There have been many high-profile industry consolidations or roll-ups in the last decade which have created significant shareholder value such as Fone Zone, Kids Campus and Medical Imaging Australia. However, as powerful as the roll-up strategy is, it is not suited to all industries and there are significant execution and integration risks, as demonstrated by failures such as Stockfords, Harts and ABC Learning Centres. This article provides an overview of the key issues associated with roll-ups and their success or otherwise.
Introduction to roll-ups
In simple terms, a roll-up involves the integration of a large number of small businesses in the same industry to create one large company. Roll-ups are generally suited to large and highly fragmented “cottage industries” with strong cash flows but without a dominant player.
Usually a “sponsor” (sometimes backed by a private equity (PE) fund) establishes a new entity (a “platform”) to acquire the other companies (“bolt-ons”) with the objective of generating economies of scale and reducing costs through standardisation.
Criteria for success
To maximise the likelihood of success, the following questions should be considered:
Is the industry suitable for consolidation?
Has the ease and cost of acquisitions been determined?
Does the “host” business constitute a strong platform?
What is the optimal size for the roll-up (how many bolt-ons should be acquired)?
Does the platform have access to sufficient committed capital to achieve the desired size?
Advantages and disadvantages
Benefits of roll-ups
An often touted benefit of consolidation is the ability to arbitrage the difference in earnings multiples between private and public companies. In other words, small private companies can be acquired for a lower earnings multiple than a publicly listed company. The sponsor can generally acquire a number of small companies for, say, three and a half or four times earnings before interest, taxes, depreciation or amortisation (EBITDA) and then undertake a public offering or sale of the platform at seven or eight times EBITDA. The higher multiple is achievable due to the liquidity and transparency (due to audited accounts and continuous disclosure) of public markets. Even in a trade sale to a larger sponsor or strategic buyer, the earnings multiples often increase directly with the size of the target due to similar factors as well as the professionalisation of the management of the platform.
In addition to the earnings multiple arbitrage, some of the benefits that consolidation may generate include:
Cost synergies: Cheaper insurance, merchant fees and buying power for stock.
Revenue synergies: These can include cross-selling of products and services and introducing large clients into other regions.
Brand: Superior brand recognition is likely to result.
Capital: Access to (cheaper) capital is an ancillary benefit of not only the scale of the consolidated group but of PE backing.
Leveraging fixed costs: Fixed costs (such as maintaining a head office and sales and marketing costs) can be spread over a large revenue base.
Corporatisation: The introduction of a head office with access to more sophisticated information technology (IT) and accounting systems, for example, will free up time for the founders to get on with their business (rather than spending all their time doing administration, chasing bad debtors or paying bills).
Succession: Many small business owners lack natural succession plans and the roll-up provides them with a future retirement plan.
The importance of these benefits will differ considerably between industries.
Disadvantages of roll-ups
On the downside, consolidation usually brings enormous integration difficulties, clashes of culture/ego, and execution risk:
Integration risk: It will be difficult to integrate the different businesses acquired as they will all have different systems (including IT, accounting and business systems), management styles and cultures. The more companies acquired the greater the effort required to integrate and the higher the risk of integration failure.
Increased costs: Sometimes the cost synergies do not outweigh the additional costs of a head office (such as salaries and lease expenses).
Non-alignment of incentives: Once the founders have received a large cash payout as part of the roll-up, they lose focus and become distracted by their new-found wealth (concentrating on decisions about which super fund to invest in and what holiday house to buy) rather than focusing on driving their business forward. Many sponsors will seek to mitigate this risk by requiring sponsors to rollover some of their proceeds into the equity of the platform, but that approach often exacerbates the integration risk and cultural issues from having “too many chiefs”. In some recent deals, there have been cases where the founder has actually left the group to start a new competing business.
Cultural issues: Often the targeted bolt-ons are run very informally with little or no corporate governance mechanisms in place and with limited finance or reporting systems. Under the new platform regime they will inevitably be forced to deal with a more formalised culture with far stricter reporting requirements and governance.
Execution risk: This risk should not be underestimated and applies at both the acquisition stage and eventual exit stage. The greater the number of counterparties to be negotiated with means the greater the risk that the deal will not go ahead, and also increases the risk of “greenmailing” where one stakeholder seeks to hold up the consolidation or the eventual exit by relying on some technical right (in other words, refusing to sign the relevant acquisition or sale documents) to get a special deal.
Legal risks: Roll-ups present complex structuring and legal issues which have a significant impact on the likely success of the integration. If the stakeholder arrangements are poorly planned there is a risk of unworkable corporate governance or susceptibility to greenmail as noted above. If the target shareholders are offered scrip in the platform company, there may quickly be a large number of shareholders. When embarking on a roll-up there are a number of issues which need to be carefully navigated through:
Prospectus rules: Consider whether a prospectus is required when offering shares — the rules on disclosure documents apply to private companies as well. There are a number of exemptions, such as fewer than 20 offers in 12 months to raise no more than $2m (20 in 12), minimum subscription of $500,000 or the “senior manager” exemption. A common misconception is that executive shareholders of targets will qualify under the senior manager exemption but this will need to be carefully considered (at the time of the merger the executives are not yet part of the staff).
Takeover rules: Another misconception is that the takeover rules only apply to listed companies. Care needs to be taken here as the rules also apply to private companies with more than 50 members. What this means is that investors or other material shareholders would need to comply with the takeover scheme rules or other exemptions before acquiring or increasing their holding in the platform company.
Some examples of failed roll-ups have been in the accounting services area. Both Harts Australasia and Stockford attempted to consolidate accounting firms. After a period of rapid consolidation, both companies were placed into liquidation. The most likely cause of this failure would appear to be forcing previously small independent practitioners to work under a corporatised structure with all strategic decisions being dictated at board level so, according to Tom McKaskill “few of them would be able to participate but all of them would have to abide by the decisions.”
Are industry roll-ups a good idea?
Industry consolidations create opportunities to create significant shareholder value. They are, however, not without significant complexity and risk, such as integration problems, execution risk and stakeholder alignment concerns. These risks can be mitigated through the implementation of key strategies and structures, such as ensuring vendor interests are aligned with the ongoing business (including vendor-centric governance and long-dated restraints), “push” rather than “pull” cultures and the use of de-centralised management structures.
The information contained in this article is for information purposes only and does not constitute legal advice.
About the author
Nick Humphrey is the managing partner of Hamilton Locke. He is the Chairman of the Australian Growth Company Awards and author of a number of best-selling books on business and leadership including Negotiated Acquisitions and Buyouts, a plain English reference guide for mergers and acquisitions and buyouts with step-by-step advice on the key legal, tax and structuring issues when implementing transactions, published by Wolters Kluwer.
Nick Humphrey, Negotiated Acquisitions and Buyouts (Wolters Kluwer 2016)
Keith Brown, Amy Dittmar, Henri Servaes “Roll-ups: Performance and Incentives for Industry Consolidating IPOs” (March 2001).
Nick Humphrey “Key Structuring Issues in Industry Roll-ups” (December 2006) Australian Private Equity and Venture Capital Journal 33.
Tom McKaskill “Unite and Conquer” (2 March 2006) Business Review Weekly.
Peter McKelvey, LEK Consulting “The Ties that Bind in Roll-up Plays that Work” (May/June 1999) 33/6 Mergers & Acquisitions: The Dealmaker’s Journal 1.