Roll Up Strategy in Private Equity

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 episode of the M&A Science podcast, we will discuss roll up strategy in private equity with Gerry Williams, Partner at DLA Piper US LLP.

Roll Up Strategy in Private Equity

15 Apr
Gerry Williams
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Roll Up Strategy in Private Equity

Roll Up Strategy in Private Equity

“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

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 episode of the M&A Science podcast, we will discuss roll up strategy in private equity with Gerry Williams, Partner at DLA Piper US LLP.

special guests

Gerry Williams
Partner at DLA Piper LLP (US)

Hosted by

Kison Patel

Episode Transcript

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 companies 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.

I've been working on an HVAC platform for the last three years. It began when a client acquired three small HVAC businesses, each covering a part of a city. These were combined into a larger platform. Since then, we've been acquiring similar-sized businesses, either to expand into new geographic areas or to strengthen presence in existing markets. 

Once these businesses reach a critical mass and add a level of C executives, they professionalize aspects like scheduling and customer service. Then, they're sold to larger groups attempting similar expansions.

Many different sectors are experiencing roll-ups, with a notable shift in interest towards the healthcare sector. Initially, there was hesitation due to regulatory risks. 

However, the focus has shifted to acquiring service-oriented aspects of healthcare, such as dental practice management and optometry businesses, avoiding the highly regulated areas.

For example, I have a client who specializes in consolidating businesses that supply low-end products to major healthcare providers and distributors. They seek opportunities to add value, aiming to grow large enough to attract significant customers. 

This strategy involves acquiring smaller, moderately regulated businesses and scaling them up to create substantial platforms.

In another case, we are working on a roll-up of service companies that provide testing services to commercial kitchens. These companies, often with just two or three commercial clients, are being combined to increase their customer base and footprint. 

The objective is to professionalize these operations, expand geographically, and ultimately build a platform attractive enough for acquisition by larger entities.

The trend of roll up strategy in private equity

There used to be this idea that buying service businesses wasn't viable because they lacked a "secret sauce." They didn't have a specialized product or a unique ingredient that provided barriers to entry, making them defensible. 

As a result, roll-up strategies were mainly focused on products with unique features, and those were the companies getting consolidated.

However, someone realized that service businesses, especially those in the lower middle market, often have limitations. They might lack efficient accounting, billing, or collections functions. 

This deficiency, which translates to unclaimed money, became an opportunity. Even though these service businesses didn’t have a secret sauce, they could be rolled up, professionalized, and resold. 

What was once a negative—lack of a unique feature—became a positive. The service aspect itself, which draws customers back repeatedly, became the key.

In my view, this shift has been the driving force behind the roll-up strategy in an area that was previously overlooked.

Complexities of Roll up strategy

Clients who excel in this space typically have a tolerance for two particular aspects.

Firstly, unlike targeting larger businesses or other industries, when acquiring small businesses, you won't find an investment banker who has prepared a detailed description or a book about the business. 

Instead, buyers must build that story from scratch, which is a significant factor. The willingness to engage in this process varies. Many see it as a disadvantage because it requires hands-on effort. 

However, I view it as a benefit. By doing the groundwork, you can often acquire the business at a lower cost. Without a top-tier investment banker inflating the business's perceived value, you're likely to buy at a lower multiple.

These are small businesses, so on the continuum of industry multiples, you're at the lower end. If you execute this strategy correctly—buying two or three businesses at low multiples and successfully professionalizing and streamlining them—you not only make the business more profitable, but you also create a larger platform. 

Many of these businesses lack robust accounting, leaving them uncertain about their financial performance. By rectifying this and other areas, you position the business to be sold at the higher end of the multiples, creating a significant arbitrage opportunity. 

It's a lucrative area, but it requires the fortitude to undertake the challenging initial work.

The other key element is having an eye for the important verticals within an industry. Every industry, once it reaches a certain size, needs a well-functioning accounting system. 

However, it's crucial to identify specific needs unique to each industry. For instance, I had a client who was acquiring a business in the beauty and wellness space. This company, which sold products in this industry, had a warehouse. 

During a visit to this warehouse, which appeared well-operated and clean, the client realized something crucial for selling to major retailers like Walmart and Target: the importance of volume and inventory management. 

They needed to balance not ordering products too soon while avoiding running out of stock.

