A couple of months ago the Boston Consulting Group released an interesting report on the ‘Power of Buy and Build‘ in Private Equity deals. To quote the first sentence of the report, “buy-and-build deals, in which private equity firms introduce operational improvements to their portfolio companies through add-on acquisitions, are now the PE value creation strategy of choice“.
Undoubtedly buy-and-builds are on a roll. In 2000, only 20% of private equity deals were including inorganic growth transactions. In 2012, that share rose to 53%. Bain & Company reported that a record $267bn worth of add-on acquisitions were completed by PE sponsors in 2015. What is more doubtful, though, is the fact of considering these buy-and-builds as the “PE value creation strategy of choice”. Based on my experience of private equity as well as existing academic literature, here are 6 reasons why:
- My first remark involves the very definition of ‘buy-and-build’ “in which private equity firms introduce operational improvements to their portfolio companies through add-on acquisitions”, according to the report. Although post-merger integration phases can sometimes trigger the implementation of a wider operational improvement plan, enhancing a given company’s processes can most often be done independently of any acquisition activity.
2. The report seems to overlook the distinction between ‘value creation’ and ‘value capturing’. As explained by Berg and Gottschalg in their paper Understanding Value Generation in Buyouts, value creation “is directly linked to a fundamental change in the financial performance of the target organisation” while value capturing “reflects the fact that [an increase in the equity value of the company] can occur without any change in the underlying financial performance of the business”. Value generation is simply obtained by summing up the two components. The BCG report states that multiple arbitrage is the key driver of superior performance behind buy-and-build deals. And multiple arbitrage is typically one of the value generation drivers that cannot be considered as value creation but value capturing.
3. An increase in multiple is not simply attributable to “increased expectations of profit growth”, as mentioned by the report, but also reflects the dynamics of the sale process. An asset coveted by a larger number of buyers will likely sell at a higher price. Bain’s Private Equity Global Report 2016 is in that sense right to state that “by adding on enterprises in the same or related business to a portfolio holding, GPs can target companies that are often too small to attract the attention of big corporate acquirers and can be bought at reduced prices” – we could extent the argument to the competition coming from mid to large-cap PE funds which benefit from an extensive sourcing network and an abundance of liquidity.
4. For a given average financial performance level, more stable cash-flows will often lead to a higher multiple. Meeting the debt schedule is indeed a key requirement for any PE-owned company. This enhanced cash-flow stability can be achieved by widening the ‘business base’ and developing new (adjacent) business lines, entering new geographies etc. If the PE owner decides to combine two ‘narrow base’ businesses, it can create a merged ‘wide base’ business which will benefit from a massive multiple uplift without having delivered any value, simply on the basis of unproven and undelivered potential growth. The uplift will be even more significant the smaller the standalone companies originally are.
5. Furthermore, the BCG report concludes that “deals that include one or two add-on acquisitions outperform both standalone deals and those that include more than two acquisitions”. This conclusion holds if we consider IRR as the only performance metric, but can be challenged if we take the money multiple (‘MoM’) into consideration as well. Indeed, each additional add-on acquisition may enable the PE owner to capture incremental value in nominal terms, but the extra time required to complete and integrate the additional transaction may penalise the deal’s IRR. A concrete example is outlined at the bottom of this post and is a perfect illustration of the conflict which may arise between the two concepts and ultimately between the main stakeholders – GPs are incentivised to sell as soon as the multiple arbitrage related to the first add-on acquisition has cristallised whereas LPs would be financially better-off by waiting for another acquisition. Historically, IRR was the key measure to ensure that investors were directing their money towards the most profitable investments at any point in time. Today, with limited growth, negligible inflation and sometimes negative interest rates, we could wonder if IRR has not actually become a secondary indicator – but we will pursue this debate in another post.
6. Last but not least, when we come back to the true definition of ‘value creation’ and when we look at the chart above, we could actually conclude that add-on acquisitions deliver almost no incremental value – ‘synergies’ – and potentially destroys some. In a standalone deal, the IRR attributable to operational improvement is 12.9% (7.4% + 5.5%) whereas the buy-and-build deal only delivers 12.2% (5.0% + 7.2%). In his book Thinking: Fast and Slow, Nobel Prize Daniel Kahneman – whom we have already talked about in another post – has identified a couple of unconscious phenomenons underpinning our ‘overconfident’ self: ‘planning fallacy’ is the tendency to take on a risky project confident of the best case scenario without seriously considering the worst case scenario and our ‘optimistic bias’ gives unwarranted optimism which does not calculate the odds and therefore could be risky.
The conclusion is simple: buy-and-builds are not value creation processes but are sources of value captured by private equity funds as a reward for consolidating markets and making companies more financially robust; an arbitrage mechanism rather than a pure operational effectiveness program.
Example of additional add-on investment with mixed effect on IRR and MoM
We suppose here that the Enterprise Value (‘EV’) perfectly corresponds to the price the PE owner can buy or sell companies for. The year count starts at 0.
The MoMs and IRRs are as follows:
As a consequence, while investors would ultimately make a larger nominal profit under scenario 3, the IRR, which drives GPs’ behaviour (and carried interest), is actually lower.