What is an Add On Acquisition?
An Add On Acquisition in private equity refers to the purchase of a smaller-sized target by an existing portfolio company, where the acquired company is integrated into the existing portfolio company.
The strategy of add-on acquisitions (i.e. “buy-and-build”) has become common in the private equity industry in recent times.
Under such a strategy, after the initial buyout of the core portfolio company – often referred to as the “platform” – the financial sponsor seeks to create value by acquiring smaller-sized targets and integrating them accordingly.
Add-On Acquisition: Value Creation Strategy in Private Equity LBOs
Often referred to as the “buy-and-build” strategy, an add-on acquisition can improve the platform by providing more technical capabilities, diversifying revenue sources, and expanding market opportunities among various other synergies.
The platform company is an existing portfolio company (i.e. the “platform”) of a private equity firm, whereas add-ons are smaller-sized acquisition targets with the potential to bring more value to the platform post-consolidation.
Conceptually, the platform can be viewed as the starting point for the roll-up strategy. Because of its role as the anchor, it is necessary for the platform to not only be financially sound but also be an established market leader to effectively serve as the foundation of a consolidation strategy.
Usually, the industries in which roll-up investing is common are non-cyclical with minimal disruption risk from external threats, making them attractive to firms that specialize in the “buy-and-build” strategy. And while not always the case, the platform often operates in a mature, stable industry with a substantial market share.
The industries where the consolidation play is most prevalent are frequently fragmented, such as among landscaping companies, where competition is location-based, i.e. the scalability of certain companies is constrained.
By pursuing fragmented markets, the consolidation strategy is more viable because the market is not a “winner takes all” environment and there are more opportunities to benefit from synergies.
Multiple Arbitrage: Platform vs. Add On Acquisition
In roll-up investing, add-on targets are typically valued at a lower valuation multiple relative to the initial purchase multiple of the acquirer.
The transaction is therefore considered accretive, wherein the cash flows belonging to the add-on are, immediately after acquisition, able to be valued at the same multiple as the platform, creating incremental value prior to any implementations of material operational improvements or integrations.
Furthermore, the platform company has normally reached a stable low-single-digit growth rate, with a defensible market position and minimal external threats in the market, which is the reason for its pursuit of inorganic growth in lieu of organic growth.
In comparison, the companies targeted as add-ons are usually underperforming from a lack of resources, poor decision-making by management, a suboptimal business plan or capitalization, or other issues; i.e. add-on targets possess significant upside and value creation opportunities.