The client's solution was to hire a third party to advise on maximizing the warehouse space. An engineer redesigned the layout to triple the volume capacity. They also implemented RF tags for real-time inventory tracking. Within four to five months, they completely overhauled the company's inventory process. 

This enabled them to approach Walmart with a proposal to expand their presence from 100 stores to 500, showcasing their enhanced manufacturing capabilities to service five times their current volume. Understanding and addressing these industry-specific requirements is crucial.

Sure. If it's not plain vanilla, anyone with a decent level of intelligence on the buy side can figure out how to cater to the demands of big-box retailers like Walmart and Target, including understanding what's currently trending.

However, what's more challenging is choosing an industry, like the data center industry, which is significant yet has a finite number of centers typically clustered in certain areas. The strategy involves purchasing companies that supply products or services to the data center industry or its customers. 

This requires understanding the current market, as well as predicting future changes, especially given the open capacity in real estate and the evolving needs for products or services.

This kind of market research and future intelligence is critical. Some funds excel at this, leveraging their expertise to make informed predictions about future trends. It's a specific skill to be able to bet effectively on what the future holds.

Challenges of executing roll up strategy

When executing roll ups, there are significant challenges particularly on the legal side

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. 

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.

To bridge this gap, buyers might adjust their multiples. For instance, if they were paying a 2.5 multiple in an industry where they could ultimately sell for a 5 multiple, they may increase their initial multiple to account for the difference while still securing a good deal. 

Earnouts are another common strategy, setting performance targets based on GAAP accounting and compensating the seller if these targets are met.

Another issue is working capital. Since these businesses don't typically 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. 

Determining a normalized working capital number can also affect the transaction's value, similar to the EBITDA adjustments. Buyers may again use higher multiples or earnouts to address these discrepancies. 

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. Without GAAP accounting, it's hard to ascertain accurate inventory levels and revenue collection practices. 

Some sellers might accelerate revenue collection or delay payables and inventory purchases to inflate cash flow before a sale, leading to inventory deficits and abnormal payables and receivables post-close. These tactics can remain undetected until a post-close audit reveals the issues.

How to mitigate risks

The quality of earnings is a crucial aspect that buyers should focus on, even when dealing with small lower middle market businesses. 

Often, there's a tendency to perform a superficial analysis, what some call a 'flash quality of earnings,' which involves a high-level estimation of the earnings' quality without delving into the details where abnormal items might be found.

It's vital to be as thorough with these smaller businesses as you would be with larger ones to detect such anomalies. The same level of diligence is necessary in negotiating deal terms. For instance, I had a client struggling to determine the true working capital number. 

They were trying to convert the seller's non-GAAP books to GAAP and estimate working capital. However, the seller was uncooperative, leading them to forego the working capital adjustment, which turned out to be a significant error.

Post-closing, they discovered substantial inventory deficits and discrepancies in accounts receivable and payable. This issue immediately caused them to breach covenants with their bank, as these were predicated on maintaining normalized levels of these items. 

Without the working capital adjustment in the deal, it became challenging to hold the seller accountable for these discrepancies.

This kind of situation highlights the importance of diligence in structuring and negotiating transactions. It's essential to maintain high standards in these processes and not compromise on critical points. 

If it's not possible to obtain a reliable working capital number or agree to a working capital adjustment, it might be better to reconsider the deal and move on to another opportunity.

In the typical process, after signing an LOI (Letter of Intent), the focus shifts to assessing the quality of earnings and understanding the financials and working capital of the company. Following this, attention turns to the legal aspects. 

However, a common mistake is attempting to handle both the quality of earnings and legal matters simultaneously. This approach often leads to significant expenditure on both accounting and legal fronts, creating a psychological push to complete the deal to avoid 'dead deal costs'.

Consequently, buyers may feel cornered into proceeding with a deal, even if it's not optimal. A more disciplined approach involves prioritizing business due diligence. 

If there's a need to renegotiate the purchase price, it should be done during this phase. If an agreement on the new price can't be reached, it's prudent not to advance to the legal stage and incur additional costs.

The key lies in disciplined due diligence, both in business and legal aspects, and in the negotiation of terms. It's crucial to identify non-negotiable factors and firmly adhere to them throughout the process.

Managing multiple roll up businesses

Management is crucial, especially in service businesses where the owner often has the key relationships. Many owners are adept at managing a smaller-scale business but might struggle with a larger one. 

