Summary: A roll-up acquisition strategy involves acquiring and merging several businesses into a single parent company. This strategy can work well in fragmented industries since consolidating can streamline operations and introduce economies of scale.

This article discusses how roll-up acquisitions work, their financing structure, and their advantages and disadvantages. We cover the following:

1. What is a roll-up strategy?
2. Roll-up acquisition example
3. How are roll-up acquisitions financed?
4. Advantages
5. Disadvantages
6. Is it an effective strategy?

1. What is a roll-up strategy?

A roll-up acquisition strategy, also called a "roll up," involves purchasing several small businesses and consolidating them into a larger parent company. This strategy is common in private equity, where a "platform company" is set up and "bolt-on" companies are added as they are acquired.

Rolls-ups by private equity groups typically last less than a decade. The private equity group and its investors typically exit through a liquidity event, such as a sale or IPO. Some larger companies follow the roll-up acquisition approach of buying smaller competitors. However, their objectives are typically strategic and long-term.

a) Approach

A typical roll-up involves buying and consolidating companies that offer the same products/services. These companies are usually – but not always – at the same production stage.

A fundamental assumption of this strategy is that the consolidated entity is worth more than the sum of all individual businesses. The increase in value may come from several areas, such as operational efficiencies, increased sales, higher valuation, etc.

2. Roll-up acquisition strategy example

Let's consider a roll-up acquisition example. Assume that a city or county has a fragmented plumbing contracting market. Consequently, the market is served by several small companies.

Each company is similar. They have a few plumbers, back-office employees, suppliers, etc. These companies also serve similar markets, such as residential, commercial, and new construction. Consequently, rolling them up into a single holding company could achieve efficiencies and ultimately be more valuable.

A private equity group sets up a platform company, provides some equity, and secures specialized financing. The platform company begins evaluating acquisition candidates, making offers, performing due diligence, and acquiring target companies.

As part of the process, the platform company integrates acquisitions as they occur. They streamline the acquisitions by consolidating back office, sales, and marketing. If all goes as planned, the integrated company should operate efficiently and profitably.

The end game is to exit the business through a liquidity event. Possible exits include a sale to a larger company or an investor group. In some cases, they may be able to take the company public.

3. How are roll-up acquisitions financed?

Roll-ups are typically the domain of middle-market companies, though they can also happen in the lower market. Most roll-ups are financed with a Delay Draw Term Loan (DDTL). These loans enable the platform company to make several withdrawals in the future as it acquires roll-up targets.

Most roll-up acquisitions use a leveraged buyout structure. However, the equity injection component is closer to 30%, which is higher than in stand-alone middle-market acquisitions. These transactions typically use rollover equity. Rollover equity helps retain management and helps lower the required equity injection from the platform company. This is another reason why rollover equity is also common in these transactions.

4. Advantages of roll-ups

A well-planned, properly executed, and carefully timed roll-up acquisition plan can offer several advantages to buyers and private equity companies. These advantages include the following.

a) Increased market share and sales

Roll-up acquisitions are typically executed in highly profitable but fragmented industries. Improving operations and using disciplined management allows the combined company to secure higher sales, improve profitability, and capture market share. Ultimately, this strategy can lead to a higher valuation when the private equity group exits the investment.

b) Operational efficiencies

Most roll-up acquisitions target small to midsize family companies. Merging them into a single entity enables operators to implement operational efficiencies across the organization. These efficiencies include consolidating redundant back-office functions, improving offerings, and using economies of scale to their advantage.

c) Access to new products and clients

Each new acquisition provides the holding company with access to new products, markets, and clients. This access allows for cross-sales, especially if the products or services are complementary. Ultimately, the company should be positioned to grow sales while increasing market share.

d) Economies of scale

Merging several small companies into a larger entity enables operators to leverage economies. Large companies typically have access to better pricing for products and services because of their bigger orders. This improved pricing can generate savings that drop straight to the bottom line, increasing profitability.

e) Access to capital

Larger companies typically have access to more financing products at better terms than their smaller counterparts. This financing advantage provides the company with more financial flexibility at a lower cost.

f) Increased valuation multiples

Companies are typically valued based on a multiple of their Earnings Before Interest Depreciation Taxes and Amortization (EBIDTA). Larger companies typically enjoy higher valuation multiples than their smaller counterparts.

