As a fast-track route to growth with a focus on efficiency gains, buy-and-build seems perfectly-suited to our low-growth world, writes Jennifer Bollen
Market consolidation, group-wide cost cuts and the potential to expand rapidly are just some of the draws of the private equity buy-and-build strategy.
Buy-and-build – where a buyout firm adds companies to a platform business – is not new to private equity. However, a global private equity report this year by consultancy Bain & Co says that it has gained popularity since the onset of the financial crisis as private equity houses face pressure to deploy vast sums of committed capital in a low-growth environment.
However, figures from data provider Dealogic show a very different trend – that the number of add-on deals in Europe has fallen to its lowest level of the past five years. So far this year, there have been 202 European add-on deals by private equity firms compared with 319 in the first three quarters of 2011. Meanwhile, the total known values of add-ons has also fallen, from $11bn (€8.6bn) in the first three quarters of last year to $2.7bn (€2.1bn), so far this year.
Neil MacDougall, managing partner of buy-and-build specialist Silverfleet Capital, says that the activity reflects the difficult economic conditions across Europe. “I expect there will be a slow recovery over the medium term,” he says. “I would be hugely surprised if there was a big rebound. I don’t think there is enough confidence and I don’t think trading conditions are, in general, strong enough.”
Nicol Fraser, a partner at mid-market buyout firm Dunedin, added that securing buy-and-builds could be challenging for firms new to the strategy: “[Private equity firms] may be struggling to find the same [buy-and-build] platforms because they may have driven into the most obvious sectors previously to do that.”
But Richard Parsons, a director at Deloitte, says buy-and-build fundamentally remains an attractive proposition. “Historically it was easier for [buyout firms] to make money by multiple arbitrage/financial engineering and the use of cheap debt,” he observes. “Private equity firms are now having to think a bit harder and demonstrate how they are adding value to portfolio businesses and one of the ways they can do this is by considering a buy-and-build strategy.”
Chief among the advantages of buy-and-build is the opportunity to scale up a business by consolidating a fragmented sector, particularly those which face regulatory burdens and high research and development costs. Bain & Co highlights that scaling up a business through add-ons can be cheaper than buying an already large company, because acquisition multiples are often lower for smaller businesses.
Some of the most popular sectors for consolidation include healthcare, education and business services. Buy-and-build-focused Sovereign Capital’s portfolio includes private school operator Alpha Plus, residential care provider Choice Care Group and insurance claims business CMGL.
Silverfleet’s portfolio has strongly featured healthcare, with investments in Aesica Pharmaceuticals, which it bought last year, Germany-based dentistry equipment provider European Dental Partners, which it sold last year to trade buyer Lifco Dental International, and management services provider TMF, which it sold to buyout firm Doughty Hanson in 2008 for €750m, making six times its investment.
MacDougall is wary of pure consolidation strategies, seeing great value in using add-ons to enhance a business’s offering. “Our approach is to have a core business and to do a smaller number of add-ons that get the business into a new market or new technology that is adjacent to what they already do, or make it in some way into a better business and a broader business than the one you started with,” he explains.
Buy-and-build also enables firms to cut spending through centralised operations and purchasing, making a bigger company a more efficient company, according to MacDougall.
Additionally, the strategy offers a good risk weighting for a fund, according to Dominic Dalli, a partner at Sovereign, which uses follow-on capital to grow its portfolio companies through the roll-out of new sites. This approach means Sovereign can back the winners of its portfolio more strongly than the investments that perform less well.
But buy-and-build is fraught with challenges, beginning with the platform company, which must be a sound business. “If a platform is thinking of making an acquisition, it has got to be performing pretty well itself,” says MacDougall. “In an environment where trading across Europe is probably flat or possibly weak in certain sectors, people are going to be more cautious about whether they should be doing acquisitions.”
He adds that the platform does not necessarily need to be a large company – Silverfleet focuses on companies worth between €100m and €150m, while Sovereign invests up to £50m (€63m) equity in its businesses – but that the platform’s management must have enough capacity and ability pursue a potentially large number of acquisitions (Silverfleet’s record bolt-ons for one platform is 50, for TMF).
MacDougall adds that firms should refrain from attempting to grow a group too fast through acquisitions that might be too big for a platform to cope with. “Some sponsors will go out and try to do a transformational deal which is big relative to the existing platform, really creating a step change in the size of the business,” he says. “That is something certain organisations really believe in.” Such deals carry a higher degree of risk, he says, since they are rarely bought for attractive prices because a range of different buyers is often hovering around the asset.
He also says that it is crucial clearly to define the role of the platform business to ensure there are no questions within the group regarding command: “We like to know who is doing the acquiring and who is being acquired so there is no ambiguity as to who is going to call the shots afterwards.”
Executing a successful integration of multiple businesses relies heavily on understanding the culture and structure of investee companies. “All of these service businesses are people businesses,” observes Sovereign’s Dalli.
Company culture is a particularly prominent issue in two sectors that have attracted more private equity interest in recent years – funeral services businesses and law firms. Sovereign currently owns LM Funerals, which runs 60 branches, and in 2009, August Equity invested in Funeral Services Partnership. The sector can be a difficult private equity play, given the hugely protective family-owned nature of the business.
Private equity firms have been mulling investments in law firms since alternative business structures were introduced by the Legal Services Act 2010. The changes allowed law firms to structure themselves with different business models – for instance, using non-lawyer partners – and led to deals such as Palamon Capital Partners’ acquisition of high street solicitors chain Quality Solicitors last year.
But Dalli is sceptical about whether the legal sector will provide straightforward opportunities. “They are people-centric businesses that do not lend themselves particularly well to buy-and-build,” he warns. “Are you going to buy teams or departments within legal firms? We would like to invest in a legal services business with the right culture and approach to private equity involvement.”
Despite talk that buy-and-build is a strong strategy for generating value in a tough economic environment, proving that bolt-ons generate higher returns than other forms of private equity remains difficult.
Bain & Co’s 2012 private equity report shows that, based on a study of more than 1,900 European companies, 34.5% of buy-and-builds had generated returns of 2-3.5 times investment, compared with 32.2% of other deals. A further 16.9% of buy-and-builds had returned 3.5-5 times investment, compared with 13.3% of other types of deals.
Burns is unconvinced. “It’s open to manipulation, depending on what the owner of the data wants the answer to be,” he says. “You could produce the data but I would have a high degree of cynicism about the data.”
You can create value or destroy value through buy-and-build, adds MacDougall. “If you do it very well you can have great IRRs,” he says. “However, if there is some underlying organic growth in the business already, distinguishing how much additional return comes from buy-and-build is very difficult.”