The buy-and-build investment model isn’t a new one, but it has had a bumper few years, with the number of add-on acquisitions nearly doubling in the last decade.
In 2017, more than $429 billion in capital flowed through 3,982 add-on deals, compared with $142 billion across 2,077 add-ons in 2008. So far this year, they have attracted $369.8 billion in investment, according to PitchBook Data, and platform companies are conducting more add-on transactions than before.
Private equity-backed companies have used the investment strategy for decades, but firms have become much more strategic about add-on acquisitions, Jeremy Holland, a managing partner on The Riverside Company’s North America origination team, told Private Debt Investor. Firms now build better companies rather than simply focusing on scale, he said.
The growth in add-ons has pushed this model to become a more active part of many lenders’ portfolios. Riverside even lists which of its portfolio companies are looking for add-ons on its website.
The majority of TwinBrook’s portfolio companies are platform businesses looking for add-ons, with 30-40 percent actively acquiring companies in any given year, said Grant Haggard, a partner at the firm.
This popular investing model isn’t exclusive to any one strategy, allowing firms to adapt it to their current industry or size focus.
Haggard said: “It’s really any industry with a lot of fragmentation in the competitor base where it makes sense for the private equity firm to consolidate and create scale, where the competitors are much smaller and have a disadvantage from a scale perspective.”
As platform companies need more financing, direct lenders with enough capacity can expand their reach and grow alongside their portfolio companies, said Randy Schwimmer, senior managing director at Churchill Asset Management.
“If a company starts out with a platform that is large and expensive, buying smaller mom-and-pop shops as add-ons also averages down your entry price for the platform,” said Alexander Ott, the managing director of European private debt at Partners Group.
This model opens the door to acquiring smaller companies that may not typically be in a large firm’s portfolio, such as coffee shops, family-owned insurance companies or painting companies.
Riverside, for example, bought the Dwyer Group, a home-service company which has since become Neighborly, in 2003. The firm exited Neighborly in 2010, then bought the company again in 2014 and exited in May of this year. The following month, Riverside made a minority equity investment in the firm.
This franchise platform used add-ons – companies like Five Star Painting, Auto Glass and Drain Doctor – to grow into a global home-service provider.
“We went out and helped them fill in the various services they were missing,” Holland said. “It was very successful in growing the company significantly.”
Neighborly now has over 3,500 franchisees across nine countries.
“Because they are small relative to the Fortune 500, mid-market companies don’t dominate an industry,” Churchill’s Schwimmer said. “But the best ones manage to carve out niches that create barriers to entry. Those barriers make it tough for competition because of the edge these companies have built over time.”
This investment model also offers a way to avoid the upward trend of mid-market companies with higher debt multiples.
Mid-market debt multiple valuations are on track to reach a 10-year high by the end of 2018 according to PitchBook Data. At the end of the third quarter, mid-market companies were valued at a 6.2 X EBITDA rate.
“Another factor driving add-on acquisitions is slow growth,” Partners’ Ott said. “Some parts of the economy in the ninth year of the cycle show lower growth than may be expected by the private equity owner. You can fuel that growth or increase the growth overall by adding acquisitive growth of the company.”
Many of Churchill’s private equity clients are active with their portfolio companies in the buy-and-build market, Schwimmer said. This creates additional opportunities for established portfolios, he added.
“Sponsors are increasingly telling us, ‘Hey, we are buying a couple companies and the other lenders are tapped out. Would you be interested in increasing your exposure?’” Schwimmer said. “Add-ons are an important part of our clients’ growth strategy – and ours.”