Alliance of equals: PE's evolving buy-and-build approach

"We are absolutely seeing a growth in the number of bolt-ons and, in particular, larger-scale follow-on deals," says Graham Elton, partner and head of the EMEA private equity practice at Bain & Company. "There has been an increase in follow-on deals as a proportion of private equity deal activity, from 28% in 2004 to 50% in 2017."

In its recently published 2018 Global Private Equity Report, Bain urged private equity investors to deploy their growing amounts of dry powder by adopting an M&A strategy akin to those employed by large corporations. Specifically, the report advocated the bolting on of businesses "of around the same size" as original portfolio companies and the divestment of non-core assets. In doing so, it argued, acquirers would benefit from a more "transformative" impact and fund managers could convert non-core fixed assets into cash prior to exit. The result, it is argued, would be more significant synergies and the generation of early returns, making the most of a market where valuations are currently high.

There is evidence to back up Elton's assertion that the acquisition-related part of the equation is, in fact, taking place. Indeed, according to Unquote Data, the average value of an acquisition finance deal in 2017 was €36.3m, the highest figure since 2007, implying that add-on transactions are becoming larger investments. This narrative is further reinforced by a report published in November 2017 by Silverfleet Capital in conjunction with Unquote sister publication Mergermarket. The report found the average value of bolt-on transactions in H1 2017 stood at £92m, the fourth highest figure since the financial crisis, with both halves of 2016 also making the top four. The Silverfleet report also found that the number of bolt-on transactions reached a post-crisis peak of 320 in the first half of 2017.

GPs are looking to maximise the reach of their portfolio companies by providing more acquisition finance" – Tariq Hussain, Jefferies

In the large-cap space, which is the market segment on which Bain's report focuses, there have been two recent examples of private equity portfolio companies buying businesses of comparative or larger scales. In April 2017, Bridgepoint's Element Materials Technology – originally acquired on the basis of an $80m EBITDA figure – bolted on laboratory testing company Exova for £620m. More recently, Clayton Dubilier & Rice portfolio company Motor Fuel Group – originally acquired for £500m – bought UK petrol station operator MRH in a deal valued at £1.2bn in February 2018.

There have also been developments that suggest the same approach is being taken in the mid-market. Since the start of 2018 alone, Waterland Private Equity's Nuts Groep – originally acquired in a deal estimated by Unquote Data to be worth less than €100m – has bolted on Nederlandse Energie Maatschappij for a reported €200m; 3i has provided portfolio company Infinis, which it acquired for £185m, with £125m to acquire Alkane Energy; and Deutsche Beteiligungs AG-backed Duagon, bought on the basis of a €75m equity value, has acquired Mikro Elektronik for an equity investment of €61m.

"The fact that it is becoming more likely for private-equity-backed businesses to bolt on similar-sized companies is, in part, driven by the fact that fund sizes are bigger and the pressure to deploy capital is greater," says Tariq Hussain, European Head of M&A at Jefferies. "This increased availability of capital is further boosted by approaches from LPs in these funds, which are more likely to want to co-invest on deals nowadays. To a certain extent, relative to the amount of cash to be deployed, there is not a sufficient supply of available targets at higher price points. So instead, GPs are looking to maximise the reach of their portfolio companies by providing more acquisition finance."

The theory that buyout houses are struggling to deploy the amounts of capital raised is backed up by Unquote's 2018 Annual Buyout Review. The publication highlighted that there was €83.65bn in aggregate commitments made to buyout funds that held final closes in 2017, marking a third consecutive year of growth, up 110% on 2014's total. By contrast, the aggregate value of all European buyouts rose by just 46% during the same period to reach a total of €146.8bn in 2017. Furthermore, according to Bain's globally focused report, private equity buyout funds were sitting on $633bn of dry powder in 2017, an all-time high.

Alpha is better
Another key factor driving the evolving approach to buy-and-build strategies, according to Bain's Elton, is the increased need for private equity players to find alpha due to the fact that the wider market and macroeconomic environment alone are unlikely to provide much upside.

"All the beta effects that have been such an important part of the value creation story for private equity over the past five or six years are no longer a factor," says Elton. "Given where valuations are, investors cannot expect to sell at higher multiples than they are currently buying at. They are also less likely to be able to refinance with larger or cheaper debt packages. And it is unlikely that recently acquired businesses are going to be sailing into significantly better macroeconomic environments."

An obvious option for enhancing alpha, he says, is through an increased focus on buy-and-build strategies and maximising merger integration synergies. Increasingly large bolt-ons, relative to the initial platform, are a natural progression. "The more you look to create value from acquisitions, the more likely you are to start moving from smaller tuck-in acquisitions to larger-scale mergers between equal-sized businesses," says Elton.

A platform investment that delivered particularly strong returns was Cinven-backed cable operator and telecommunications company Numericable. The GP's original investment in the company was conducted on the basis of an enterprise value of €528m and the consolidated group was eventually sold for €30bn in April 2016. Its seven bolt-ons included the €17bn acquisition of SFR in April 2014. Cinven realised a net capital gain of €1.7bn and an IRR of 157% from its investment in Numericable, equivalent to a 4.7x money multiple.

