Profiting twice from the sale of their business is a common benefit for sellers who participate in a multi-company, industry-specific merger.
From among the three major categories of business buyers, private equity groups (PEGs) are currently the most active purchasers of mid-market companies, and the majority of PEG acquisitions are part of what is commonly known as an “industry roll-up” – a merger of multiple companies in the same market or vertical.
The growth in industry roll-ups is an established trend that is certain to continue, says M&A broker Matt Frye, managing partner in the Oklahoma office of IBG Business. “For just about every vertical one can think of, it’s a safe bet that there’s a roll-up strategy being executed or on the drawing board.”
As an example, Frye points to his recent sale of a tree maintenance company to a New York private equity firm. “They buy arborists, and that’s all they do – 10 to 12 a year, all over the country.”
Given the prominence of industry roll-ups and the apparent reality that few industries are exempt from being targeted, the owner of a closely held company in any vertical should understand:
- the industry roll-up concept,
- why industry roll-ups are growing in popularity,
- the significant opportunities that roll-ups present to business sellers, and
- the importance of seller scrutiny of the roll-up effort.
What Is an Industry Roll-Up?
In an industry roll-up, a buyer – usually a private equity group or other financial buyer – acquires multiple companies in a certain industry, particularly one that is starting to mature. The acquired companies are then combined or “rolled up” into one master company.
“Private equity firms use roll-up mergers to rationalize competition in crowded and/or fragmented markets,” notes Investopedia, “and to combine companies with complementary capabilities into a full-service business.”
Why Industry Roll-Ups Are Popular
An industry roll-up allows the buyer to achieve significant and rapid growth, potentially profitable expansion across markets, and the creation of a larger market presence in a relatively short time.
Also, by consolidating the back-office functions of the acquired companies, the roll-up can achieve economies of scale, growing the aggregate revenue stream without a corresponding increase in overhead.
The frequent result, says IBG’s Jim Afinowich (Arizona), is an extraordinary return on investment.
“Most businesses sell for a multiple of earnings,” notes Afinowich. “If a company is making a million dollars a year, it might sell for a multiple of four, or $4 million.”
“A private equity group will go out and buy 10 companies like that, in the same industry, for a total price of $40 million, and combine them into one company. Let’s say that, after achieving some synergies and economies of scale, centralizing and upgrading management, etc., the new rolled-up company turns a $12 million profit, not $10 million, and is worth a multiple of six.
“The companies that the PEG acquired for $40 million are now worth $72 million as a single company. Just by effectively combining the 10 companies, the PEG has increased the value of its investment by 80%.”
How Industry Roll-Ups Can Be Good for a Seller
In a roll-up, a seller can realize benefits that may not be present in a more traditional sale.
First, two or more PEGs might try to roll-up companies in the same industry at the same time. That can create buyer competition for a target company, which usually results in a higher selling price. The greater the number of interested buyers, the greater the leverage for the seller. (Conversely, “one buyer is no buyer.”)
Second, and more important, selling your business in an industry roll-up provides a second option to profit from the sale, provided you are willing to “roll equity.”
In an industry roll-up, the sellers of the individual companies typically receive cash and shares in the holding company in exchange for their ownership stakes. The acquired companies are then transferred to the holding company in which each seller owns an interest.
Afinowich offers an example.
“Let’s say that, instead of selling your company for 100% cash, you elect to receive 75% of the value in cash, and then roll 25% of the value in the roll-up,” Afinowich explains. “Five years later, after it has added more companies in the roll-up, the combined company sells for a lot of money, like in the example we discussed earlier, and the individual sellers cash out.
“We’ve done deals where the seller sold for 75% to begin with, but the 25% that they received in the exit from the roll-up turned out to be worth more than the 75% they received in the initial sale.”
Why Sellers Need to Be Careful
In a conventional sale, much of the due diligence is initiated by the buyer, with the seller responding to the buyer’s inquiries.
That’s not the case when a seller elects to participate in an industry roll-up, where due diligence must be a two-way street: Certainly, the buyer has all of the usual concerns about the subject company’s worth and the veracity of your representations, but in this setting you need to take a critical look at the buyer’s ability to execute a successful series of acquisitions and achieve post-purchase earnings growth.
Plenty can go wrong in a roll-up. It can be rushed, not executed properly, and fail to acquire top-quality companies. Or it can drag on, occurring too slowly and losing momentum.
“Your second bite at the apple depends on whether the buyer can deliver,” Afinowich points out. “If you’re carrying a note, you’re rolling equity, you’ve got some kind of deferred payment, you want them to convince you that this roll-up is going to be successful.”
You should be comfortable with the buyer’s answers to key questions, such as:
- What is your experience with my industry?
- Before this one, how many roll-ups have you completed? What is your process? What kind of value have you created for your company and for your sellers?
- Where are you in this roll-up? How many companies have you purchased? What are their numbers? How many more companies will you purchase? Who is on your radar? How do you qualify a potential acquisition target?
- What is your business plan for the new company? How will it be managed? Who will be in charge? What is their track record?
- How will you integrate my company with the others? How will it be bigger than the sum of its parts?
- What is my continuing role with my business? How much autonomy will I have? What resources will you provide to make it bigger, better, and more profitable?
The sale of any desirable mid-market company warrants the involvement and insight of a proven M&A broker. The peculiar opportunities and risks associated with an industry roll-up magnify the wisdom of choosing the right professional to lead you through the process.
The M&A professionals at IBG Business have extensive experience in dealing with private equity groups in industry roll-up scenarios and can help you evaluate a buyer and their business plan.