The current deal environment has caused a partial shift in the way many private equity sponsors view deployment of fund capital. As competition for quality deals has increased, including higher pricing and other auction challenges, focus has expanded regarding the “best” deals to get done.
As more money chases platform acquisitions, many sponsors are redirecting capital to “add-on”, also known as “bolt-on”, acquisitions. Strategic acquisitions for existing portfolio companies have long been a part of fund growth strategies, but focus in this area has heightened. This accelerated refocus has led to certain interesting challenges and creative opportunities.
According to Pitchbook, as of the end of third quarter 2014 add-on acquisitions comprised 61 percent of all investments. This represents an increase from 57 percent in 2013 and 49 percent in 2012. The report further notes that as of the end of third quarter 2014, 931 add-on acquisitions were completed in the United States, which suggests a high likelihood that the number of add-ons in 2014 will surpass the 1,087 add-ons in 2013.
We have reviewed data suggesting M&A transactions in the past year have been split close to 50-50 between strategic buys and financial buys. It may be this split can be attributed in some meaningful part to private equity firms that previously were concentrating their activities primarily as financial buyers are now acting more often as strategic buyers.
Traditionally, in their role as financial buyers, most private equity firms have been interested in companies with a good management structure, a history of steady earnings, and strong growth potential. In contrast, acting as strategic buyers, private equity firms are more willing to broaden the range of companies they are interested in acquiring. When wearing the strategic buyer hat, private equity firms can look beyond weak or exiting management or a less than stellar history of earnings because the target offers certain enhancements and opportunities for the platform company, despite any accompanying flaws. Perhaps most importantly, strategic buys usually can be accomplished with less competition and better pricing.
While the rise in add-on acquisitions may be framed as a reaction to a lack of other growth opportunities, add-ons offer unique benefits that traditional platform buyouts may not. Add-on acquisitions can increase a platform company’s competitive position in its field.
Further, growth by acquisition, while not without inherent cautionary risks, can be an excellent alternative to organic growth. By acquiring a portfolio company’s competitors through an add-on strategy, or by acquiring companies in related markets, a private equity firm can position its platform company as a dominant player in a given field, enhance marketing and distribution, and create significant additional market share.
Additionally, add-on acquisitions have the added benefit of providing synergies for platform companies. Capitalizing upon these synergies can assist a platform company in increasing its value through cost cutting and greater economies of scale, as well as expanding or diversifying current offerings.
The shift in focus to the add-on arena is not without its challenges. Add-on acquisitions have the drawback of typically being smaller dollar-wise than platform purchases while still requiring the same level of diligence and professional service attention. This places pressure on the private equity firm to maximize the opportunity to its fund while minimizing the proportionate expense. As a result, we have seen the private equity community embrace creative ways to accomplish negotiation, documentation and due diligence by partnering with its professionals, particularly law firms, to stay competitive with fee arrangements.
For example, it is not unusual in this market environment to see a law firm reduce rates to accommodate the private equity client or to make fee concessions if the deal busts, trading these concessions for a success fee if the deal reaches fruition. We also have seen many investment banking firms, traditionally interested in sell side assignments, willing to take on typically less lucrative buy side assignments, to foster on-going relationships with their private equity clients.
Two areas in which private equity firms remain challenged with many add-on acquisitions are continuity and valuation. Given the nature and size of many opportunities, the target often is a company currently operated by a founding entrepreneur and in many cases an entrepreneur who has been with the company for many years and may be looking to retire.
Issues of continuity arise, primarily with respect to customers and operations, and the acquirer will need to make certain there is a next management tier in place to run the company, that the founder can remain on as a consultant, or that there is a new management team available to put in place.
Challenges also can arise if the retiring founder has an inflated notion of the value of his business. It is not infrequent that a founder will announce that he needs to receive a purchase price to maintain his retirement that is a price well above what reasonable valuation methods will support. Our experience with this latter issue has been to increase consideration to some extent by using an earnout and/or to “end run” the issue by refocusing the entrepreneur on other issues that are also important, for example protection of his remaining management team.
Add-on acquisitions also present issues relating to integration. Typically, when growing a platform company by acquisition, the target is integrated into the acquirer. Issues of employment practices, accounting systems and controls, operational best practices and corporate culture, among others, can arise. The mantra “most acquisitions fail” generally refers to the inability of the acquirer to successfully integrate the new enterprise. Successful acquisitions typically see a start to integration early-on during negotiations and due diligence, not after close.
Add-on acquisition activity by private equity firms likely will increase in 2015. We undoubtedly will see private equity continue to partner and collaborate with their professional advisors to find creative ways to allow deals to get done with efficiency and reduced cost. At the same time, private equity will continue to meet the challenges of integrating new acquisitions.
Mark Greenfield is a partner at law firm Blank Rome LLP in the Los Angeles office, focusing on corporate finance, with a concentration in the M&A and capital formation areas. Molly Crane, an associate at Blank Rome, focuses on general corporate matters, including M&A, private equity, securities and start-up related work.
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