Creating Value: Elements of a Successful Roll Up in Mergers & Acquisitions

Execution is the Key

Target companies rarely have the personnel and expertise to conduct a roll up of other targets on your list. So don’t expect to buy your first company and use that management to run the next twenty companies you acquire.

In fact, the integration of the operations of the target companies needs to be conducted by talented management of the highest calibre.   There needs to be a top-class management team set up at the outset to handle the diverse range of businesses about to be acquired. The skill-set needed encompasses prudent management of the businesses, speedy integration of each target into the organisation, the roll out of the “big idea” strategy and a relentless focus on reducing costs.

Management, Integration and a “Big Idea”

At an operational level, the key to a successful roll up involves what I call the “McDonaldisation” of the growing organisation.  By this I mean the rapid implementation of systems and procedures to show everyone “how we do it around here.”  How is it that McDonalds can have 30,000 stores around the world run by 15 year-olds and headed by a clown?  The answer is in procedures and systems.

It also involves the implementation of the “big idea.”  I don’t believe it is sufficient to acquire businesses, strip out costs, consolidate marketing and put procedures into place.  You also need a new way of doing business.  Even McDonalds all those years ago had a big idea: it was to:

  • Dispense with car-hops who took the burgers and drinks to the cars and make customers serve themselves,
  • Reduce the number of menu items, and
  • Turn the kitchen into an assembly line.

Without a big idea, the danger is that you will be accumulating a collection of “me to” businesses that will never stand out, no matter how many costs you strip out. McDonalds mastered the art of replicating business systems time and time again – and this is what is needed when taking over targets in a roll up.

Don’t Succumb to the Temptation of Overpaying

One issue with a roll up strategy is that once the industry knows about it, targets start trying on inflated valuations for size.  Another issue is that the roll up team starts to pay these valuations.  Time and time again, despite the clearest mandate from the acquirer to its negotiators, the thrill of the deal gets in the way of a buying at a sensible price.  The advantage of working in one sector or sub-sector is that because most of the targets are similar, the acquirer can use a multiples valuation method.  Businesses valuations are usually by ascertaining the average earnings before interest and tax (‘EBIT’) or earnings before interest and tax, depreciation and amortisation (‘EBITDA’) over the previous three years. For non-publicly listed companies, the average EBIT or EBITDA is then multiplied by an industry multiple or simply by 2, 4 or 6 etc, depending on the sector.

A target would want to use a multiple of EBITDA rather than EBIT because EBITDA is usually higher as depreciation and amortisation are excluded. In capital intensive industries, however, the acquirer might insist on using EBIT because cash flows are continually affected by significant capital expenditures.

There are some shortcomings with the multiples method which you as the acquirer can always point out to the targets:

  • EBITDA does not account for future restructuring of the business by the new owner.
  • EBITDA does not accurately show up future investment needs.
  • EBITDA might not reflect new operating conditions and will not reflect future operating conditions.

Multiples are not always of EBIT or EBITDA. There are other “rule of thumb” valuation formulas in certain sectors and these rules of thumb are as diverse as a multiple of revenue, or a value per customer or a value per subscriber.

One way to check that the multiple is correct is to run a discounted cash flow  based on future earnings. Since cash is always king, this is probably a better method because many businesses that turn a profit can be nevertheless starved of cash.

Whenever a roll up vehicle is tempted to pay more for a single acquisition, my advice is usually to do it by way of an earn out.  That way, if the target is correct about the future potential of its business, then the owners of the target can get the balance of the increased price if and when that future potential is realised.

Always have Capital Reserves

Not every acquisition performs according to the projections you did years before you bought it. You cannot afford to have acquisitions drain the capital reserves of the acquiring company. Accordingly, there must be sufficient dry powder to cover shortfalls in performance or sales in the targets, or the whole house of cards might come tumbling down.

The solution to this might be to have a cast iron rule that total debt of the group should not be more than a multiple of the combined EBITDA – say three or four times.  Granted, one view might be that this would crimp the rate of acquisition by artificially holding debt down.  The more conservative view, however, might be that it is better to grow slowly than to take on too much debt and have the whole thing collapse.

Pay for Exceptional Bench Strength

The individual target companies might have sufficient talented management to keep each business running smoothly, especially with the benefit of the new centralised back-office, centralised marketing, procedures and the big idea.  Co-ordinating all these target companies, however, needs to be handled by a team that sits above all the targets: this is your  A Team.  The team at the top needs to know the sector, but more importantly, it needs to be 100% focussed on acquiring, integrating and inspiring the rapidly growing organisation.  Given what is at stake, it is better to pay slightly over the odds and offer a generous incentive scheme for a successful roll up than it is to have the thing collapse through lack of talented management.

One of the issues is that the market rewards successful roll up practitioners when they IPO, but once these practitioners have done roll ups in four or five different industries, they hubristically tend to seek to do it in other industries of which they have little understanding.  Being able to roll up 30 or so different companies is one necessary component, but understanding the sector in which those companies operate is another.

Don’t Think You Know it All

The temptation is to talk down to the owners and managers of the targets – after all, you have just bought them out and you have a “big idea.”  The trouble is that amongst all the disparate systems and procedures of the targets (or lack of them), there are some gems that would add to your own systems.  The difficulty is throwing out the baby with the bathwater and upsetting the target’s owners and management in the process. The art is in spotting clever ways of doing business amongst the targets and deploying them across the group for the benefit of everyone.

On the other hand, don’t think that your new systems and procedures are going to be met with wholehearted approval in all the targets.  For each business you acquire, the team there will have done things an entirely different way and there may be some push back in pivoting to do it your way.  The difficulty is that probably won’t get that feedback immediately.  They will usually be more concerned about keeping their jobs and finding out what sort of managers you really are than telling you honestly what they think of the new way of doing things.

This means that the acquirer’s team cannot fly in and fly out of each target and expect that the new systems will be adopted wholeheartedly.  A lot of time needs to be taken with each target and the management of each has to buy into the process by being shown how beneficial the outcome will be.

Conclusion

There are two streams of talents that need to run concurrently for a roll up strategy to be successful:

  • The mergers, acquisitions and deal team that assesses 50-100 businesses, approaches the owners, negotiates deals, finances the deals and bring the targets into the fold, and
  • The execution team that works with each of the acquired targets, implements the systems, listens to management and makes the whole thing happen on an operational level.

Never let the deal team run riot without an A Team backing them up.

Ben Killerby B.Juris., LL.B., LL.M., M.A.I.C.D.

Ben is the manager of the Saxon Klein Corporate Advisory section. He has 21 years of experience in law and in private enterprise. As a lawyer, he worked in mergers and acquisitions at major law firms Mallesons Stephen Jaques in Australia and Simmons & Simmons in the City of London. In private enterprise, he has been involved in major property and corporate deals, including the establishment of the original Packer Murdoch Telstra pay television network in Australia (Foxtel).

Ben has three law degrees, including and Masters of Law from the University of Melbourne. He is also a legal practitioner admitted to the Supreme Court of Victoria, the Supreme Court of Western Australia, the Federal Court of Australia, the High Court of Australia and the Supreme Court of England and Wales.

He was the Team Attache for the Australian Olympic Winter Team at the Vancouver Olympic Games.

Contact: potential@saxonklein.com.au
Telephone: 1300 898 898
Twitter: @benkillerby