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.