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Private equity firms are established for the sole purpose of generating substantial financial returns for its investors. And one of the most effective ways of maximizing investment returns is the roll up strategy.

This involves buying small-sized businesses in a highly fragmented industry and combining them into a larger platform. The goal is to improve efficiency and be sold later for a higher price.  In this article, we will discuss roll up strategy in private equity with Gerry Williams, Partner at DLA Piper US LLP.

“Small businesses use reviewed accounting, which result in adjustments that could have huge swings when converted to GAAP. So what they think their bottom line EBITDA number is, ends up being significantly different. That becomes a problem.” - Gerry Williams 

Industries susceptible to roll up strategy

Over the last decade, there have been many companies in the health services sector that got rolled up. Additionally, in the commercial arena, businesses like HVAC, roofing and various types of plumbing companies are being consolidated. This includes businesses that provide products directly to consumers or offer services in this sector.

The latest trend involves single-location businesses, often with one or two owners and a handful of employees, being integrated into larger platforms in the lower middle market and then sold upstream in the private equity arena.

Challenges of executing roll up strategy

One major issue is that these small businesses often don't use GAAP accounting, which creates a disparity when sophisticated buyers like PE funds try to translate their financials into GAAP to determine EBITDA and justify the purchase price.

Often, the EBITDA calculated under reviewed accounting differs significantly from GAAP, impacting the sale price. To bridge this gap, buyers might adjust their multiples

Another issue is working capital. Since these businesses don't use GAAP accounting and don't track working capital accurately, buyers must ensure they're not acquiring a business that will require immediate significant capital infusion. 

Additionally, rollover equity in these deals is often higher compared to larger deals, as buyers seek to reduce the immediate purchase price and share some risk with the seller.

These challenges can be exacerbated when sellers, intentionally or not, manipulate their financials. It is why the quality of earnings is a crucial aspect that buyers should focus on, even when dealing with small lower middle market businesses. 

Negotiating the LOI in roll up strategy

In negotiating the LOI, there are four key considerations. 

  1. Be as clear as possible - It's important to outline any purchase price adjustments and earnout components in sufficient detail to ensure a mutual understanding. This clarity is essential to avoid future disputes.
  2. Tax implications - It’s necessary to perform due diligence on the business structure before signing the LOI and include appropriate language in the LOI regarding the deal structure. 
  3. Management aspect - Determining the extent of the current owners' involvement post-acquisition is crucial. 
  4. Indemnification - the framework for indemnification should be addressed early. Often, buyers prefer to delay this discussion, but leaving it for later stages can lead to significant issues.  

Employing earnouts in roll up strategy

Earnouts are a great strategy, setting performance targets based on GAAP accounting and compensating the seller if these targets are met. However, most earnouts often end up in arguments. And while there's no single best practice, Gerry provides these tips when structuring earnouts. 

  1. Define performance metrics - Be clear on what needs to be achieved, over what period, and what are the key components of this measurement.
  2. Be specific on the earnout calculation - ensure clarity in the earnout’s language and definition.
  3. Examine the business's expense structure - Determining how expenses are calculated currently versus post-transaction, especially if an add-on is done soon after closing, is critical.
  4. Address potential scenarios like the sale of the business - If the business is performing exceptionally well and attracts a substantial offer, how does this affect the earnout?
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