For instance, someone who can handle a $4 million business might not be equipped for a $30 million operation. Buyers often anticipate a change in management direction as the business scales.

The challenge is to keep the owner/manager engaged long enough to impart their expertise and ensure a smooth transition without customer loss. 

After a sale, owners may receive a significant payout, which could be a considerable sum for them, even if it's not as high as $30 million. The balance lies in incentivizing them to stay involved and motivated.

A common strategy is to include a substantial rollover component in the deal. Convincing the owner/manager that their continued involvement can lead to a much larger payout in the future is often a key part of the sales pitch. 

If they understand and appreciate the potential for future gains, they are more likely to collaborate.

In terms of transitioning management, if an owner isn't suited for long-term management, the prospect of a larger future payoff can be enticing. They might already have a significant sum in the bank but are informed that staying involved could potentially increase their earnings substantially. 

The plan then involves gradually reducing their management role while maintaining their vested interest for a second, more lucrative payout.

This comprehensive approach is critical for the buyer to communicate and for the seller to buy into. It helps mitigate potential pitfalls during the transition.

Negotiating the LOI in roll up strategy

In negotiating the LOI, there are four key considerations. Firstly, 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.

Secondly, the tax implications of the deal structure, especially for sellers, are crucial. For instance, many small businesses might be organized as S corporations. When there's a rollover component, there are only a few ways to structure the deal to avoid tax events for the rollover portion. 

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. This is important because smaller law firms representing these companies might not be fully aware of these complexities.

Thirdly, the management aspect needs consideration. Determining the extent of the current owners' involvement post-acquisition is crucial. While this can be less detailed if uncertain, having a preliminary agreement on management roles can prevent misunderstandings during detailed negotiations.

Lastly, 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. 

If there's a discrepancy between what the seller is willing to offer and what is market standard, it could jeopardize the deal, especially if it doesn't meet the expectations of capital providers or banks. It's better to agree on these terms upfront to avoid unnecessary expenditure and complications later in the process.

In our approach, we might identify, for example, that out of five managers, two are essential to retain. For these managers, we would require them to sign customary employment agreements with non-compete clauses, with terms mutually agreed upon by all parties. 

Additionally, we reserve the right to require similar agreements from the other managers following further due diligence. This is a broad, umbrella strategy.

If a client indicates that they want agreements with two out of five managers, and one of these managers is a 70 percent shareholder looking to gradually step back, we need to craft a transition plan. 

This plan might involve initially retaining them for 50 percent of their current role, with the flexibility to reduce their involvement to 20 percent if necessary. 

This requires more customized language in the Letter of Intent (LOI) to ensure there's a mutual understanding of how the transition and reduction in involvement will be handled, both from the buyer's and the seller's perspectives.

In our approach, we typically ask for 60 to 90 days of exclusivity in the letter of intent. If possible, we also include one or two automatic extensions. 

For example, representing the buyer, we might propose 90 days of exclusivity with the option for two automatic 15-day extensions, contingent on the buyer actively working in good faith to close the deal. 

This arrangement provides the buyer with maximum flexibility and additional time if needed, thanks to the automatic extensions.

Conversely, when representing the seller, our strategy shifts to limiting the potential for extensions and reducing the initial period of exclusivity. This approach aims to streamline the process and maintain a tighter schedule.

Breakup fees on private deals

In rare instances, breakup fees become relevant. This usually occurs when a buyer has been engaging with a seller for two or three months, believing they have agreed to the main components of the deal. 

However, if the seller has a history of starting and stopping negotiations multiple times, the buyer, now facing potential costs with third parties, may seek protection.

In such a case, we can incorporate a breakup fee concept into the agreement. This would typically be a simpler version of what might be seen in larger transactions, without extensive complexities. 

For example, the agreement could state that if the seller withdraws from the deal without a valid reason, they would be responsible for paying up to $200,000 to cover the buyer's third-party expenses. 

As the situation becomes more complex with additional variables, the details and creativity in structuring these fees can increase accordingly.

Once deals reach an enterprise value of around $150 to $200 million, the dynamics change significantly. Typically, these deals involve sophisticated private equity funds. A smaller fund might be selling to a much larger one, possibly a multi-billion dollar entity.

