(Charlotte, NC – July 24, 2018)
In our last newsletter series, we covered five key practices PE firms have employed to maximize portfolio company values and equity returns. While these tactics remain effective, shifts in the broader market have forced PE investors to reconsider and develop more creative strategies. This week, we address one way PE firms have adapted their strategy in response: buy and build.
There are many macroeconomic trends currently impacting M&A: low interest rates, low cost of capital, high leverage levels, and high multiples (1).
Average PE Deal Multiples and Leverage
Note: US PE middle-market EBITDA multiples; Source: PitchBook Data
The combination of the above factors has generated increased competition for good deals. Both PE and Corporate acquirers have access to cash and attractive financing, with PE sitting on record levels of cash. Historical returns have also drawn new entrants to the PE market, with the number of firms at an all-time high as well. But, PE faces significant pressure from investors to deliver returns. While PE deal volume is up, PE deal count is down (1). The challenge in the years ahead for PE will be to find new ways to generate growth and underwrite value (2).
Dry Powder and # of PE Firms Both at Record Highs (2)
With increased frequency PE is adopting a buy-and-build strategy to create value in it its platform companies. This strategy is displacing PE’s historical playbook of pure financial engineering. 30% of PE-backed companies now undertake at least one add-on acquisition, compared to less than 20% in the early 2000’s (3). Buy and build deals generate an average internal rate of return of 31.6% from entry to exit, compared with 23.1% for standalone deals (4). If done right, the acquired company is leveraged as a platform for further, add-on acquisitions, and two potential routes for value creation emerge: reaping synergies between platform and add-ons, and creating a larger and more attractive company that may be valued at higher earnings multiples than the individual acquisitions (4). Besides multiple expansion obtained by increasing a platform acquisition’s scale, add-ons are usually smaller businesses that fetch cheaper valuations and help blend down the multiples paid for the original platform (3).
Half of Global PE Deals are Now Add-Ons (3)
To be successful at a buy-and-build strategy – acting as strategic acquirers and beating corporate buyers at their own game – PE must be even more focused and selective while performing due diligence for companies they intend to leverage as platforms. A PE should dedicate more time to developing a list of future potential add-ons during initial due diligence and planning. On the back-end, PE firms can extract more value from the sale of a platform investment if there is already a vetted pipeline of add-on targets in place for a new owner to pursue. PE firms should work in close collaboration with the platform’s senior management, external bankers and consultants to identify and approach priority targets.
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