This benefit is important to private equity groups since they could enjoy a higher sale price at the exit even if many (or all) improvements fail to materialize. This strategy is colloquially referred to as "multiples arbitrage," though the term is not entirely precise.

5. Disadvantages of roll-ups

Most roll-ups have short time horizons, tight operating requirements, and little room for error. This situation creates a difficult operational environment for operators even if everything goes as planned. Disadvantages fall across six categories.

a) Financial problems

The typical roll-up LBO structure requires a substantial amount of leverage. High leverage has some disadvantages and leaves the company vulnerable to financial problems. The high leverage prevents most roll-ups from getting additional financing to deal with unexpected problems. Consequently, the roll-up may be unable to respond effectively to challenging conditions.

b) Integration failures

Integrating the companies is one of the most challenging parts of every merger. The integration process is the source of most operational problems.

Few integrations go as planned. They typically take longer than expected, encounter unforeseen problems, and face opposition from the affected parties.

This process is challenging even when it is done in an ideal environment. However, a roll-up is far from an ideal environment. The operator must merge several small companies with disparate processes in a short time frame with the objective of a profitable exit.

c) Over-optimistic forecasts

Some roll-up acquisition plans have over-optimistic growth, cost-saving, and profitability forecasts. These forecasts are used to secure acquisition financing, develop plans, and develop acquisition targets.

The situation can create problems if the company doesn't meet the forecasts. It could trigger issues with securing financing for operations or additional acquisitions. Ultimately, it could put the project in jeopardy.

d) Unrealized economies of scale

Another potential problem is that the expected economies of scale are not guaranteed and could fail to materialize. At the very least, this scenario can affect the forecasted profitability of the entity.

This problem could be severe if leveraging economies of scale was central to the roll-up strategy. It could jeopardize the company's viability, especially if it is highly leveraged and has tight profit margins.

e) Overpaying for acquisition

The potential for overpaying for an acquisition is a significant obstacle for roll-up acquisition operators. They are faced with the prospect of quickly sourcing, valuing, and buying several small companies in a short timeframe. This haste can lead to mistakes and overpaying for companies.

Small business acquisitions are challenging and require substantial due diligence. This process takes time and accelerating it could cause buyers to miss potential problems. One way to reduce this risk is to use a Quality of Earnings report from a competent provider.

Recovering from the wrong acquisition, either because of overpayment or other issues, is difficult. It will affect the parent company's finances, operations, and viability, even if all other acquisitions have no problems.

f) Exit does not materialize

A significant risk of this strategy is that an acceptable exit may not materialize in the expected time frame. This outcome could happen due to any previously mentioned reasons, unexpected challenges, or an economic downturn.

This problem could become serious if some loans are approaching the end of their term and require refinancing. A company in this position may not be able to negotiate financing at better rates, which could trigger financial problems due to debt payments.

6. Are roll-ups an effective strategy?

A roll-up acquisition strategy is considered a high-risk operation. Using an LBO structure to acquire bolt-on companies increases the potential risk due to high leverage. A single LBO is usually risky. A roll-up is a collection of LBO-financed acquisitions executed in quick succession. This approach magnifies the risk.

Successful roll-up operators typically need to execute three different roles, which may have competing objectives.

a) Buyer

As a buyer, the acquiring company needs to source, evaluate, and acquire several companies in a short time frame, typically three to seven years. Each acquisition must fit with the company's current portfolio and strategy.

b) Integrator

The operator must also become an expert at integrating companies effectively. This process is challenging and takes time in even the best of circumstances.

Every company has its processes, back office, and culture and will likely resist change. However, change happens quickly as new companies are added to the portfolio.

Integration is key to the success of the strategy. Otherwise, the expected gains and benefits may not materialize.

c) Operator

The buyer must also operate the combined entity skillfully to grow it to its full potential. This role is challenging to execute in a single company. Executing it in a dynamic of multiple acquisitions and short-term pressures is exponentially more challenging.

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Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.