Roll-Up Acquisition Advantages and Disadvantages
Summary: Roll-up acquisitions are a popular strategy for private equity companies, large corporations, and entrepreneurs. They offer several advantages, such as the potential to profit by selling the company at a higher multiple. However, it is a high-risk strategy that requires detailed planning, careful execution, and foresight.
This article goes over the pros and cons of roll-up acquisitions. We cover the following:
1. What are roll-up acquisitions?
A roll-up acquisition is a type of merger strategy. Its objective is for an acquirer to consolidate smaller companies into one more efficient entity.
Acquisition targets come from industries and markets that are fragmented. Larger companies in the chosen industry should command higher valuation multiples than their smaller counterparts. Otherwise, the strategy may be of little value to acquirers.
Private equity companies execute the majority of roll-ups. They set up a platform company to handle the acquisitions. Once set up, the platform company can "bolt-on" smaller companies as they are acquired.
Platform companies typically have short time horizons. They aim to merge several businesses and exit through a liquidity event 3 - 8 years later.
Roll-ups are not the exclusive domain of private equity companies. Mature corporations and acquisition entrepreneurs also use roll-up mergers as a long-term growth strategy.
2. How are roll-ups structured and financed?
Roll-ups are typically financed by specialty lenders that offer middle-market financing. These lenders can set up facilities with Multi-Draw and Delayed-Draw features. These loans enable the platform company to make a draw as "bolt-on" companies are acquired.
Roll-ups typically use a leveraged buyout strategy. Due to risk, their equity injection requirements can be as high as 30%. However, individual lenders may require a higher or lower equity injection based on risk tolerance and industry comfort.
Roll-up acquisitions typically use seller financing and rollover equity as well. This can lower the equity injection requirements of the transaction, though it has other benefits.
3. Advantages
Successful roll-up acquisition exits can be very profitable for their owners. While roll-ups are high-risk, they offer several benefits.
a) Increased valuation multiples
In some industries, larger companies command higher valuation multiples than their smaller counterparts. Some roll-up mergers can result in a profitable exit even if the company does not achieve its intended operational efficiencies. This is colloquially known as "Multiple Arbitrage," though this term is not entirely accurate.
b) Increased market share and sales
The consolidated entity will have a larger market share and a more diverse product set. Consequently, it should have a competitive advantage over smaller companies with less reach. The platform company can use this advantage to pursue a growth strategy further.
c) Access to new clients and products
The platform company will have access to new clients and products as "bolt-on" companies are integrated into the business. This allows them to cross-sell products/services to clients and grow the business.
d) Improved operational efficiencies
A major objective and advantage of roll-ups is that the platform company can streamline production, back office, and sales. The improved efficiency can lead to increased profits and a higher eventual sale price.
e) Economies of scale
Due to its larger size, the merged company has more negotiating power with suppliers than smaller competitors. This advantage enables them to lower costs and negotiate longer payment terms.
Longer supplier payment terms are an important benefit that is seldom discussed. Small companies typically get net-30 to net-45 days to pay invoices. A larger company may get Net-60 days or longer. This can improve their cash flow and decrease their reliance on working capital financing.
f) Access to better financing
Larger companies can access more financing products at better terms than smaller companies. This is an important advantage that the company can leverage as it grows. Once it achieves scale, it may be able to reduce financing costs. These savings can drop directly to the bottom line.
4. Disadvantages
Roll-up acquisitions have important disadvantages that must be considered before pursuing this strategy.
a) Vulnerable to financial problems
Roll-up operators typically use a LBO structure for each "bolt-on" acquisition. A major disadvantage of LBOs is that it leaves companies vulnerable to financial problems. The high amount of leverage limits their options when problems occur.
b) Execution failure
Navigating a successful roll-up acquisition strategy is challenging. Success depends on the operators' ability to execute a complex set of tasks.
They must merge several entities while increasing operational efficiencies and maximizing profits. Each of these tasks is difficult by itself. Executing all of them correctly in a short time frame is exponentially more challenging.
c) Integration problems
Integrating merged companies into a single efficient business is probably one of the most challenging tasks. The team will need to integrate all back office, operations, and sales teams so they can work efficiently.
To complicate matters, the integration process must be repeated successfully for each acquisition. Few operators consider the effect of this in the transaction risk profile.
Consider this simplistic example. Assume the overall chances of a successful merger with a "bolt-on" company are 90%. That is a very high rate of success, by the way.
Now, assume the platform company must acquire five "bolt-on" companies to achieve its objectives. Each successive acquisition reduces the chances of success of the whole enterprise. The chance that all five integrations will be successful is 59% (calculation: 90% ^ 5)
The reality is that mergers typically encounter unexpected integration issues. This often leads to problems or even failure.
d) Cultural issues
Integrating employee company cultures can be particularly challenging. Every small company is unique, and their cultures can differ significantly.
Consider the challenge of integrating a company with a rigid culture with another one that is more relaxed. Both companies are successful independently. However, the merged entity could alienate employees from both sides. This could lead to problems if morale is low and key employees leave.
e) Economies of scale don't materialize
The ability to capitalize on economies of scale is essential for many roll-ups. These advantages aim to reduce costs, improve market share, and increase profits.
The impact of these improvements is challenging to forecast and easy to overestimate. Unfortunately, these benefits don't always materialize as expected. This can seriously impact the company if the business model depends on achieving these savings.
f) Missed red-flags
Buying a single company is difficult. It requires careful due diligence to ensure you identify problems beforehand so you can avoid them.
Executing a string of mergers in quick succession amplifies the chances of encountering problems exponentially. This is one important reason why roll-ups are considered high-risk.
A way to improve your odds of identifying potential problems is to use a Quality of Earnings report. Work with a competent provider that is familiar with the industry you work in. We consider these reports an essential tool for acquisitions.
g) Mismatching
Roll-up acquisition strategies only work if all the "bolt-on" companies match the platform company well. At a minimum, their products, services, culture, market, and clients must fit the platform company's strategy.
A mismatch in some areas could be fixable. However, a "bolt-on" company that is a bad match becomes a single point of failure for the platform company. It can easily derail the whole strategy and lead to failure.
h) No exit or liquidity event
The ultimate goal of most roll-ups is an exit via a liquidity event, such as a sale or an IPO. However, the existence is not guaranteed.
A team could execute a roll-up acquisition flawlessly and still be unable to exit. The reasons can be beyond the team's control, including downturns, market changes, etc.
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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.
