Buy-and-build: a pricing panacea?

Welcome to private equity's new normal, where relying on multiple arbitrage or on natural economic growth in European markets to generate value is risky at best. GPs increasingly need to prove their mettle by making genuine improvements to a business's operations. While this remains doable outside of buy-and-build scenarios, the prospect of mathematically enhancing the size, and ultimately value, of a portfolio company by leveraging market fragmentation is sounding increasingly tempting.

But perhaps one of the main selling points of the strategy, given the current valuation levels seen in the European mid-market, is to buy "better" – patiently picking smaller assets at better valuations, while the bulk of GPs outbid each other in high-profile auctions for vanilla assets.

EY's Bridget Walsh highlights the popularity of the strategy: "The message we are getting from the market is that GPs have to be more innovative, and buy-and-build is a key part of that. We've been commissioned on a number of strategic advisory projects along these lines for private equity funds, looking at consolidation opportunities in several sectors. Some of these could be very niche roll-ups that could have been too small for some sponsors in the past, but that now make sense given the current environment."

Recent months have indeed seen players more accustomed to large-scale buyouts dedicate time and resources to bolt-on plays. Take BC Partners, for instance: the GP's portfolio company Teneo acquired communications agency Blue Rubicon from LDC, and StockWell Group from Iceni Capital, in August alone. Another one of its investments, publishing group Mergermarket, recently acquired unquote" and AVCJ from Incisive Media, adding to several other bolt-ons since the late-2013 buyout.

This activity adds to the amount of capital raised in recent months by funds dedicated to, or heavily skewed towards, build-up strategies. UK stalwart Sovereign Capital held a final close for its latest fund on its £395m hard-cap in August last year, after just four months on the road. Over on the continent, French buy-and-build specialist Industries & Finances Partenaires (I&F) closed its third fund on €135m, surpassing its original target of €125m, in April 2014.

This increasing popularity, added to the attractiveness of quality European assets to overseas corporate and financial buyers, begs the question: is buy-and-build starting to suffer from the frothiness it should theoretically be side-stepping?

Small is beautiful
As a rule of thumb, GPs will distinguish between roll-up programmes with an overall turnover size of €50-100m, and those above. The larger bracket, where the platform would typically turn over €100-500m, with bolt-ons generating revenues of €50-150m, drops sponsors right in the hot spot of the highly competitive European mid-market, argues I&F founder Pierre Mestchersky: "Add-ons tend to be intermediated, so the heightened competition and the general increase in valuations seen in the market certainly have an impact on pricing."

Aiming smaller, typically for platforms making £3-10m of EBITDA and bolt-ons generating profit in the £1-5m region, can help avoid this, says Sovereign Capital partner Jeremy Morgan: "That space can still be surprisingly unfarmed by corporate finance. I also believe that there can be more of an entrepreneurial drive to businesses before they reach a certain EBITDA scale, and sometimes successful entrepreneurs can decide they don't need as much advisory support as might naturally be expected."

Ultimately, this lack of intermediation should allow GPs to knock on the door of businesses that are not on the market and offer prices more in line with what was commonplace a few years ago – with EBITDA multiples in the 4-6x range compared to the current 10x-plus. "It is still possible to find attractive opportunities at the smaller end – businesses with turnover in the region of €5m or so are still under the radar of financial advisers and of most private equity houses," notes Mestchersky. "Prices have therefore remained very reasonable in that bracket since competition and intermediation are less of a feature."

But even then, Mestchersky warns that the situation is evolving – at least in France – with higher entry multiples across the market ultimately threatening the competitive advantage of smaller bolt-ons: "In practice, it is very difficult to explain to the managers of the bolt-on businesses that we are buying them at a lower multiple compared to the larger platform. A successful buy-and-build strategy requires transparency, so there is a risk of fostering resentment. This tends to homogenise prices and makes it harder to avoid higher entry multiples."

While most players in the market point out that the best value is still to be found in the smaller, niche roll-up plays, this hasn't stopped European GPs from steering their portfolio companies towards sizable bolt-ons. For instance, Aleph- and Crestview-backed fibre-optic networks and cloud operator Interoute bought cloud infrastructure business Easynet from MDNX for £402m in September. The target company is understood to have generated a £37.5m EBITDA last year.

Looking further afield
The benefit of securing under-the-radar deals at attractive entry multiples may be under threat, but buy-and-build strategies can still bring other cards to the table. One that is now more relevant than ever is the potential to quickly scale up a group to the international level without painstakingly growing export capacities from scratch. This approach can also have the benefit of potentially side-stepping sourcing or valuation issues with domestic bolt-ons, instead tapping into less competitive markets.

Permira-backed Pantheon Healthcare, for instance, which is based in the UK and Switzerland, acquired Italian clinical engineering business Ingegneria Biomedica Santa Lucia (IBSL) from Gruppo Giglio at the end of July. And fresh off its buyout by new majority owner 3i, UK-based Aspen Pumps boosted its Australasian presence with the bolt-on of Australian business Pro Pipe Supplies in July.

This rationale resonates with Morgan, who says that Sovereign is increasingly broadening its horizons when devising roll-up strategies: "We are frequently looking further afield than simply the UK for acquisitions, with a good recent example being Cordium, where we went from a London-centric hedge-fund compliance business to a global player through buy-and-build and greenfield development in the US and the Far East. That approach is more challenging since you have to be aware of local dynamics, but the potential upside of a well-integrated international business is also more attractive."

This last point highlights the fact that buy-and-build cannot be seen as an easy way out of the challenges currently faced by GPs in the wider European private equity market. With increased popularity comes increased competition – this is not only likely to affect pricing as seen above, but also requires sponsors to be much more proactive in order to secure build-up opportunities in the first place.

"Making bolt-ons is not something that you switch on and off, so when we look at making the platform investment we also run the bolt-on strategy in parallel – we are talking multi-year relationships before getting a deal done," says Morgan. "If you make the platform investment and you haven't really progressed the bolt-ons, it is going to take a long time to execute on that roll-up strategy. What you can't predict is when a business owner will want to sell – all you can really do is build a strong relationship so that when that life event happens, you are thought of first to take the discussion further."

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• Topics
• Industry
• Buy-and-build
• Sovereign Capital
• Bee Up Capital (formerly Industries & Finances Partenaires)
• EY (Ernst & Young)
• unq2015nov