a faster rate and size than those of their larger counterparts, and also because smaller businesses predominate in fragmented industries, which are primed for consolidation.

Buy and Build experience

One factor can have a significant impact on the success of this strategy regardless of a deal’s size, location, or industry. The strategy stands little chance of success if the GP or portco management team executing it lacks operational and Buy and Build experience.

BCG found that teams with experienced operators not only did more deals but also reaped higher returns. According to their survey, GPs with more than 10 deals under their belts earned an average IRR of 36.6%, compared with 27.3% for firms with fewer than two Buy and Build deals and 28.7% for firms that did two to ten. That strongly suggests that operating experience is essential to creating value through the successful realisation of synergies and integration of acquisitions. GPs that do multiple add-on deals often generate higher returns from them than firms with less Buy and Build practice (BCG, How Private Equity Firms Fuel Next-Level Value Creation, 2016).

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 GP or platform management) created or destroyed value. Outcomes improve only when leaders use insights from past deals to make better choices the next time.

Secondaries thrive from Buy and Build

Buy and Build is most commonly utilised in primary deals. According to BCG, 43% of primaries engaged in Buy and Build, compared with 32% of secondary transactions (in which ownership of an asset passes from one GP to another). The strategy, however, is more successful in secondaries. Although this strategy is more common among platforms acquired as primary deals, occurring in 43% of cases (compared with 32% of secondaries), Buy and Build deals among secondary platforms generate higher IRRs.

These findings suggest that Buy and Build is a crucial means of value creation in secondaries. The primary owner will have used the basic operational improvement levers, such as margin gains and revenue enhancements, by the time the asset is sold. It then falls to the secondary owner to apply the next, more advanced set of operational improvement moves to create additional value in the portfolio business. Such improvements might include improved price realisation, enhanced sales force effectiveness, or increased sales of higher margin products or services.

International expansion creates more value

Buy and Build is especially effective when used to internationalise the acquirer’s business. The international expansion of a formerly domestic business creates opportunities for cross-selling and economies of scale, as well as multiple expansion if the business improvements raise investors’ expectations of future gains in financial performance.

A comprehensive and well prepared integration plan

It is not enough to acquire and let businesses run independently on a stand-alone basis. As more than half of private equity deals are secondaries, investors have become savvy to quick-flips, therefore diligence and analysis of an investment that has undergone Buy and Build is much more rigorous. Acquired businesses need to be successfully integrated into a well-functioning, merged organisation in order to credibly argue a full priced exit valuation.

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 portco management will take the lead. Given the typical Private Equity holding 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.

3 key integration success factors distinguish successful Buy & Builds deals:

1.      The merged organization design (Target Operating Model) should have the economically most optimal degree of integration between platform and add-on acquisitions within each function, which takes advantage of scale, but without sacrificing accountability.

2.      An atmosphere of collaboration must be established between the respective businesses from the beginning to facilitate constructive realisation of synergies.

3.      A well structured governance process and neutral 3rd party facilitation is needed to ensure smooth integration and risk mitigation.

Reasons why Buy and Build can fail

Due to the multitude of factors involved in implementing a successful strategy, there are also several factors which can lead to a failed strategy. These include:

• Cyclicality can disrupt cash flow. In an industry with fluctuating demand, this can wreak havoc on free cash flow, hindering 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 of plans. Buy and Build depends in part on creating scale advantages, however if suppliers or customers are combining in parallel, a business plan that relies on increased purchasing leverage or pricing power can fall apart quickly.
• Moving into adjacent business lines can make sense, but it is critical to understand the risk. The further a business moves away from its core, the greater the risk.
• Negative synergy, where two or more businesses are worth less in combination than they were separate. There are various reasons why a merger might fail in this way. A clash of leadership styles or incompatible corporate cultures are often blamed.
• A lack of understanding in terms of the amount and complexity of work involved in order to create value. If the answer is a lot, it can drastically affect the timing of value creation. The business may have already made acquisitions that are poorly integrated. Too many attempts at creating value through Buy and Build fall apart due to bad planning. What looks like a slam dunk strategy….rarely is.
• Coming in too late and acquiring expensive add-ons which push up the combined cost of capital for the investment, and wipe out any opportunity to create value.

Conclusion

To capture the opportunity that Buy and Build presents, GP’s must raise their game in all phases of their value creation plans in their portfolio businesses. The strategies that outperform typically rely on multiple paths to value creation, as this is critical to create value in all markets and in all stages of the economic cycle.

While this strategy has been around for quite some time, it has never been as popular as it is right now. This is because it can offer a clear path to value at a time when deal multiples have been 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. The potential for significant value creation is there, and to do so requires sophisticated investment diligence, a clear playbook, and strong, experienced leadership.

Spotting the ideal Buy and Build opportunities has to be the explicit target of investment diligence, so that the GP can begin pulling each of the value creation levers from day one of ownership. Execution is as important as the investment. Great diligence leads to a great playbook. The best GP’s have a clear plan for what to buy, how to integrate it, and what roles fund and portco management will play. The most effective practitioners diligence the whole opportunity throughout the period of ownership leading to exit.

The proliferation of Private Equity firms over recent years, and the sheer amount of dry powder yet to be deployed, creates additional challenges in terms of competing for the most attractive opportunities at the right price.