In these scenarios, the focus is on minimizing downside risk associated with financing. It’s crucial to ensure that the purchasing firm can secure financing without fallbacks due to fluctuating interest rates or other financial issues. 

To safeguard against this, the agreement might require the buyer to either guarantee the equity or, alternatively, agree to pay a breakup fee. 

This fee is designed to give the buyer the flexibility to withdraw from the deal for specific financial reasons, like a minor change in interest rates or unsatisfactory terms with their lender.

These breakup fees become more commonplace in transactions of this scale, especially when the transaction involves a large private equity fund or a major strategic buyer.

Typical deal structure in roll up strategy

The dynamics of rolls ups vary based on the transaction size. In the lower middle market, which I consider to involve deals of $25 million in enterprise value or less, rollover equity is commonly involved, together with earnouts or seller financing. 

As the deal size decreases below $25 million, there tends to be a higher percentage of rollover, larger seller notes in terms of dollar value, and a greater portion of the purchase price in earnouts.

However, even in deals above $25 million, such as family-owned businesses or companies with high customer concentration or industry-specific challenges, similar trends can be observed.  These businesses might not achieve their desired multiples due to these unique factors. 

In such cases, higher rollover values, earnouts, and seller notes become more prevalent. The buyer's rationale is that while they can agree to a certain purchase price, their equity contribution and borrowing capacity might be limited due to various reasons. Therefore, they request the seller to assume a part of the risk through higher rollover, seller financing, or earnouts.

In essence, the seller takes on some of the risks, whether through seller notes subject to performance benchmarks or rollover equity. Special circumstances in a business, such as customer concentration or regulatory complexities in less fragmented industries, also influence deal structures. 

Typically, in deals of around $25 million or less, these three tools—rollover equity, seller financing, and earnouts—are increasingly utilized to distribute risk to the sellers.

Before you can start structuring the deal, you need to consider how much financing can be obtained first. Typically, people look to secure senior debt financing, assessing how much they can get for a business in a specific industry. 

They have a predetermined idea of how much equity they want to invest in a platform within that industry. This could be for a single deal or for a series of acquisitions, so they have an overall equity allocation for the entire platform. Often, they might only want to use two-thirds of that equity initially.

Next, they combine this equity with what they can get from a senior lender and then assess the difference, or delta, relative to the seller's asking price. If there's a significant gap, it needs to be bridged with a mix of rollover equity, earnouts, or seller financing. 

Seller financing might not always be practical, especially if pushing the limits of senior debt financing. In such cases, a higher rollover and possibly an earnout might be needed to fill the gap. This process begins before an LOI is put in place. 

That’s why parties typically first seek indications from senior lenders to understand their borrowing capacity.  Regarding senior debt, it usually involves lending a multiple of the purchase price, often ranging from two to five times. 

However, in lower middle market roll-up strategies, the multiple is typically lower due to the overall lower purchase price multiples. Therefore, debt might be around two to three times the agreed-upon EBITDA.

For smaller businesses, multiples are generally less than five, often between two and a half and four. If a business can be acquired at a multiple of two and a half times EBITDA, then the financing structure might consist mainly of senior financing, a small portion of rollover equity, and the buyer's equity.

However, the best deal in terms of multiples can eliminate some financing options. If dealing with a challenging seller, particularly regarding working capital and other transaction components, more tools from the financing toolkit might need to be employed to bridge the gap and secure the deal.

That’s why when interest rates are high, it significantly impacts the multi-billion dollar private equity funds. Despite borrowing similar multiples, these firms deal with large businesses and, consequently, large aggregate borrowing amounts. The resulting interest burden is substantial. 

Therefore, these firms often shift their focus to portfolio company add-ons. In most cases, unless the company is underperforming, add-ons can be financed primarily with debt, allowing them to exploit arbitrage opportunities without injecting more equity. 

In such scenarios, they're willing to bear the additional interest rate burden since they're not increasing their equity contribution. If the add-on is a cash-flowing business, they aim to pay down the debt quickly.

Conversely, in the lower middle market, deals still happen even when interest rates are high. Given the relative size of these businesses, borrowing doesn't result in high leverage. 

The borrowing is often around two to two and a half times the business's size, so these transactions aren't heavily leveraged. Additionally, various other tools are used as hedges against the risks associated with high interest rates.

