Add-On Acquisition

Synergies from Add On Acquisitions: “Buy-and-Build” Investing

Generally speaking, most add-ons are accretive acquisitions, i.e. the platform company is trading at a higher valuation multiple than the add-on.

The full benefits provided to the platform post-acquisition are entirely dependent on the industry and context of the transaction.

For example, one notable benefit could be improved technical capabilities post-integration of the add-on. In other cases, the consolidation could create value from more brand recognition and geographical expansion, i.e. an increased number of locations and client relationships.

The strategic rationale for add-on acquisitions states that the acquired company will complement the platform’s existing portfolio of product or service offerings.

Therefore, the add-on acquisition presents an opportunity for the platform company to realize synergies, which can consist of revenue synergies and cost synergies.

• Revenue Synergies → Greater Market Share, More Brand Recognition, Cross-Selling / Upselling / Product Bundling Opportunities, Geographic Expansion, New Distribution Channels, Pricing Power from Reduced Competition, Access to New End Markets and Customers
• Cost Synergies → Eliminate Overlapping Workforce Functions, Reduced Headcount, Streamlined Internal Processes and Integration of Operating Efficiencies (“Best Practices”), Less Spending on Professional Services (e.g. Sales and Marketing), Closure or Consolidation of Redundant Facilities, Negotiating Leverage Over Suppliers

Value Creation Strategies from Add Ons M&A (Inorganic Growth)

Many private equity firms specialize in the strategy of identifying and buying a platform company to subsequently use to pursue inorganic growth from add-ons.

The proportion of debt used to fund a buyout has reduced over time relative to the traditional LBO capital structure, as the industry continues to mature.

The gradual shift towards longer holding periods and less reliance on debt in private equity – i.e. financial engineering – has compelled firms to focus more on real value-creation from operational improvements and strategies like add-ons.

By virtue of being an established industry-leading company, the platform more often than not already has a strong management team, robust infrastructure, and proven systems in place to facilitate more operating efficiency (and those are passed down and integrated into the operations of the add-on companies).

The list below provides details surrounding some of the more frequently cited value-creation levers stemming from add-ons.

• Increased Pricing Power: Customers can often become more open to paying a higher price for a higher quality product and stronger branding.
• Upsell / Cross-Selling Opportunities: Offering complementary product or service offerings can be an effective method to generate more revenue, as well as instill greater brand loyalty.
• Increased Bargaining Power: As a result of holding significant market share, larger-sized incumbents have greater negotiating leverage when discussing terms with suppliers, which allows them to receive more favorable terms such as extending their days payables and discounted rates for bulk purchases.
• Economies of Scale: By selling more products in terms of overall quantity, each incremental sale can be brought in at a higher margin, which directly improves profitability.
• Improved Cost Structure: Upon closing of the transaction, the consolidated company can benefit from cost synergies that improve profit margins, e.g. combined divisions or offices, shutting down redundant functions, and lower overhead expenses (e.g. marketing, sales, accounting, IT).
• Reduced Customer Acquisition Costs (CAC): The access to improved software capabilities (e.g. CRM, ERP) and other infrastructure-related integrations can cause the average CAC to decline over time.

Of the value-creation return drivers in LBOs, growth in EBITDA is particularly challenging for well-run, mature companies. However, accretive add-ons are still one method for platform companies to achieve improvements in their EBITDA given the new growth strategies on hand and opportunities to improve the overall margin profile, e.g. cost-cutting and raising prices.

How Add Ons Impact LBO Returns (IRR / MOIC)

Historically, a company targeted by a strategic acquirer should reasonably expect to fetch higher purchase premiums compared to being pursued by a financial sponsor, i.e. a private equity firm.

Unlike a private equity firm, strategic buyers can often benefit from synergies, which enables them to justify and offer a higher purchase price.

In contrast, private equity firms are returns-oriented, so there is a maximum price that can be paid such that the firm can still reach its minimum required rate of return – i.e. the internal rate of return (IRR) and multiple on invested capital (MOIC).

The trend of financial buyers using add-on acquisitions as a strategy has enabled them to fare much better in competitive auction processes and place higher purchase price bids because the platform can in fact benefit from synergies.

On the date of exit, the private equity firm can also achieve higher returns from multiple expansion, which occurs when the exit multiple exceeds the original purchase multiple.

The expectation of exiting an LBO investment at a higher multiple than the entry multiple is highly speculative, so most LBO models set the exit multiple equal to the purchase multiple to remain conservative.

In certain scenarios, however, building a quality company via strategic add-ons – i.e. entering new markets, geographic expansion, and technical product development – can improve the odds of exiting at a higher multiple relative to the purchase multiple, and contribute to the sponsor earning higher returns at exit.