Why You May Want to Reconsider Your Industry Roll-up Strategy

Listen to this Blog Post

---

In its simplest form, a “roll-up” or consolidation thesis would see the acquisition of a single (often larger) “platform” company, to be followed by subsequent acquisitions of other (often smaller) “bolt-on” companies within the same industry. The industries in which this thesis is most prevalent tend to demonstrate the following characteristics:

1. They are highly fragmented, and as a result present acquirors with a large universe of potential bolt-on targets;
2. Smaller companies trade at lower multiples than larger companies (typically because there is a larger supply of small companies than there is a demand to acquire them);
3. As a result of both considerations above, they present the opportunity for multiple arbitrage: For example, when a larger company valued at 6x EBITDA buys a smaller company valued at 4X EBITDA, the entire consolidated entity may be valued at 6X, allowing the buyer to benefit from the 2X delta “for free”; &
4. They feature meaningful economies of scale (that is, there are substantial economic benefits to being a larger company)

Though pursuing the consolidation of an industry is not necessarily a new thesis for search funds, I have observed that it has become increasingly popular over the past few years. And though the thesis isn’t necessarily limited to any one industry, it seems to have become particularly popular within the home services ecosystem (HVAC, landscaping, roofing, plumbing, etc.). Indeed, the “HVAC roll-up” thesis has become so prevalent of late that it has become a sort of caricature of itself.

Though there have been, and will continue to be, many consolidation success stories within the search fund ecosystem, I suspect there will be an equal number of failures, though this latter outcome will surely be much less publicized.   

Though I’m not against consolidation theses in and of themselves (indeed, I invested in one last year), I do find myself more skeptical than most when presented with one.

In today’s blog post, I’ll attempt to explain why.  

First Principles Thinking on Industry Fragmentation

In almost every PPM that I’ve ever read, prospective searchers list fragmentation as one of their most important and desired industry characteristics. Though there are indeed certain benefits to operating within a fragmented industry, it’s worth asking how and why any industry becomes fragmented in the first place: Often, it is because there are few (if any) barriers to entry. These low entry barriers usually produce a large number of small companies that compete against each other intensely, and in many cases these companies offer products and services that offer very few options for competitive differentiation outside of price.

When the product or service offerings between provider A and provider B are virtually identical, there is a tendency to revert to competitive differentiators like “reputation”, “quality” and “experience” when explaining any given firm’s right to win. While considerations like these can be differentiators in some instances, in an equal or greater number of instances they’re simply not. Instead, they’re listed as differentiators due largely to lack of a better explanation as to why they win customers over the proverbial competitor across the street. Indeed, when was the time you spoke to an owner who told you that her company was known for low quality, a poor reputation, or minimal experience? When every company in a given industry touts the same competitive differentiators, it is often because their industry doesn’t present them with many other options.

This is all to say that fragmentation, in and of itself, isn’t necessarily a good thing.

Execution Challenges

The skeptical reader may point to some of the challenges above as the reasons to pursue a consolidation thesis in the first place: Indeed, a larger company, built up through M&A, can do better marketing and generate better brand awareness, can purchase supplies from vendors at lower prices and pass those savings through to their customers, or can offer more attractive packages to prospective employees (with employees generally being the most important and powerful “suppliers” in most of these types of businesses).

Though these considerations can indeed be true in some instances, each presupposes a successful acquisition and integration process. The problem with this assumption, however, is that consolidation strategies are generally much harder to execute than they are to dream up. Indeed, the data is quite clear in this regard: It is estimated that between 50% – 80% of all M&A deals fail to achieve their intended goals or end up destroying shareholder value. For this reason, any aspiring consolidator ought to ask themselves what they are likely to get right that 50%-80% of their better financed and more experienced peers apparently got wrong.

The reasons why inorganic growth strategies are so fraught with peril are numerous, and have been widely discussed by many people far more qualified than I. For this reason, I won’t get into them here, but instead will highlight a few considerations that I often discuss with prospective consolidators:

• Bandwidth Constraints: On average, approximately one-third of all search funds wind down after 24 months without consummating an acquisition. Of the two-thirds that do acquire a company, they take approximately 20 months from start to finish to do so. These endless months of toil tend to teach searchers just how hard it is to acquire one company, never mind acquiring two, three, four or five of them. Furthermore, once one ascends into the CEO seat, they’re often overwhelmed by the demands of that full time job, to say nothing of the second full-time job that they would assume if they added “industry consolidator” to their job description. This is particularly true for solo searchers, who, by definition, are more bandwidth-constrained than their partnered peers. This concern is also particularly acute when the first company acquired doesn’t have a deep bench of managers who are willing and able to manage the day-to-day operations of the company while their new boss searches for acquisition candidates.  