Employing earnouts in roll up strategy

This is why earnouts and seller financing has been a much bigger part of the industry in the last two and half years. And no one is excited about doing earnouts. oftentimes, there’s always an argument.

When structuring earnouts, buyers often enter negotiations with a certain mindset, which I frequently encounter. I always emphasize the importance of being specific in the earnout language to avoid future disputes. 

However, some clients may downplay the need for precision, believing that the seller is unlikely to meet the earnout criteria anyway, so they say, "It doesn't matter."

Fast forward to after the deal, and this lack of clarity can lead to conflicts. Sellers, who often believe they have a good chance of meeting the earnout conditions, may feel misled if they don't achieve it. 

They might suspect the buyer of deliberately sabotaging their chances to reach the earnout targets. This discrepancy in expectations between the buyer's skepticism and the seller's optimism can escalate into disputes, with the seller accusing the buyer of intentionally hindering their ability to earn the earnout.

When dealing with earnouts, there's no single best practice, but I approach them in several layers. 

The first layer involves defining the performance metrics: What needs to be achieved, over what period, and what are the key components of this measurement? If the target isn't fully met, we consider whether a pro-rata payout is applicable, and if so, the minimum performance threshold for this.

The second later is,  I dive into the specifics of each component that determines the earnout calculation. For instance, we don’t just refer to gross profits in general terms; we break down all elements contributing to gross profit in the business’s current context. This ensures clarity in the earnout’s language and definition.

Another layer examines the business's expense structure. How expenses are calculated currently versus post-transaction, especially if an add-on is done soon after closing, is critical. This analysis helps determine any limitations on altering the business's operational or financial structure post-acquisition.

A crucial aspect is the impact of the earnout on the buyer's credit agreement. If the combined business doesn't perform well, affecting covenant compliance, it’s important to understand whether the earnout obligation still holds. 

The language in the agreement needs to clarify that the earnout isn't solely based on the performance of the acquired business, but also considers the overall business health in relation to lender covenants.

Finally, I 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? 

Does it continue as planned, or is there an acceleration? All these variables are important to think through with the client, as neglecting any of these aspects can lead to disputes later.

Unique negotiations during LOI

Sometimes, there are weird listings of assets that the seller wants to take, like retaining a particular painting or a life insurance policy. These requests can be unusual, but on the practical side, one of the most bizarre things I’ve encountered in smaller deals involves the purchase agreement structure.

For example, buyers agree to buy a business for $5 million, and everyone is on board. Then, as they formalize this in the LOI, a lawyer who isn’t specialized in M&A, often a litigator, gets involved. 

The language they introduce stipulates that the $5 million purchase price excludes inventory and accounts receivable (AR), which must be paid for separately. This approach is nonsensical. 

The essence of buying a business is acquiring an operational entity, which includes working capital like AR. This misunderstanding is probably the most frequent oddity I see. 

It's clear that if the parties involved were more experienced in such deals, or if they consulted knowledgeable counsel, they would recognize the impracticality of this arrangement. However, this scenario occurs quite often.

Do’s and don’ts of executing roll up strategy

One major mistake I often see buyers make is getting ahead of themselves. For example, they sign an LOI, promising to close the deal in 60 days, while already knowing it’s unrealistic. Their plan to renegotiate at the end is problematic. 

You're setting yourself up to deal with an unreasonable seller, and it's not wise to spend money and time only to face difficulties later on. It’s better to address these issues upfront.

Another mistake is being overly optimistic about the financials of the business. Buyers, usually fairly sophisticated, might have a 60 percent confidence level in the financial information provided. 

In such cases, it’s crucial to conduct thorough financial diligence before proceeding. Rushing into legal proceedings without this clarity can lead to costly mistakes and cornering oneself into a difficult position.

On a positive note, one thing I recommend doing in every transaction is to focus on the primary points of the deal. Identify the four or five most important business aspects and ensure there’s a satisfactory agreement on these before proceeding. This disciplined approach saves a lot of headaches down the road.

Another key aspect is fairness. Often, sellers may not be fully informed, and a buyer might recognize incorrect assumptions or misunderstandings. It's important to correct these and be fair, which not only earns goodwill but also prevents future complications. 

This principle applies to both business and legal aspects of a deal. Staying rational and avoiding irrational commitments due to feeling locked into a deal is crucial for a successful transaction.

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