Operational improvement has become the main source of value creation in private equity, increasing its share from 18 per cent in the 1980s to 48 per cent in 2012, according to a new report by The Boston Consulting Group (BCG).
When PE professionals were asked their most frequently used approach to operational improvements in portfolio companies, more than 90 per cent answered that they conduct buy-and-build deals.
The Power of Buy and Build: How Private Equity Firms Fuel Next-Level Value Creation, which was produced by BCG in conjunction with HHL Leipzig Graduate School of Management, reveals that buy-and-build activity has increased from 20 per cent of all PE deals in 2000 to 53 per cent in 2012. The reason for the surge is clear: buy-and-build deals generate an average internal rate of return (IRR) of 31.6 per cent from entry to exit, compared with 23.1 per cent for standalone deals.
"The strategy is most successful when the portfolio company is small or medium-sized, has a PE sponsor with operational and buy-and-build experience, and is in a low-growth, low-profitability, highly fragmented industry," says Michael Brigl, a BCG partner and a coauthor of the report. "Value in buy-and-build deals often results from traditional synergy levers – such as scale effects in procurement and in selling, general, and administrative expenses – and from improved sales force effectiveness and pricing."
The report's authors analysed a set of 121 deals, about 40 per cent of which involved buy-and-build transactions. They selected deals for which they could obtain consistent sets of performance data, such as IRR, and detail on the levers employed to create value. They used this sample to analyse the relative contribution of each value-creation lever (deleveraging, multiple expansion, and operational improvements) to deal performance. The authors drew several conclusions from their analysis.
Multiple expansion is the main engine of superior performance in PE deals – particularly in buy and build. In many cases, the expansion is the result of increased profit growth expectations fuelled in part by higher revenues or wider margins. The contribution of multiple expansion to the IRRs of the buy-and-build deals in the sample was 15.3 percentage points, on average, compared with 7.5 percentage points in standalone deals.
eBuy-and-build activity increases with the size of the initial platform deal, but the buy-and-build deals of small platforms outperform those of medium-sized and large platforms by sizeable margins. The deals of the small platforms in the analysis, defined as those with an enterprise value of less than USD70 million, generated an average IRR of 52.4 per cent, compared with 20.3 per cent for standalone deals. The buy-and-build deals of large platforms – those with an enterprise value of more than USD290 million – underperformed relative to both smaller platforms and standalone deals.
Buy and build is employed most commonly in primary deals – in the study, 43 per cent of primaries engaged in buy and build, compared with 32 per cent of secondary transactions (in which ownership of a company passes from one PE firm to another). The strategy, however, is more successful in secondaries. Add-ons to secondaries yielded an average IRR of 36.9 per cent; the average IRR of buy-and build deals for primaries was 29.9 per cent, and for standalone secondaries, it was 11.2 per cent.
Buy-and-build deals that involve cross-border add-on acquisitions outperform both standalone deals and deals involving domestic acquisitions, generating an average IRR of 38.2 per cent, compared with 23.1 per cent for standalone deals and 27.3 per cent for domestic acquisitions.
Deals that take the platform company deeper into an industry generate an average IRR of 43.5 per cent, compared with 16.4 per cent for deals that diversify the business and 23.1 per cent for standalone deals.
Experience with buy-and-build deals boosts returns. PE firms in the sample with more than ten buy-and-build deals under their belts earned an average IRR of 36.6 per cent, compared with 27.3 per cent for firms with fewer than two buy-and-build deals and 28.7 per cent for firms that did two to ten.
Deals that include one or two add-on acquisitions outperform both standalone deals and those that include more than two acquisitions. Deals in the sample with one or two add-ons generated an average IRR of 35.5 per cent, compared with 23.1 per cent for standalone deals and 19.9 per cent for deals involving more than two add-ons.
Superior performance in buy-and-build deals is limited to industries that share specific characteristics, including low growth rates, low margins, and high fragmentation.
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As experienced PE professionals know, successful buy-and-build deals hinge on a range of factors. To capture the opportunity that buy and build presents, every plan for a portfolio company should include a clearly defined set of potential add-on acquisitions.
