More managers try 'build and buy' to boost portfolio companies through acquisition
Private equity firms are dusting off a tried-and-true strategy, spending some of the $842 billion in dry powder to bulk up their portfolio companies through acquisitions with the goal of increasing returns and obtaining higher exit prices.
While the practice — sometimes called “buy and build” — is not new, the frequency of such deals has increased exponentially. Growth by acquisition has become one of the most popular ways for private equity firms to increase the value of their portfolio companies.
On June 8, for instance, Sovos Brands, a San Francisco-based portfolio company formed by private equity firm Advent International Corp., bought pasta sauce producer Rao's Specialty Foods. (The transaction did not include Rao's restaurants in New York, Las Vegas and Los Angeles, which will remain under current ownership.) And in February, Sovos Brands acquired Michael Angelo's Gourmet Foods, which makes frozen Italian entrees.
In May, Cleveland-based private equity firm Blue Point Capital Partners and a portfolio company in its $425 million Blue Point III, Hilco Vision, announced the acquisition of the cases and accessories division of LBI Eyewear. This marked Hilco's sixth add-on acquisition since Blue Point acquired Hilco in 2014 and the second acquisition for Hilco in 2017.
Growth hard to come by
Propelling the trend is that organic growth in a relatively low-growth economic environment is difficult to come by. At the same time, prices for portfolio companies are near all-time highs. Instead of trying to boost organic growth through existing operations, private equity firms are merging existing portfolio companies with often smaller companies from outside of their portfolios. Not only do these mergers accelerate the portfolio companies' growth, but also they can reduce the purchase multiple of the original portfolio company, increasing the investment's potential profits, industry insiders say.
“Certainly it's been around as a strategy but this is an accelerating trend — what's different now is almost everyone is doing it,” said David Fann, president and CEO in the New York office of private equity consulting firm TorreyCove Capital Partners LLC.
These days, “acquisition targets are almost "a priori' to the deal closing,” Mr. Fann said. Larger companies sell at higher multiples and are easier to sell. And it's “easier and faster to buy revenue than to grow it organically,” Mr. Fann added.
Buying companies in the same or overlapping industries usually creates synergy, lowering costs, he said. A properly executed buy-and-build strategy can create a bigger, more profitable business that has more exit options — strategic buyers, private equity buyers, dividend recapitalizations or going public, he added.
“It's one of the few ways in which a private equity firm can add value, and justify buying assets in this environment,” Mr. Fann said. “Typically, smaller companies trade at lower purchase price multiples, so averaging down the purchase price multiple is critical.”
Upacala Mapatuna, chief investment officer of Chicago-based middle market private equity firm Victory Park Capital Advisors LLC, said she noticed these deals, also called add-ons, picked up in the last six months. Statistics are hard to attain because these deals are sometimes counted as acquisitions by strategic buyers, she added.
In these scenarios, the original portfolio company is sometimes called a “quasi-strategic” buyer because these portfolio companies are buying other businesses effectively like a strategic — non-private equity — buyer, Ms. Mapatuna said.
There are a number of reasons for the increase in such deals.
“There is definitely a huge amount of dry powder private equity firms have to deploy,” Ms. Mapatuna said. “Valuation multiples are very, very high and ... prices have tightened over the last year or so by 100 basis points in certain parts of the market.”
U.S. economic growth predictions now vary between 2% and 4%.
“With that being the case, if you feel you have a stable business, and can finance it reasonably well, it's not a bad time to be offensive. If you are a quasi-strategic and feel you can buy something, not at a cut-rate price but at a reasonable price, it could be a very interesting way of deploying capital,” Ms. Mapatuna said.
In the past, private equity firms relied on cost-cutting at their portfolio companies and bought businesses for their potential for organic earnings growth, she said.
Driven by dry powder
Ryan Flanders, head of private debt products in the New York office of alternative investment research firm Preqin, agreed he has seen an increase in growth by mergers due, in part, to a record amount of unspent commitments.
There was $842 billion in dry powder for private equity funds as of March 31, according to Preqin.
Higher prices paid to buy the original portfolio company are making it tough for private equity managers to achieve the returns they need to earn their share of profits when they exit the investment, said Randy Schwimmer, a New York-based senior managing director and head of origination and capital markets at private equity firm Churchill Asset Management LLC.
Churchill's approach is to buy much smaller companies as add-ons to existing portfolio companies. These smaller companies typically have lower purchase prices and so when averaged into the initial leveraged buyout price, the deal lowers the overall purchase price.
For example, say a private equity firm buys a company with a purchase price multiple of 10 times EBITDA (earnings before interest, tax, depreciation and amortization). Subsequently this platform company acquires other smaller businesses at lower multiples, perhaps in the 4-6 times EBITDA range. Over time, this will bring the blended multiple below the original price, Mr. Schwimmer explained.
“Then when the sponsor ultimately sells the now-larger business, even at somewhat less than the 10x figure, it can still be accretive for the shareholders,” he said.
Due to the high purchase prices, private equity firms will sometimes identify potential acquisition targets even as it is making the initial portfolio company investment, he said. At times, the companies to be acquired are competitors.
“Creating a compelling acquisition story for many of these companies is often a critical part of the (private equity firm's) growth strategies for these businesses,” Mr. Schwimmer said.
This article originally appeared in the June 12, 2017 print issue as, "If you can't grow it, buy it".