Firms turn to roll-ups to find instant growth

Private equity firms with a record $1.6 trillion in dry powder are leaning heavily on roll-up strategies as a way of avoiding high purchase prices for portfolio companies. Instead, they are buying smaller, cheaper companies — especially in the wealth and alternative investment management and insurance sectors — and merging them for instant growth.

Private equity-backed deals including roll-ups have been on a tear since the fourth quarter of 2020, despite a pause in transactions in the earlier part of 2020 when valuation uncertainties caused by the pandemic drove private equity players to the sidelines. So far in 2021 to July 7, there were 1,741 roll-up transactions (also called add-ons) in the U.S. with a total value of $164 billion, compared to 3,168 roll-ups worth a combined $323.4 billion in all of 2020, a according to PitchBook Data Inc.

"We are in a very unprecedented time in M&A," said Stacy Kirshner, a New York-based managing director with Alvarez & Marsal Holdings LLC's transaction advisory group.

The increase in roll-ups — a growth strategy that has been around for decades — is being driven, in part, by the reopening of the U.S. economy that encouraged private equity managers to get back in the game as well as an expectation that favorable capital gains tax treatment could soon change, pushing business owners to sell now.

"There was a thought going into 2021 that there would be an increase in capital gains taxes, causing volume to increase," Ms. Kirshner said. "There's a significant concern of private equity investors and also a concern of privately held businesses that if they sell next year, they would get taxed at a higher rate."

These factors are leading industry executives to expect that 2021 will be a banner year for mergers and acquisitions in general, and roll-ups, in particular.

"2021 as an overall matter is proving to be one of the most active years in private equity ever," said Marc Lipschultz, New York-based co-founder and co-president at Blue Owl Capital Inc. "Roll-ups are a very, very big theme."

There are a lot of roll-ups partly because "of the high multiples private equity firms are paying," Mr. Lipschultz said. "They have to have a way to generate returns."

Alternative investment firm Owl Rock was formed in May by the merger of Owl Rock Capital Group and Neuberger Berman Group's former subsidiary Dyal Capital Partners with special purpose acquisition company Altimar Acquisition Corp.

For example, on July 7 private equity firm Genstar Capital announced the firm's portfolio company Obsidian Insurance Holdings Inc. acquired Western Home Insurance Co. from Western National Mutual Insurance Co. On June 30, Genstar Capital and TA Associates announced they signed a definitive agreement to merge their portfolio companies, Compusoft Group, a software provider, and 2020 Technologies. The newly combined company will be majority owned by Genstar and TA Associates.

Activity is quite strong in certain sectors including wealth management, alternative investment management firms and insurance companies, industry executives said.

Indeed, roll-ups of wealth management registered investment advisers are "at an unprecedented level," said Ted J. Gooden, New York-based partner and head of private markets at Berkshire Global Advisors, a mergers and acquisitions adviser in the investment management industry.

"These firms have now grown along with the market to become valuable businesses, which has attracted capital from roll-up firms like Hightower (Advisors LLC) and Focus (Financial Partners)," he said.

Another area of activity is among private market managers, he said.

"This is more strategic as (alternative investment) firms are coming together to offer broader solutions" to investors by adding new lines of business such as private equity, private credit, real estate and infrastructure, Mr. Gooden said.

StepStone Group LP, a private markets manager and consultant, announced on July 7 it acquired Greenspring Associates, a venture capital and growth equity manager with $17 billion in assets under management, for $725 million.

There has also been a surge in activity in the insurance area. Historically, buyers concentrated on property and casualty insurers, but now they are most interested in investing in life and health insurers, particularly those serving the aging baby boom generation, Alvarez & Marsal's Ms. Kirshner said.

Private equity firms' interest in the insurance brokerages was enhanced during the pandemic when insurance companies thrived.

"Buyers love the insurance distribution (brokerage) space. It has highly, highly predictable revenue streams with high margins," she said. "2020 was no exception to that … Insurance brokers did pretty well during COVID-19."

What's more, growing competition in the insurance brokerage area means that to generate a desired profit for investors on exit, it is more crucial than ever that insurance brokerage companies diversify their offerings, which they are doing through acquisition, Ms. Kirshner said.

Sellers are being motivated by high valuations to offload companies. But while the roll-up strategy supercharges growth, industry insiders are divided as to whether these new group of roll-ups will result in higher returns for investors.

In the past, investors could roll up insurance brokerage companies, for example, sell the larger company for more than investors paid for all the companies — known as "multiple arbitrage" — and "expect to ... make a pretty good profit for your investors," Ms. Kirshner said.

Increased competition, mainly from private equity firms, makes that multiple arbitrage less of a sure thing, she said. To reap a profit these days, investors have to show they have a unique business, whether that is through new lines of business, technology or service offerings, Ms. Kirshner said.

Whether roll-ups will result in larger companies worth more than the sum of their individual company parts is not just a consideration in the insurance area but across industries, insiders say.

Sources familiar with the roll-up strategy said that there is nothing about them that suggests the returns will be higher or lower. Although with more and more roll-ups occurring, there are more bidders and therefore upward price pressure on the add-on companies for which these private equity firms are competing, these people said.

But executives at industrial-focused private equity firm Sole Source Capital LLC believe that the roll-up strategy can boost returns.

"Our team has done a good job building larger businesses at high speed," said David Fredston, Los Angeles-based CEO and founder of Sole Source Capital.

"Roll-ups absolutely have an impact on returns with larger businesses having more potential buyers due to more competition for the asset, especially at auction," he said.

Sole Source has announced five roll-up transaction so far in 2021. The latest was on July 7, an acquisition by portfolio company Supply Chain Services, a provider of automatic identification and data capture and factory automation, of ISG Technologies. This is the fourth acquisition made by Supply Chain Services since Sole Source bought the company in May 2020, a news release said.

What's more, the roll-up phenomenon has caught the eye of Rohit Chopra, a commissioner on the Federal Trade Commission who said in a letter issued in July 2020 that the FTC should take steps to increase its oversight of roll-ups, particularly in the health-care sector. One of the issues, he noted, was that many of the individual deals are too small to be reported under the Hart-Scott-Rodino Antitrust Improvements Act.