In an extremely competitive deal market, one way private equity firms create value is by merging together a number of smaller firms to create an "at scale" competitor. This strategy is called "buy and build" because it emphasizes both buying several companies and building the infrastructure to support a larger firm. Generally, these strategies do well. It can be one of the best ways to generate above-market returns. This creates a compelling value creation opportunity for both buyers and sellers.
Research shows that building at-scale firms with several hundred million dollars in revenue creates economic value. This happens because smaller firms will be valued at substantially lower multiples of earnings than larger firms, primarily driven by the inherent concentration of risk in a smaller number of customers, markets and key employees. Buy-and-build strategies take advantage of this valuation differential by combining many smaller firms, acquired at lower multiples, in order to create a larger, more diversified organization that the market will value at a higher multiple. This is especially true in the business and professional services industries, where human capital is the core asset. There is a wealth of quality firms under $100 million in revenues and a very strong correlation with increased valuation multiples as these firms grow.
A common way deals are structured in these strategies is through a mix of cash at close and equity, which is typically rolled into the go-forward company on a tax-free basis as part of the purchase agreement. From the buyer’s perspective, this equity ensures an alignment of interest in the success of the venture going forward. For the sellers, it allows them to take home significant value for the organization they’ve built, while still sharing in the upside of the larger organization that is being created.
This multiple arbitrage creates a return profile that is highly compelling. A recent study showed that buy-and-build deals focused on smaller organizations (those with an estimated value of less than $70 million) performed significantly better than those of larger acquirers, generating an average internal rate of return from entry to exit of 52.4%. Given this, a hypothetical seller could sell their business for $10 million, take home $8 million in cash at close and roll $2 million into equity in the go-forward venture. At this rate of return, in four years the $2 million equity roll would be worth approximately $10.8 million, for a total take home of $18.8 million. This is how these strategies allow sellers to maximize the value of their business over time.
What To Look For In The Private Equity Firm Backing Your Buy-And-Build Strategy
When done well, these strategies also create more value than just the dollars and cents, they address a top concern for selling owners: how their employees will be affected by a change in ownership. The best private equity firms employing these strategies put the optimization of human capital at the core of their thesis and do several things that create value for employees and protect the legacies of selling owners.
Foster opportunities for leaders to emerge: These strategies are inherently growth-focused, which means the scope and depth of leadership opportunities will expand significantly compared to what is possible at a smaller firm. The best organizations take a purposeful approach to identify talent, create opportunities for them to grow and provide training and mentorship to support that growth.
Facilitate diffusion of ownership: Best-in-class organizations will also create opportunities for a wider range of employees to participate as stockholders. This can be done in many forms (stock purchase rights, options plans, profit sharing, etc.), but the key is to align incentives and share the upside of the value being created with top performers.
Focus on culture: When combining a multitude of organizations, cultural alignment is a critical factor in employee satisfaction and productivity. The best operators implement strong HR functions to ensure employee engagement strategies are designed to support and enhance the desired culture. They give employees a voice, establish positive working norms and hold managers accountable for adhering to and strengthening the firm’s culture.
What To Consider Before Employing A Buy-And-Build Strategy
If considering PE buy-and-build as an exit option, an owner should begin preparing well in advance, with several important considerations.
Length of transition: The most successful candidates in these strategies are those that are excited about taking on key management positions in the go-forward organization. Therefore, it is mutually beneficial for owners to start preparing for and approach this process well in advance of an ultimate transition to retirement. In the event this is not possible, having a management succession plan in place is critical and handing off key client relationships should be a top priority.
Strength of management bench: Even when the ownership team is planning to stay on for an extended period, the best way to maximize value is to have a strong management team in place that can grow into broader leadership positions in the go-forward venture. Owners should make the recruitment and development of practice area leaders a top priority.
Strategic fit potential: It is also important to consider what type of organization and strategy your company would fit best with. Where is your company strongest and weakest? What type of services, expertise and relationships would best complement your current operation? Who would you acquire if you were implementing a buy-and-build strategy? Having answers to these questions will not only make you a more attractive candidate but will also help you better assess your fit with a potential acquirer.
In today’s market, owners of strong lower-middle-market firms have many options when considering a sale. When done right, PE-backed buy-and-build strategies can be a win-win situation that maximizes value and promotes opportunity.
Tony Brindisi Forbes Councils Member
Co-Founder and Managing Partner at RTC Partners, an NYC-based private investment firm focused on lower middle market buyout strategies