Summary: A roll-up acquisition strategy involves consolidating smaller companies into a larger company to achieve a higher valuation. The buyer's objective is to eventually exit the transaction through a liquidity event.

Roll-up acquisitions are typically financed with a Delayed Draw Term Loan (DDTL). These loans allow multiple draws as acquisitions are made and rolled up. This type of financing is offered by specialized lenders. This article explains how roll-up acquisition strategies work and how they are financed. We cover the following:

1. What is a roll-up acquisition strategy?
2. Advantages and risks
3. Typical financial structure
4. Qualification requirements

1. What is a roll-up acquisition strategy?

A roll-up acquisition strategy involves buying and consolidating several smaller companies into a larger parent company. Buyers and sponsors typically use this strategy in fragmented industries that they believe would benefit from consolidation.

Roll-ups are a common strategy for Private Equity and certain entrepreneurs. The transaction's sponsor typically sets up a platform company that handles all the acquisitions.

Each subsequent acquisition is merged with the platform company. These acquisitions are colloquially known as "bolt-on" companies because they are "bolted into" the platform company.

The private equity group and its investors typically have a short time horizon. They want to be in a position to exit the transaction in 5 to 8 years through a liquidity event, such as a sale or IPO.

a) Platform company

The platform company is the sponsor's initial acquisition in the target industry. The platform company becomes the equivalent of a "parent company.’' All subsequent acquisitions are merged with the platform company.

2) Advantages and risks

Roll-ups have the potential for substantial gains. This is why the strategy is popular with Private Equity companies and some entrepreneurs. However, achieving a profitable exit is challenging because the strategy is vulnerable to several risks.

a) Advantages

Roll-up acquisitions offer several advantages. These are the most important ones.

i. Increased valuation multiples

Larger companies typically command higher multiples than their smaller counterparts. This scenario presents an interesting opportunity. The sponsor has the potential for a profitable exit if no efficiencies are gained. This advantage is colloquially known as "multiples arbitrage."

ii. Efficiency gains

The buyer should be able to consolidate several overlapping functions, such as HR, marketing, accounting, sales, etc. This efficiency increases profits by reducing costs.

iii. Increased market share and sales

The larger firm should have access to a larger market share. This access can be leveraged to increase sales. Additionally, the cross-selling of products offers the opportunity to increase revenues.

b) Risks

Roll-ups are difficult to execute and are considered risky. The sponsor must execute a series of complex acquisitions and integrations in a short time period. This difficulty leaves roll-ups exposed to the following challenges.

i. Financial vulnerability

The platform company and subsequent "bolt-on" acquisitions are typically financed with an LBO structure. Roll-ups typically have higher equity injection requirements to minimize risk. However, they still have a small margin of error and remain vulnerable to financial issues.

ii. Execution risk

Mergers are notoriously difficult to execute and seldom work as expected. However, this strategy relies on the buying team's ability to successfully acquire and merge several companies quickly.

iii. Bad merger fit

A major vulnerability is that a bad acquisition can derail the plan and postpone an exit indefinitely. However, sponsors have a short time horizon and tend to move quickly. This urgency increases the chances of missing a problem during the due diligence process.

iv. No exit or liquidity event

There is no guarantee that the anticipated exit will materialize, even if the team executes its plans correctly. A buyer may not materialize, or outside events, such as a recession, could delay the exit indefinitely.

3) Financial structure

Middle-market roll-up acquisitions are financed using a leveraged buyout strategy. However, the equity injection requirements tend to be higher due to the risk.

Roll-ups combine several types of financing, and larger transactions have more options. The main financial components are the buyer's equity injection, the seller's rollover equity, and a term loan with a multiple draw feature.

a) Equity injection

The equity injection is the cash component a sponsor contributes to the acquisition. This contribution is mandatory for acquiring the platform company and all bolt-on acquisitions.

The equity injection typically covers 20% to 40% of the acquisition cost. However, this requirement varies based on transaction size, sponsor experience, management team, and industry.

Roll-up acquisitions typically require a higher equity injection than conventional acquisitions. This requirement is due to their inherent risk.

b) Rollover equity

Rollover equity is the proceeds a seller subsequently reinvests into the buying company. Sponsors use equity rollovers in their acquisition structure to help retain key managers/sellers and reduce their equity injection requirements.

c) Delayed Draw Term Loans (DDTL)

A Delayed Draw Term Loan (DDTL) is a special type of loan that allows buyers to draw funds at different intervals. The sponsor can draw funds from the line as the platform company acquires bolt-on companies.

DDTLs are available only for middle-market acquisitions. Each bolt-on acquisition must have a minimum value of $5 million.

Each acquisition must meet the lender's underwriting criteria. These include suitable:

• Valuation
• Financial metrics
• Equity injection
• Transaction fit

4. Qualification requirements

No generic set of requirements applies to every transaction. Every transaction is different and is evaluated on its merits.

However, lenders typically look for middle-market companies and sponsors that meet certain guidelines. These guidelines include the following:

a) Industry experience

The buyer must have experience in the industry they want to roll up. This experience can come from prior management experience or business ownership. Experience executing previous roll-ups is desirable but not required.

b) Platform company

Lenders prefer to work with sponsors who have already acquired their platform company. Owning the platform company shows the sponsor knows the industry and has experience. However, a platform company is not always required. Exceptions can be made for experienced teams.

c) Equity injection

Every lender requires the sponsor or buying team to contribute an equity injection to the transaction. This amount cannot be financed by another lender.

The typical equity injection requirement is 20% to 40% of the transaction. However, this amount varies by lender, industry, and transaction details.

d) Suitable targets

Each acquisition target is underwritten independently to ensure it meets financing criteria. These criteria include:

• Ability to provide an equity injection
• Suitable FCCR (1.2 or better)
• Debt to EBITDA ratio < 4
• Valuation 2.5 - 9 x EBITDA
• Reliable financial statements

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