With his extensive experience in the industry, Dr. John Binkley has seen trends and movements come and go within the U.S. financial landscape. One current phenomenon that he has observed with interest is the popularity of additive deal making, or “add-on” acquisitions, among middle market businesses by private equity firms.
While Dr. John Binkley and other professionals at Generational Equity have observed and commented upon the increase of add-on acquisitions in recent articles on the subject, the latest evidence shows that this trend has escalated significantly.
Add-ons Becoming Another Norm
Newly emerging figures are suggesting that additive deal making on behalf of private equity funds is no longer simply a significant contributor to the volume of U.S. middle market M&A activity, but that add-ons have become the primary means by which mid-size American businesses are now acquired.
According to PitchBook, compared to 15 years ago when less than 20% of buyouts globally were add-ons, so far this year they account for more than half, with this figure breaching two-thirds in the U.S. So, for a U.S. middle market business owner exiting their company this year, there is a significant chance the buyer will be a private equity firm aiming to bolt on the business to an already held platform company.
This clearly has huge implications for business owners picturing how they will one day exit their company. Given this shift in how and why middle market firms are acquired in the U.S., sellers will have to plan differently and look beyond their competitors as potential buyers.
For business owners with a limited understanding of the behavior of private equity funds, and the increasing complexity of exit transactions where private equity is involved, seeking professional advice on exit planning is now more essential than it has ever been.
The Traditional Model
When we consider M&A activity, we typically envision the situation where existing businesses expand their own operations on the ground by buying up competitors and associated businesses. The appeal of acquisitions to an operating business are quite clear:
- Acqui-hiring: Recruitment can be costly and time consuming for businesses. By acquiring an associated business, the buyer effectively hires that company’s core of trained employees that are more prepared to hit the ground running.
- Geographical expansion: Acquiring a business with a strong record in a target location can be a great way for a company to expand its reach while minimizing risk.
- Economies of scale: Operating on a larger scale can deliver savings through the consolidation of job roles, and bulk buying of raw materials, wholesale items or goods not for resale and other such economies.
- Diversification: By acquiring a business with a different focus from the buyer’s own, the buyer can introduce new functions onto their existing holdings immediately.
- Supply chain: Acquiring a business that supplies yours, or even acquiring one that your business supplies, can cut costs or increase margins for the resulting entity.
- Consolidation and alleviating risk: A consolidated business may have more capacity to take on larger contracts with larger partners. Such a business might also be offered some measure of stability and protection should they lose a key business partner.
In other words, good old-fashioned growth. You buy another business similar to your own to expand your operations, or an associated or disparate business to acquire new functions or capabilities. That much is clear. However, the market share represented by this traditional model is dwindling.
Same Game, New Players
This is despite the clear benefits of the approach and the fact that M&A activity is thriving. In fact, according to Deloitte:
“[A]bout 68 percent of executives at U.S. headquartered corporations and 76 percent of leaders at domestic based private equity firms say deal flow will increase in the next 12 months.”
However, rather than businesses buying other businesses, Dr. John Binkley has seen the M&A landscape shift with the rise of acquisitions through private equity funding. It may come as a surprise to many that private equity investment is now rivalling this traditional model in driving M&A. So, what has changed in terms of market benefits that a smaller percentage of acquisitions now stem from the corporate sector?
In an important sense, nothing has changed in the way that businesses benefit from consolidation. All the above benefits to expansion certainly still apply. These deals are still happening – and at record volumes – for the same reasons and achieving the same beneficial outcomes as they always have. All that has changed is the players involved. The difference lies in who is spotting the opportunities and building the deals.
What has occurred in the last decade is that the success and profitability in middle market M&A activity has attracted the attention of the substantial private equity funding that currently covers the market. Now, the players bolting these companies together are sophisticated “big picture” finance professionals who always have financial outcomes in sight – generating the maximum ongoing returns or divesting with the greatest profit.
What is in it for Private Equity?
But don’t these funds exist to dip in and out of industries, buying low and selling high? What interest would they have in buying a business as an add-on to another business that they have already acquired?
On the face of it, developing businesses with add-on acquisitions is the interventionist, labor-intensive, time-consuming activity you might not expect from private finance. However, where the returns justify it, PE has proved itself willing to roll up its sleeves and get involved.
According to an analyst note published earlier this year by PitchBook, the proportion of businesses held by private equity firms that have undertaken at least one add-on acquisition has increased from less than 20% in the early 2000s to over 30% in the first half of this year.
And the results for PE have been rewarding. Funds with a high proportion of add-on holdings have been posting greater returns than those with fewer such holdings. According to PitchBook, the two sample sets of add-on heavy funds that they analyzed demonstrated greater total value to paid-in ratios than less add-on loaded samples. The PitchBook report goes on to conclude that:
“36.3% of add-on funds beat the top-quartile hurdle rate, while just 10.0% of funds fell into the bottom-quartile, indicating that funds that employ the buy-and-build strategy generate superior returns.” Additive Dealmaking: Part II – An analysis of add-ons’ effect on fund performance PitchBook
So, with add-on heavy funds outperforming those with fewer add-ons, why wouldn’t PE pursue this buy-and-build policy through additive deal making? Over 25% of private equity add-on acquisitions are undertaken by funds that had already completed at least 5 add-on deals previously – demonstrating that those funds’ successes in pursuing buy-and-build made it worth their while to repeat the policy on multiple occasions.
Private Equity Influx Changing the Complexion of the M&A Market
With his vast experience in the industry, Dr. John Binkley interprets this move towards private equity add-on purchases as a culture shift within the industry that has been in the works for some time. Brokering business sales is no longer a matter between fellow business owners. The days of the business owner bowing out while negotiating a mutually beneficial deal with a local competitor are disappearing.
The current booming seller’s market remains a huge opportunity for sellers. The reason PE firms are clamoring after the American middle market is because it is so attractive and profitable to them right now. This level of demand can mean business sellers are in a position to realize extremely favorable valuations on their businesses, exiting with higher sums than they ever thought possible – but only with professional advice to match the shrewd business strategies of this professional buyer.
If you are a middle market business owner, exit planning warrants serious consideration. But without an understanding of your prospective buyer, that planning will be of little use. As we have seen, it is increasingly likely that your buyer will come from the private equity sector, and most business owners can be forgiven for having a limited understanding of how that sector operates.
Learning about the profile of your buyers is just one of the areas covered in Generational Equity’s complimentary conference – so arranging to attend could be a very wise move given the shifting complexion of the M&A market.