• “Single Point of Failure” Risk: Unless the “platform” that one acquires is large enough and attractive enough on its own to make for a compelling investment thesis, then any given consolidation strategy may be subject to a “single point of failure” risk. That is, if your ability to acquire is harder, more expensive, less successful, or takes longer than originally anticipated, you don’t want to be left holding a single asset whose attractiveness is largely dependent upon its combination with another asset. Any investment thesis that features a single-point-of-failure risk has me immediately skeptical, this one chief among them.

• The Optimal Size of a Bolt-on Acquisition: I’m not sure that there is an objectively correct answer to this question, but it’s at least worth asking whether any consolidator would be better off buying five $1M companies, or buying a single $5M company. I find that most prospective consolidators tend to lean towards the former over the latter, but I’m not entirely convinced that this is due to underlying economics. Instead, it seems to be largely reflective of their enthusiasm for simply doing deals, or perhaps their view that doing a large number of small deals is simply what any consolidator ought to do.
  
  
• Is the “Juice Worth the Squeeze?”: Some industries are so fragmented that prospective acquirors would be wise to ask themselves whether the increase in size attributable to a bolt-on acquisition is likely to be worth the time, expense, and headache of consummating that acquisition in the first place. This question seems to be particularly relevant in healthcare practice roll-ups (dental, podiatry, etc.), where the universe of available targets seems to be largely comprised of practices boasting only 1-2 physicians, that are, by definition, small and highly dependent upon their physician-owners. In situations like these, acquirors would be wise to contrast the uncertain benefits likely to accrue to them after closing with the certain time, expense, and distraction costs that will be borne by them prior to closing.

Personal Motivations

Almost any experienced industry consolidator will tell you that doing the deals is the easiest part of any roll-up strategy. It is the subsequent integration process that is the brutally hard part, and is often the place where shareholder value goes to die. As A.J. Wasserstein said on his recent appearance on the In the Trenches podcast: “In some ways, I wish acquisitions weren’t called acquisitions. I wish they were called integrations. Because that’s what acquisitions are really about. They’re about everything you do after the close, not before the close. Acquisitions can be awesome if you love integrating payroll systems, invoice presentation solutions, re-registering vehicles, getting customers to mail checks to a new lockbox, or getting customers to remit to a new electronic payment solution.”

I’m not suggesting that one can’t be genuinely motivated by the prospect of buying a number of disparate companies and rolling them up into a single and cohesive whole. Instead, I’m suggesting that one should reevaluate if their primary motivation is derived largely from the thrill of the deal.

How to Finance Inorganic Growth Strategies

Because search funds target small companies that only generate so much operating cash flow in any given year, subsequent acquisitions usually need to be financed through some combination of new equity and/or debt. Broadly speaking, there are two possible financing structures to consider:

Deal by Deal: On one hand, searchers can choose to simply finance new acquisitions on a transaction-by-transaction basis, which provides less certainty for the operator but more flexibility for her investors. If she’s raising additional debt, she’ll need to consider whether the combined company can support additional leverage, especially if she’s been reinvesting profits back into the business to fund organic growth and has been driving profitability flat (or even down) as a result. If she’s raising additional equity, she will likely have to contend with dilution concerns from existing equity investors, especially if they participated in acquisition A but have chosen not to participate in acquisition B.  

Committed Capital Vehicle: To combat some of these concerns, some searchers choose instead to employ a “committed capital” structure, where they raise a given amount of money upfront and call that money over time (usually several years) as needed. This structure provides the most certainty to the operator, but the least amount of flexibility for her investors. It’s worth noting that under this structure, the operator may run into issues if her timeline for drawdowns doesn’t nicely align with her LP’s timelines for capital deployment in their own funds. In addition, unless investors are very compelled by the thesis at an industry level, they may prefer to reserve their judgment (and their commitment to fund) until they’ve evaluated the merits of each individual acquisition target.

