General partners may insist that buy and build has always been popular, and is indeed central to the industry’s value creation proposition, but the level of recent activity has been particularly robust.
In the third quarter of 2015, platform companies executed 125 add-on transactions in Europe, the highest in a quarter since Q2 2008, and 404 add-ons over the year, up on 2014, according to a report by Silverfleet Capital.
The reason is clear: performance. A Boston Consulting Group study, which describes buy and build as the “PE value creation strategy of choice,” shows investments in which a portfolio company acts as a platform for further add-on acquisitions outperform standalone deals. Buy and build transactions generate an average internal rate of return of 31.6 percent from entry to exit, compared with 23.1 percent for standalone deals, according to BCG.
Among value drivers, consolidating a fragmented sector through M&A promotes cost and revenue synergies, accelerates scale and operational improvements – including the acquisition of new capabilities, products or technology – grabs market share, and facilitates rapid geographical expansion, with the additional promise of growth through future acquisitions.
And the price impact of add-ons is appealing. The potential for favorable post-synergy adjustments on the entry multiple is always attractive to investors. In the current high price environment and abundance of dry powder, add-ons provide GPs with a route to deploy capital into smaller businesses, typically through a proprietary process and at more competitive values than bidding on larger targets in an auction.
Add-ons are usually less risky than a standalone deal, notes one European GP. “You have a management team you’re already comfortable with [at the platform company] who can help you with the strategic rationale for the add-on, in an industry where you’ve already conducted due diligence because you own [the platform]. The decision is much more likely to be focused in the right areas than if you’re buying a platform.”
Developing a relationship with the management team executing the investment thesis is critical. “Management can usually do a pretty deep dive on what the synergies might be – which ones make more strategic sense, which are operated in a way that will be complementary rather than destructive to their own structure,” says the GP. “If you have a bad relationship with management, then doing M&A and allowing them to stay in charge is quite risky. It’s very important for them to think you bring something. If they begrudge you as an annoying shareholder who just analyses their performance, that relationship doesn’t work.”
With many add-on targets too small to be sourced by advisors, firms are typically dependent on management to generate dealflow. “Buying through your portfolio company, you rely quite heavily on management to have the connections within that sector and bring the transactions,” says Ashurst partner Nick Rainsford. “It’s important that they are well-known in the market and alert to the opportunities.”
Management teams with an acquisition track record are therefore very appealing. “If the CEO and CFO of a portfolio company have already done an acquisition or two, got it under their belt, and had the experience of integrating it, that is very positive because it’s no longer idle chat,” says Silverfleet Capital managing partner Neil MacDougall. “If you’re a regular acquirer of businesses, you are more likely to get them right because you’ll have learnt the key things to look for and you would have adopted some of the disciplines that stop you doing things that are too difficult or too dangerous.”
One way to ensure management engages with the strategy is to give them ownership of the M&A process, MacDougall says.
“That means the CEO, CFO and whoever is in charge of production and sales absolutely need to be completely involved, and the deal has to be theirs. It is one of the things some corporates get wrong, the idea that there is a strategy and you [simply] delegate it to management to make it happen. It rarely works.”
But, the European GP warns, the private equity firm needs to monitor the process and ensure management does not get “starry-eyed” at the prospect of running an enlarged business and misjudge opportunities. After all, the firm has typically completed a number of acquisitions, whereas management might not.
In the face of other tasks competing for attention, the GP’s role is to ensure the management team stick with the M&A strategy in line with the value creation vision. “When we review portfolio progress on a quarterly basis, one of the key questions is: where are you getting to in terms of implementing your value creation strategy, which in many cases means those bolt-ons you wrote about in the investment paper, and have we made any progress in making them happen,” says MacDougall.
“You have to remain disciplined and when due diligence [of a target] turns out to reveal things you didn’t expect to find, you need to be able to walk away.”
