The Key Ingredients of a Successful Rollup
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Atlasview Perspectives: The Art of a Rollup
While we do love reading about a business’s rollup success, our approach at Atlasview Equity is different from that of a rollup.
We pursue a “buy-and-build” strategy. It can be best described as buying a larger platform and then subsequently making add-on acquisitions to gain access to new customers, geographies, intellectual property, and product lines.
What is a Rollup?
A rollup is an inorganic growth strategy where a company acquires many small and or local businesses within a single vertical.
The acquired businesses are merged into a single brand and several functions are centralized. The end result, if successful, is a single large national (or global) enterprise with:
Efficient cost structure
Better offering for customers
Rollups have been around for decades, and just about every single industry has either been rolled up or attempted to be rolled up. Industries include dental clinics, car washes, pest control companies, IT services, funeral homes, HVAC services, and many more.
Why Do So Many Rollups Fail?
On paper, rollups look fantastic:
Share functions and professional management
Work in a cohesive manner to increase competitiveness and reduce costs
But the reality is that many rollups fail, and end up delivering subpar returns for investors. Below are a few of the common reasons why:
Overestimating Economies of Scale
A lack of alignment and cooperation has led many rollups to become nothing more than a bureaucratic mess. Systems that work well for a small-sized business don’t always fit that of one that is 10x of its original size.
Overpaying for Acquisitions
Once small mom-and-pop shops know that there is a big corporate acquirer interested in their business, their sale price expectations go up. While most rollups might be able to get the first few acquisitions done for reasonable prices, eventually they may need to accept higher acquisition prices in order to continue the strategy.
Many rollups employ an obscene amount of debt, which is how they finance their acquisitions. The debt service puts a massive hamper on the cash available inside these rollups and makes the organization fragile. In many cases, the return on the overpriced and underearning acquisitions does not exceed the cost of capital.
Short Term Incentives
In many rollup scenarios, senior executives don’t really care about capital allocation. They’re hired to execute acquisitions. Even if it would be best to return capital to equity & debt holders, it’s just not in their DNA to do so.
The Key Ingredients of a Successful Rollup
We’ve come to realize that there are 5 key ingredients for a rollup’s success. Most rollups have ingredients 1-3 below, which may be enough to drive above-average returns for investors, but capturing all 5 most often leads to very significant ROIC. The ingredients are, in increasing order of importance, as follows:
1) Fragmented Industry
There have to be many targets available to merge into the parent brand. This is also how you can (at least initially) acquire at a reasonable multiple, since the smaller the business, the lower the acquisition multiple.
2) Strong Platform
The acquirer needs to employ a winning strategy/process that is executed by a sharp and disciplined management team. This improves economics, cash flow and better aligns incentives compared to competitors.
3) Economies of Scale
There should be significant cost savings as more and more targets join the rollup. Centralizing overhead and back office functions, exercising buying power over suppliers, and concentrating efforts around sales/marketing initiatives are key to driving economies of scale.
4) Constrained Supply
The number of businesses in the industry is stagnant (or even shrinking), so the supply of the service/product is constrained. New mom-and-pop entrants aren’t able to open up with relative ease. This is usually a result of a large barrier to entry (costs, regulatory, etc). When this exists, a rollup can successfully reduce the supply and thus capture significant value.
5) Network Effects
The network effect refers to the concept that the value of a product or service increases when the number of people who use that product or service increases. Similarly, rollups can have network effects too (albeit very rare). Each additional acquired business enhances value for its existing customers and network.
We hope this post illuminates why rollups can be so successful and also why so many fail. If you’re interested in learning more about Atlasview’s strategy for inorganic growth, feel free to reach out.
TLDR: Vapor Corp manufactured mass transit equipment, oil & gas valves/pumps, and industrial process control parts. The KKR crew acquired the business in 1972 for $37.9M (7.6x EBIT). They put down $4.4m of equity (12%) and used $33.5m of debt (88%) to finance the deal.
Vapor’s earnings subsequently grew by around 20% annually, largely thanks to its pricing power.
Thanks for tuning in to another edition of Atlasview Insights. We’ll be posting bit-sized content every Wednesday with longer-form pieces going out on a bi-weekly/monthly basis. We have a ton of content lined up for small business owners, deal makers, and investors. Lots of valuable topics including:
Optimizing cash flow for your business
Preparing your business for an exit
Inner workings of an emerging private equity firm
Scaling customer acquisition
Deal sourcing and structuring
Software and technology investing
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