Situations in Which I’m Less Skeptical of the Consolidation Thesis

If you’ve made it this far, you’d be forgiven for thinking that I’d be unlikely to invest in any consolidation opportunity. However, as noted above I already have, and plan to continue evaluating them in the future. If I do invest in a consolidation thesis however, then substantially everything below would need to be true:

First, the “platform” company being purchased has to be large enough and attractive enough, on its own, to present a compelling investment thesis. This eliminates the single-point-of-failure risk mentioned above, and creates a situation where even if you’re completely wrong about the consolidation opportunity, you still have the potential to realize an attractive return on your investment with that single asset. In my opinion, one should never buy an asset whose attractiveness is largely contingent upon its combination with another asset (as my Strategy professor used to say “two donkeys do not make a thoroughbred”).

Second, and related to the consideration above: The ideal investment thesis would treat inorganic growth as a “nice to have”, not a “need to have”.

Third, there needs to be specific returns to size beyond simply being bigger. A “1 + 1 = 2” thesis is one where additional companies are purchased simply to make the parent company larger. While larger companies often do trade at higher multiples than their smaller peers, in my opinion the promise of increased size alone is insufficient to justify the risk inherent in any acquisition strategy. Instead, I’d need to understand what the potential is for “1 + 1 = 3” economics: That is, beyond size, how else do we benefit from being larger? And how meaningful are these additional benefits?

Fourth, I would need to ensure that there aren’t incentives in place that would compel the searcher in question to acquire companies at a pace that is faster than would otherwise be prudent. When searchers utilize the “committed capital” funding structure mentioned above, they’re often forced to choose a timeline during which they’ll make all of their contemplated acquisitions, after which they would return any leftover capital to investors. While this type of arrangement can help align timelines between an entrepreneur and her investors, it can also incent the searcher to consummate deals faster than she otherwise would. The reason why I think this is so important is because most successful acquirors “go slow to go fast”. That is, they take many years to truly understand how to run and optimize their platform business before they start looking for bolt-on opportunities. Any incentives that would preclude this learning process would make me reasonably skeptical.

(Though this falls outside of the realm of M&A, it is nonetheless my favorite story about “going slow to go fast”: Danny Meyer, known as the world’s most prolific and successful restauranteur (best known for such establishments as Union Square Café, Gramercy Tavern, Eleven Madison Park and Shake Shack, among others), took nine years to open his second restaurant after opening and running his first, Union Square Café, in 1985). Talk about going slow to go fast.

Finally, it would need to be clear that the risk-adjusted economics of growing via acquisition are superior to those of simply growing organically. For an example of when this might be true, consider an asset-intensive, industrial equipment rental business: To grow organically beyond the company’s current geographic location, they would need to find and secure new warehouse space, acquire hundreds of pieces of equipment to rent out to customers, establish brand new relationships with customers who already have long-standing relationships with local suppliers, apply for all of the local permits, and hire and train a brand new set of employees. While growing organically in an industry like this is certainly possible, it’s also likely to be extremely capital intensive, time consuming, risky, and difficult to establish a local foothold in any reasonable amount of time. In industries like this, growing via M&A may actually be the better risk-adjusted bet.

In Sum

Pursuing a roll-up strategy can be a wonderful opportunity for personal fulfillment and financial success for the right entrepreneur, with the right motivations, operating in the right industry, with the right structure and the right investors. However, the data is overwhelmingly clear that consolidation strategies are much harder to execute than they are to dream up.

Specific to the increasingly popular home services roll-up thesis: Despite the oft-cited “historical under management”, “low hanging operational fruit” and “ripe for consolidation” possibilities, my least favourite industries to invest in seem to fall in the “call the top 3 Google results, and choose the one who gets back to you most quickly” category.

For this reason, I would encourage all prospective consolidators to be deeply thoughtful about their personal motivations, the stand-alone size and attractiveness of their platform company, their bandwidth constraints, the single-point-of-failure risk that may or may not reside within their thesis, how many acquisitions they think they ought to do, their financing structure, the incentives created by that financing structure, and the specific returns to scale in their industry beyond absolute size.

---

Thanks to our Sponsors