Buy-and-building through the storm

GPs across Europe have had to balance the emergency liquidity demands of many of their portfolio companies with the need to deploy capital and continue to create value. Deal-doing has decreased in value and volume, according to Unquote Data: there were 334 buyout deals in the period of January to May 2020 with an aggregate value of €72.35bn (although the €17.2bn acquisition of Thyssenkrupp Elevator will have significantly boosted this), compared with 412 deals totalling more than €79bn in the same period in 2019.

Furthermore, activity recorded over April and May 2020 (which would also cover any deal inked in March under lockdown but announced later) fell to 96 transactions worth an aggregate €11.9bn, a far cry from the €29bn over 168 deals in the comparable period last year.

In light of the coronavirus-induced drop in activity, many were quick to highlight bolt-ons as one way to keep deploying capital. Many GPs indeed agree that now may be an opportune time to build a group in a sector that they know well, based on a platform investment for which they have already secured acquisition financing. "Buy-and-build is easier than doing a new platform right now, since there is usually committed financing," says Carsten Rahlfs, a partner at Waterland Private Equity. "Secondly, you are already invested in the sector, so it is easier to test the likelihood of a dramatic downturn in that company. For example, we know the healthcare space up and down, so we can assess what will happen after the crisis and the specific risks."

The managers have relationships and a higher level of familiarity, so it is easier to understand the risk" –  Oliver Haarmann, Searchlight Capital

Searchlight Capital bought a majority stake in Global Risk Partners (GRP) in February 2020, with the deal completing in June, and announced its intention to support the company in a buy-and-build strategy. Oliver Haarmann, founding partner at Searchlight, says it has been challenging to conduct due diligence and often impossible to hold face-to-face meetings under lockdown, but argues that this is not such a challenge when it comes to bolt-ons. "Add-ons can be easier, since you typically already know the companies quite well. For example, the companies that we are buying will have been known to GRP's senior management for years, as will their clients. The managers have relationships and a higher level of familiarity, so it is easier to understand the risk. The second thing that makes it easier is that synergies are so much higher; an acquisition always has information benefits and synergies if it is an add-on."

Getting through
Although the appetite to do bolt-ons is certainly there from PE's perspective, getting sellers to the table and ironing out a deal remains challenging. The gap between buyers' and sellers' pricing expectations are regularly cited as a barrier for deal-doing in the current market, and it goes some way to explaining why bolt-on statistics have also been depressed in Q2.

According to data from Unquote sister publication Mergermarket, build-up activity has indeed fallen significantly in 2020, following a record year for add-on value. PE-backed companies in Europe made 251 add-ons with an aggregate value of more than €2.6bn in Q1 2020, compared with the 238 add-ons totalling €7.56bn in Q1 2019, indicating that the appetite for bolt-ons was still present, albeit with a preference for targets with a lower enterprise value on average.

However, Q2 2020's numbers look unlikely to challenge those of Q2 2019; as of the end of May 2020, there have been 78 add-ons amounting to €769m, compared with 226 deals totalling €8.42bn in Q2 2019.

"Overall right now it's our preference to do more buy-and-build," says Rahlfs. "But if the seller is sticking to the old historic price level, they will have to agree to a lower price right now, and that is the typical problem, as the levels of the past two years are no longer valid."

Gilles Collombin, head of investor relations at Charterhouse, concurs: "During the Covid-19 crisis it could be more difficult to agree a price – buyers want to know more about the company, and sellers want a higher price than the buyers do. You may need to wait a few weeks and months before the buyer and seller can agree."

Rahlfs points out that familiarity with a particular market segment is a good way to communicate with potential sellers, and try to overcome sell-side reluctance in coming to market under difficult circumstances: "Bigger groups are usually more stable and can be a strong partner to help a single clinic or nursing home through the crisis, to help the employees and the company to come into the company 'family' and be a strong partner."

Healthcare businesses, ranging from eyecare clinics to care homes, have been key targets for sponsors pursuing buy-and-build strategies. Rahlfs notes that there are operational and procurement advantages for healthcare companies joining a buy-and-build group: "Take protective equipment, for example: if a company joins our clinic group, we can help with protection material for employees in a couple of days as we are bigger and can source in Asia."