People issues
Beyond picking the right targets, the post-acquisition integration of businesses — including of management teams — will determine the success of a buy and build strategy and the possibility of value creation, GPs say. Management inexperience, lack of bandwidth, and a clash of business cultures are all elements that can sabotage the integration process.
“Whether or not your management team can deal with all the social issues around managing a larger organization post-acquisition is a risk that belongs to the GP rather than management,” says the European GP. “Management come in different shapes and sizes. Some can be unused to buying smaller companies and bolting them on, and sometimes they can adopt an attitude that alienates people. You have to make sure you keep them on a straight and narrow.”
Losing key talent can be hazardous and is likely to be value destructive unless accounted for in the business plan. “The thing you’re after is the people,” says MacDougall. “It’s their knowhow, their contacts, their experience, their track record, their customer relationships. As long as you remember that’s really why you bought the company and you go out of your way to make sure you hang onto it, then you’re likely to make a successful acquisition.”
To skilfully manage the relationship with senior executives, GPs emphasize the advantage of having a buy and build track record themselves. What firms know intuitively is supported by data. Frequently acquiring firms generate average IRRs of 36.6 percent on deals, compared with infrequent acquirers with IRRs of 27.3 percent, according to BCG. Experience, in this case, creates value.
Under the microscope
Just over a year ago, Cinven took a major step in the execution of plans to create a pan-European clinical laboratory group. In August 2015 it acquired French laboratory group Labco, followed in October by the acquisition of Synlab, based in Germany. The two companies operated in a large, fragmented market that promised economies of scale. They both furnished solid M&A track records with complementary geographical footprints. These elements meant, post-merger, the platform was ideally suited to pursue further significant bolt-ons and opportunistic buys.
“By putting Labco and Synlab together we have created by far the market leader in the sector with complete continental coverage,” says Cinven partner Alex Leslie, who sits on the healthcare sector team. “We’re transforming the businesses, changing their geographical, business and product reach. The combined enterprise, from a multiple perspective, is worth more than each of the sum of the parts.”
One of the significant operational changes already made at the combined entity, Synlab, was the creation of a single management team and a number of new senior roles. Theseinclude a new chief operating officer, chief commercial officer and chief strategy officer, who oversees its cross-border buy and build activity.
Aligning management to its operational structure “has taken some time, but we are starting to feel the benefit of that on the ground. The role of the central functions is to support each country team to run their business,” Leslie says.
Another significant priority “is to streamline operations in the practical sense,” says Cinven portfolio team partner Immo Rupf. This encompasses procurement and suppliers, the location of equipment, and the organization of laboratories. “We established a view on what a lab should look like for a target operating model.”
A third has been to develop an IT “blueprint” for the company in place of proprietary systems developed by individual laboratories. A fourth is to percolate commercial best practice through the group, with the help of the new CCO, involving “choices about how we acquire new customers, avoid customer churn, in-sourcing or out-sourcing specific tests,” says Rupf.
Equally important has been the creation of a “bolt-on machine” run by management using a template developed by Cinven’s portfolio team. The template outlines the way management presents opportunities to the board’s investment committee; tracks the delivery of synergies within each bolt-on; and “simplifies decision making as much as possible so we don’t become a bureaucratic block on the ability of the company to execute on its strategy,” Leslie says.
Rupf adds: “There will be targets for the year, but the origination, execution and integration of them is done by management. In Synlab’s case, origination is often at the local level.”
A year on, Synlab has already completed a number of bolt-ons and has a strong pipeline of deals, averaging more than one transaction a month. It currently operates in 35 countries and is eying expansion into emerging markets, especially Latin America.
“A lot of M&A at the moment is focused on investing in labs with genetic capabilities, or anatomical pathology,” says Leslie. This, in turn, promotes organic growth where Synlab can partner with pharmaceutical companies to enter into the companion diagnostics market, or work with other med-tech companies to launch new genetic testing, he says.
This article is sponsored by Crowe Horwath. It was published in a supplement with the October issue of pfm magazine.
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