The Art of the Roll-up: 7 Keys to Success
Ask a fellow investor to invest with you in a roll-up strategy and one of two things will happen:
A) He’ll mortgage his home and give you every cent he’s got
B) He’ll say… “GET OUT.” Ouch, don’t let the door hit you on the way out…
Roll-ups are a controversial topic among investors. By roll-ups, we mean the strategy of growth by acquiring multiple companies in an industry.
Roll-ups have produced spectacular blowups. Valeant Pharmaceuticals (VRX:NYSE) is a painful example of a stock that imploded 95%. Bill Ackman’s hedge fund lost $4.2 billion in the Valeant debacle.
But roll-ups have also produced some of the most incredible gains we know of. The best performing stock in Canada over the last 10 years was a textbook roll-up strategy. Betcha can’t guess it….
It’s a company called the Boyd Group Income Fund (BYD.UN:TSE). They rolled-up car collision repair shops. Boring business. But returns that were anything but boring.
We are talking 56X returns for investors over the last 10 years.
So there seems to be no in between with roll-ups. But why do some roll-ups lead to unbelievable returns? And why are others spectacular failures?
And how can you as an investor tell which way a roll-up strategy will go?
We’ve seen the good, the bad, and the ugly in roll-ups over the last 30 years of investing. And from our experience we are going to share today the 7 keys to a successful roll-up strategy.
Ignore these at your own risk…
1) They target a fragmented industry
Fragmented means there are many players in an industry. No big guys dominate the market.
The first reason is simple math – a roll-up, by definition, makes multiple acquisitions and in a dominate market there is nobody to buy. Even if there are mid-size players to target, they are usually too pricey to build a roll-up with. Roll-up CEOs’ best bet is to negotiate with mom-and-pops.
The next reason is scale. As the roll-up grows, it uses scale to drive results and convince other sellers they are better off with them than as a stand-alone. This is hard to do if there are large players waiting in the wings to compete for deals.
We look for industries where the top 4 players control no more than 40% of the market. Roof truss manufacturing, for example, is a great industry to target. The credit rating industry is a very bad one.
2) They go for boring businesses
Warren Buffett will be the first to tell you that boring is often the most profitable investing.
We like boring in roll-ups for two reasons: 1) They are easier to understand and 2) there is less competition for deal flow.
Let’s start with 1). Let’s say the CEO wants to roll-up the artificial intelligence industry to make an industry-first complete solution. Most of the targets are pre-revenue, and the CEO will have to estimate each technology’s future value not only as a stand-alone business – but as part of the complete solution he’s building. Humans by nature are not good at this. They tend to be wrong on the optimistic side.
Now let’s say that same CEO is rolling-up the garbage removal industry. That’s a recurring business – everyone has trash whether the market is good or bad. He can vet their service contracts and relationship with cities. He can assess the condition of their equipment. With good due diligence he will have a handle of future cash flows. He’ll know what he should pay for the business.
Now for 2). It is human psychology to be invested in the next “big thing.” People like sexy, and they are willing to pay up for it. If a CEO is trying to roll-up say machine learning or cryptocurrency startups, he is going to face competition from all kinds of venture capitalists and hedge funds. That usually means higher valuations – and higher risk.
There is a reason the most successful case studies have been in industries like funeral services, waste management, and car repair. Boring industries, sexy returns.
3) They capitalize on industry succession challenges
As every successful entrepreneur gets older, they inevitably must think about succession. This a stressful part of every business owner’s journey.
How much money will I get from my business? Will it sustain me and my family into retirement? Will the buyer treat my business well and carry on my legacy?
For many mom-and-pop businesses, the answer is to keep the business in the family. The kids take over and the business continues to support the family.
Other sexy businesses like SaaS companies can sell for healthy multiples to other innovative tech companies or venture capitalists.
But let’s say you own a funeral home company…
It’s probably not your kid’s life goal to take over a funeral home business. As one funeral home CEO once said to us, “no kid is going to get laid running a funeral home.”
You’re too small to sell to private equity. You’ve got a dilemma.
Now imagine if there was a player in your industry who’s acquired companies just like yours. They offered you a fair price, cash up-front, and equity with big upside potential. Not only would they keep your business running, they’d use their scale and resources to grow it.
Sounds ideal doesn’t it? And let’s face it, you don’t have much of a choice.
These “acquirer of choice” situations are exactly what you want to look for as a roll-up investor.
Oh and one of the greatest roll-up stories ever came from the funeral home industry. It was Service Corp International (NYSE: SCI), made famous by Peter Lynch’s book One Up on Wall Street.