Florian Schepp, a partner at Family Trust Invest, told Unquote that the IT consultancy market was a key one for buy-and-build, following the GP's acquisition of Germany-based AlphaQuest, and that the strategy benefits the companies in the group. "It's a very fragmented industry and it makes sense for a smaller company to join a bigger group. Clients appreciate one-stop shops. And when it comes to bigger companies, the customer acquisition is easier – they have a bigger network, so it's easier to generate new sales. From the risk perspective of a larger client, if a company consists of a group of 15 highly specialised data scientists, for example, a large project might take up half of the staff. But with a bigger organisation, bigger clients can trust you from a risk perspective and it makes sense for them to hire bigger groups. That's why buy-and-build makes sense in the sector."

You may need to wait a few weeks and months before the buyer and seller can agree" Gilles Collombin, Charterhouse

Collombin says that buy-and-build is one of Charterhouse's key value creation pillars, and that the appeal of being owned by a PE firm in difficult times can be a powerful tool in the current climate. However, he also notes that this has not led to a surge in add-ons in the market, as evidenced by the aforementioned Mergermarket statistics: "We haven't seen much of it happening yet during the coronavirus crisis, but for some companies it makes sense to join a bigger platform."

Lending a hand
Now might not be the best time to initiate a new buy-and-build play either, given the challenging financing conditions. "The financing markets have definitely got much tougher," says Haarmann, before noting that some sectors have fared better in that regard. "But on the other hand, the insurance industry is still reasonably popular with investors and lenders as it is viewed to be quite resilient in times of recession. From that perspective, the Global Risk Partners platform investment is still a deal you could finance today, although perhaps on less attractive terms. We were fortunate to have signed it before."

Collombin agrees that the debt market is unlikely to be there for new deals, but argues that add-ons should be relatively trouble-free, provided portfolio companies are in a sound financial position and sponsors have capital to deploy: "You don't need the debt market that much, and often you can use the cash from the business. We are under 5x leverage across the portfolio, so we have debt capacity and are well-positioned to inject equity into businesses that we own in order to finance acquisitions."

Non-bank debt can also be an option, seeing as debt funds face the same deployment conundrum as their equity cousins – although they are also likely to proceed with caution. Peter Gottron, a partner at Beechbrook, tells Unquote: "Special steps need to be taken with the analysis, and it is currently more difficult to integrate the businesses given the lockdown restrictions. We are still open for business though, and we are still looking for opportunities; if the businesses stack up, have a solid strategy and can show that they have not been affected by the crisis we definitely consider providing funding."

"The most challenging thing is to assess the impact of the coronavirus crisis on the target/add-on and the main company – to properly assess the impact and assess the long-term effects on it," Gottron says. "For example, whether its recovery will be a V-shape, U-shape or an L-shape, and then to see whether the add-on then fits with the main company."

Laying the foundations
With record amounts of dry powder accumulated in the past three years by European GPs – and little opportunity to deploy it at scale for new deals in the current environment – bolt-ons also have the appeal of keeping deployment steady. Thus, many sponsors would not rule out backing add-ons with equity from their funds if necessary. Says Haarmann: "For existing platform investments, we would obviously always want to use debt to fund the add-ons if we can. But if we think it is a particularly interesting value-enhancing acquisition, we would also consider using equity and putting value into the platform. It would be to do with the relative value of the deal."

The market may see add-on valuations coming down and a higher percentage of the price being pushed into the earn-out, which reduces the risk from the buyer's perspective" – Oliver Haarmann, Searchlight Capital

Meanwhile, earn-outs can go some way to mitigating the difficulties in agreeing a price in the current market, says Haarmann. "A lot of the time, when you make a small add-on, you don't pay all of it up front; you pay an entrepreneur a certain amount and the remaining two thirds over the next few years, for example, as an earn-out. The market may see add-on valuations coming down and a higher percentage of the price being pushed into the earn-out, which reduces the risk from the buyer's perspective. In some ways this is even more valuable, since it gives a lot of protection."

Collombin says that the crisis should boost buy-and-build strategies in the longer term too, in an environment where exits will inevitably be few and far between and organic growth can be more challenging to achieve. "People will want to do more and more buy-and-build as we all know that it is a tool very often used at the beginning of the holding period, so that you have enough time to benefit from the synergies," he says. "But even three to four years down the road, when you should be thinking about the exit, in some cases you will continue to do buy-and-build as you know that an exit may not be available any time soon at a price that makes sense for you."

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