Roll-ups (not the fruit snack)
A searcher recently asked me for my advice on roll-ups. I’ll share that advice with you here.
A roll-up is when an investor acquires a number of businesses in the same industry and merges them. The idea is to buy cheap, cut redundant costs, improve margins and valuation multiple, and sell at a beautiful profit.
It looks great in Excel. Just layer one company atop the other, realize the synergies, and wazaam! You’ve made a boatload of money. Nearly every searcher explores this option for precisely this reason.
I did too. At one point in my search, I fell in love with the idea of buying a bunch of doggie daycares in the San Francisco Bay Area and merging them into one sexy brand with robust systems, a reputation for quality, and greater value. This was about the time when institutional investors were getting into the business, so I thought there might be something there.
After visiting a few doggie daycares, my enthusiasm grew. There was a lot of opportunity for process optimization, price increases, customer retention… It’s not an incredibly sophisticated industry, and I thought I could add a lot of value.
Then I did the math. Each daycare I visited was doing about US$100k or less in EBITDA. There were somewhere in the neighborhood of 20 legitimate doggie daycares of this size in the Bay Area, so in order to build a business that was worth my time and my investors’ capital, I would have to buy half the doggie daycares in the Bay Area. Sadly that was not going to happen.
After falling into a similar trap in a couple of other industries and watching other searchers lose time doing the same, I’ve come to the following conclusions:
Buying multiple companies is difficult. Heck, buying one company is difficult! But if your investment thesis relies on closing multiple transactions, you have a long road ahead littered with question marks.
Closing on multiple acquisitions at the same time, or close to it, is near impossible. Ask any searcher who’s done diligence on a target whether they think they could do several concurrently. I doubt you’ll get many positive responses. This means you’ll have to start by buying one tiny company, then hope and pray you’ll be able to close on the others. If you need to buy several more companies for your investment to make sense, you’ll be vulnerable to confirmation bias and panic buying, and it’s hard to negotiate well from this position.
Sellers often demand a post-merger valuation. A roll-up works well if you can buy each small business for what it’s worth today. The valuation will be a multiple of the current EBITDA, and the multiple will be low because the business is small. The merger will then theoretically improve margins and, because it’s a bigger business, the valuation multiple. However, because sellers and their representatives see what you’re trying to do, they’ll ask for a valuation on their business as if it had already been merged. This makes no sense for you, because you’ll still have to do the work and assume the risks of the merger.
Merging companies is difficult. Executing a merger is far from an ideal first project for a first-time CEO. The search fund model is based on the premise of putting an inexperienced CEO into a simple business. In a roll-up, you’re immediately in a very complex environment, which lowers your probability of success.
As alluring as they may be on the spreadsheet, please stay away from roll-ups. There are just too many ways for it to blow up in your face and/or waste your time.
That said, once you buy a platform company that can stand on its own and generate the returns you need, you should absolutely consider being on the lookout for add-on/tuck-in acquisitions that would add value to your business. You’ll need to analyze these opportunities carefully and fund the acquisitions strategically, but acquisitive growth can be a legitimate strategy for a searcher. However, you should see it as a bonus after you have a business that makes sense on its own.
Action Items
Decide on a reasonable lower size threshold for the company you buy, and eliminate anything below that threshold from your pipeline. Then promise yourself you’ll stick to that threshold going forward. Even if you’re thinking “but maybe these companies could go together and…”, resist the temptation. Keep it simple and buy a good company. What comes after that is gravy.