4) They see financing as a strategic tool
Every CEO has three main tools in the kit: cash, equity, and debt. Do they take the purchase price and divide by 3? No way!
Great roll-up CEOs think strategically about financing. They are always looking to minimize dilution and lower the effective purchase price.
Cash. Cash as they say, is king. Cash is often needed, especially if the seller is a founder looking for liquidity. That said, great roll-up CEOs know debt and equity can be better tools and are always mindful of their war chest for future acquisitions. Much like the all-cash home buyer, a strong balance sheet affords negotiating power with future sellers.
Debt. Debt as Warren Buffet says, is a “four letter word.” And that’s true, excess debt is probably the number #1 reason for failed roll-ups.
Great roll-ups CEOs have a deep understanding of the industry they are rolling up. Is it a predictable industry with steady cash flows? Is it recession-proof? If so, then debt could be the magic word. John Malone famously rolled-up the cable TV industry, using interest expense to lower net income and taxes. More cash, more deals. Rinse, repeat.
Other creative debt strategies include low (or better yet no!) interest seller financing and mortgage financing.
Equity. Great roll-up CEOs don’t see equity as black and white. It’s all price dependent. When shares are hot, they look to equity for currency.
When shares are fairly valued, or undervalued, they avoid dilution at all costs. The more stock management owns, the more you’ll see this behavior typically.
We like CEOs that will go to great lengths to avoid issuing equity – unless of course shares are trading at silly valuations.
But we never like to see a deal with no equity. That’s because sellers need to be incentivized to stay on or at least manage through a transition. With no equity on the table, sellers will do all they can to keep skeletons hid in the closet during due diligence.
5) They are value-minded and always thinking arbitrage
Sellers in M&A always know more than buyers. Maybe they are selling because they want liquidity. But maybe they see the writing on the wall… and things are about to go south.
M&A is full of unknowns. Beyond good due diligence, the acquirer has just one defense. And that’s price.
Great CEOs define valuation metrics up-front and don’t stray. They are not afraid to walk away from a deal when sellers won’t hit their price.
One CEO we invested with waited a year and a half for an acquisition because of a .5X difference in EBITDA multiple. That’s exactly what we like to see.
They also understand arbitrage. Because of the liquidity premium, public companies often trade at higher multiples than private companies.
When a roll-up buys earnings, those profits can get re-rated at a higher multiple. Then if the market gains confidence in the CEO’s strategy, the stock can see multiple expansion. It’s a powerful cycle.
Now do we want a CEO that can negotiate his targets to the bone? Do we want to see companies bought at fire-sale prices, 1-2X EBITDA?
If the selling management team is staying on – and we almost always hope they do – it’s important they feel the deal was fair. Having a sense of goodwill will keep them engaged to grow the combined companies.
6) They do deals that make sense from day one
Forget synergies. Accretive is the word we want to hear.
Accretive means that post-acquisition, earnings increase per share. For this to happen, two things must be true:
1) The acquired business is profitable
2) The acquired profits are big enough to offset equity dilution
Many acquisitions pass 1) and fail 2). Great roll-up CEOs pass both with flying colors.
Now that’s not to say there shouldn’t be synergies. Greater purchasing power. Sharing fixed costs. Cross-selling.
All those are great and part of the upside. It’s just that far too often CEO’s use synergies as the deal rationalization. Synergies have a bad habit of falling short.
Great roll-ups CEO make sure they pay a fair price for the business today. And they see synergies as pure gravy.
7) They move fast. But not too fast!
Speed is important in a roll-up strategy. Momentum gets the investment community excited to write checks. It gets sellers excited to sell.
But great roll-ups CEOs know speed can kill. Acquisitions are complex. You have different cultures and personalities to mesh. Uncertainty can paralyze employees.
Great roll-up CEOs have a sound integration strategy they can repeat over-and-over. It usually has three phases. Phase I, just let the business run, don’t touch it. Phase II, begin to consolidate and integrate. And only in Phase III, do you merge strategies and go for growth with cross-selling.
The right speed of a roll-up strategy is more art than science. Great roll-up CEOs are always pushing the limits and trying to find that right balance between growth and risk.
We will leave you with a sobering statistic: 70-90% of acquisitions fail to deliver shareholder value.
That’s just for one deal. For roll-ups, it only compounds. Let’s say a roll-up is going to do 10 acquisitions. The success of each one is 25%.
This puts the roll-up’s success rate at 25% x 25% x 25%… okay you get the point. It’s a really low number.
But don’t let this scare you. Roll-ups are risky, but as investors in 50+-baggers like Boyd Income Group will tell you… they’re worth the chase.
Paul & Brandon