All the beta effects that have been such an important part of the value creation story for private equity over the past five or six years are no longer a factor" – Graham Elton, Bain & Company

Fotis Hasiotis, global co-head of financial sponsors group at Jefferies, points out that another factor behind the move towards larger add-ons is a development that has been increasingly prevalent across the entire private equity landscape – improved access to credit. "The credit documents related to acquisition facilities are much more flexible – in terms of both quantity and terms – than they were even two or three years ago," he says. "The covenants that you are required to meet are looser." This view is supported in the report by Silverfleet and Mergermarket that makes reference to a "superabundance of debt to fund such acquisitive growth".

However, Hasiotis is keen to point out that, while private equity portfolio companies are more likely to make larger acquisitions than has historically been the case, this is not at the expense of smaller bolt-ons. Instead, he suggests the development forms part of an evolution in buy-and-build strategies and a pragmatic approach to deploying cash from larger vehicles. "Private equity is comfortable doing larger acquisitions through portfolio companies but they are still making smaller acquisitions, too," he says. "Whether it is a small bolt-on or a larger acquisition, it is a better risk-adjusted way to deploy capital, rather than moving into areas of the market you are less familiar with."

Yet, as with all investments, making bolt-on acquisitions involves risks and challenges, and those presented by larger deals differ from their smaller counterparts. "Historically, in corporate M&A activity, groups that make string-of-pearls acquisitions – making one to three acquisitions a year – have a much higher success rate than those that make one big seminal deal in a decade," says Bain's Elton. "Less frequent 'bet the ranch' deals have a success rate of no more than 50%. It is not simply a case of buying well; it requires a lot of skill to execute a good merger integration, and businesses that do that very infrequently are more likely to make a mistake than those that do it more frequently. Naturally, larger deals that involve the integration of more moving parts will involve greater risk."

Twice the effort
One of the most common challenges in successfully merging two similarly sized businesses relates to the integration of two workforces and management teams. Indeed, conflicts have emerged often enough for the term "culture clash" to have embedded itself into common M&A lexicon. But beyond simple differences in vision and approaches to doing business, private equity owners looking to merge two similarly sized companies face more immediate human-capital-related choices.

"The main reason bigger deals can be more problematic to execute is that, by definition, where you have two large companies coming together you will have two well-entrenched management teams," says Jefferies' Hussain. "How do you pick the best between the two companies? That can be a sticking point because you have to re-cut the incentivisation, you have to pick one management team over another and take care of various governance procedures. You don't typically have that situation in a more straightforward bolt-on or roll-up situation."

Given the increased complexity involved in larger acquisitions, it stands to reason this might have a knock-on impact on holding periods. Naturally, private equity owners are keen to see their growth strategies reach a certain level of maturity – and show up in portfolio companies' financials – in order to extract maximum remuneration for the risk undertaken. Indeed, Cinven's aforementioned investment in Numericable, while providing impressive returns, lasted 11 years.

LPs are more comfortable with the idea of a GP making significant bolt-ons that will drive better returns and perhaps holding onto a company for slightly longer" – Fotis Hasiotis, Jefferies

Bain's Elton says he expects typical private equity holding periods to remain at around the five-year mark for the foreseeable future; shorter than they were in the aftermath of the financial crisis but longer then they were beforehand. Yet, he acknowledges that portfolio companies undertaking larger scale M&A activity are likely to require a longer-term approach. "Given the increased focus on alpha over beta, it takes longer to deliver on value creation strategies, be they organic or acquisitive," he says. "None of these strategies with businesses of a certain scale happen very quickly. It is not exclusively applicable to large-scale bolt-ons, but where there is a significant change agenda or a significant merger integration to implement, it will take even longer for the business in question to truly reap the benefits."

To that end, a handful of large-cap players – including Carlyle Group, CVC Capital Partners and Blackstone Group – have raised flagship buyout funds with longer lifespans in recent years. Meanwhile, Nordic Capital recently completed the transfer of the remaining nine portfolio companies from its seventh fund to a continuation vehicle specifically because it wanted more time to fully exploit what it believes to be their significant potential for further value creation. Among these portfolio companies is banking and trading software provider Itiviti, which acquired Ullink in a deal that was reportedly valued at up to $650m.

Setting aside the emergence of funds with longer lifespans, Jefferies' Hasiotis argues that the entire private equity community is becoming more comfortable with the idea of longer holding periods. "Typically, in the past, a sponsor would not make a significant acquisition beyond the first year or so of their initial investment," he says. "That was because it would set the clock back in terms of ability to exit within a three-to-five-year window. Now, LPs are more comfortable with the idea of a GP making significant bolt-ons that will drive better returns and perhaps holding onto a company for slightly longer. LPs are cash rich, so they are not in any hurry to get capital back."

As dry powder continues to mount and entry multiples remain stubbornly high, private equity players will have to find creative ways of putting capital to work and ultimately driving returns. There is evidence to suggest an increasing number of GPs are heeding Bain's advice and adopting a more corporate-style approach to acquisition strategies within their portfolio companies. "Patient capital" may well become the name of the game.

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