In late 1997, former chief executive of U.S. Office Products Jonathan Ledecky formed Building One Services Corp. with the strategy of rolling up maintenance companies. His plan was to offer sellers stock and cash for their businesses in order to entice management to stay on board and to provide an incentive to perform. The problem he faced, however, was that many sellers were interested only in cash, which was more difficult for him to provide on his own. As a result, Mr. Ledecky is now selling 43% of Building One to well-funded Apollo Advisors, L.P. Mr. Ledecky could not be reached for comment.
Although Mr. Ledecky was able to reconfigure his strategy, not all financial buyers are as fortunate, and they are often saddled with platforms and roll-ups that are foundering, G.P.s and intermediaries say.
To drive good returns when multiples have been high, many buyout firms have launched platform and roll-up strategies despite the partners having little experience consolidating industries and culling the promised synergies. Sources now say many investments made by buyout firms will underperform because G.P.s have shown a lack of vision, exhibited poor operating skills and have not fully understood the industries they have been consolidating.
In an analysis of the 119 deals reported in BUYOUTS in 1998 and closed last year, G.P.s still showed a tendency to invest in platforms and add-ons. Despite there being fewer fragmented industries to consolidate than when the trend took off in 1995, G.P.s invested in platforms in 46% of their deals and used equity from their funds to invest in add-ons 19% of the time. G.P.s made stand-alone investments in 35% of their buyouts.
But while the current level of platform investing shows the continued interest on the part of G.P.s, there has been a drop in the percentage of platforms acquisitions. Last year, G.P.s invested in platforms less often than in 1997 when they did with 55% of their deals. And at the peak of the platform boom in 1995, firms invested in platforms 63% of the time. The drop, sources say, is the direct result of changing conditions for the platform play that are making this kind of investing less favorable.
The problems with platform-building now-as opposed to in the mid-1990s when there was less competition in this strategy and purchase price multiples were low-start when choosing an industry to consolidate, especially with smaller buyout firms. Not only do firms need to conduct due diligence on a platform investment, but they also need to identify candidates quickly for add-ons.
“It’s very difficult and time consuming if you’re doing five to 10 buyouts a year like this, and almost impossible to do this without a big staff,” says Todd Berman, president at Chartwell Investments, which invests in one or two platforms and five add-ons a year.
Many G.P.s see the hazard and are adapting by partnering with others when forming platforms. “We limit the number of industries we look at and work with other private equity firms and operating managers, who are interested in becoming principals, and that helps leverage the resources at a small firm,” says Malcolm Applebaum, a partner at Wand Partners, which invests in one or two platforms and three or four add-ons a year.
“Reducing costs invariably proves more difficult than anticipated. Reductions in productivity of 20 to 30 percent are not uncommon, easily offsetting the paper gains that were anticipated as a result of downsizing.”
G.P.s note that it is also becoming increasingly difficult to find industries to consolidate. For example, Chartwell in 1995 started rolling up companies that operate parking lots at airports. It grew SunPark from three to eight locations in 18 months, paying a purchase multiple of about six times EBITDA, and soon other financial buyers-Apollo and Kohlberg & Co.-entered the niche with similar consolidation plans. Sellers quickly became aware they had several suitors and raised asking prices to a nine times EBITDA multiple. Chartwell sold SunPark in 1997 to Chase Capital Partners because Chartwell’s partners believed their thesis no longer could work even though they were the first buyers to consolidate the industry, Mr. Berman says, adding he would have stayed in the investment longer had prices not escalated.
“There’s always a risk of a lack of vision. It’s an area where people can make money very quickly, so there are a lot of imitators,” says Jeffrey Evans, a vice president and analyst at Credit Lyonnais Securities.
He says he knows of a roll-up in which the buyer was the second major investor in that industry but could not bring its investment to an IPO because the first major investor already had satisfied the public’s appetite with an offering, leaving the buyer with limited exit options.
Then there is the problem many firms have in driving revenue and building internal operations, which starts when firms pay a high price for platform companies and become obsessed with cutting costs.
“Certainly, pricing for attractive platforms is getting expensive, and some people go in with the attitude of thinking you can pay up for a platform and acquire add-ons cheaply,” says David Herman, a vice president at Sperry, Mitchell & Co.
“We’re seeing groups that are willing to bridge a purchase price and are worrying about financing after a closing,” he adds, illustrating why firms are in a hurry to cut costs and reduce the level of leverage.
He also says there are practical reasons for why some firms focus only on savings. “As much as they claim to be operators, I don’t know how many of them actually add value at the operations level,” he says.
In a new book that examines the problems that occur when buyers merge companies, co-author Mark Feldman, a partner in PricewaterhouseCoopers’ global mergers and acquisitions consulting group, takes particularly hard shots at financial buyers for not focusing more on internal growth.
“Our sense is many of them will have underperforming investments. They’ll achieve basic synergies in cost cutting but move slowly to drive revenue,” he says.
Instead, Mr. Feldman advises, financial buyers need to go after companies in industries in which they have some operating strengths and have not just been dealmakers. “If you have no operating expertise, you’re going to be focused only on cost-cutting, and you’ll look to all the world as losers,” he adds.
Pushing Too Hard to Reduce Costs
The book, Five Frogs On a Log, also directly addresses the issue of rushing to reduce costs and its impact on the bottom line: “Reducing costs invariably proves more difficult than anticipated. On the surface it appears to be a simple matter of eliminating duplication and reducing unnecessary overhead. However, the extraction of cost requires fundamentally altering work processes and procedures, redeploying people, making additional investments in training, and coping with the demoralized and overworked workforce that remains after others are laid off. Reductions in productivity of 20 to 30 percent are not uncommon, easily offsetting the paper gains that were anticipated as a result of downsizing.”
General partners who have experience building platforms also point to poor communication among the various acquisitions in a platform and too much diversity within the platform as other reasons for strategic failure.
“These build-ups founder many times because of poor [internal communications] systems, and at some point you need to build an MIS system and you need critical mass,” says Lawrence Schloss, a partner at DLJ Merchant Banking Partners. “Companies hide it by making even larger acquisitions, and then they blow up because they never take the time to assimilate,” he says.
“It’s very difficult and time consuming if you’re doing five to 10 buyouts a year [as platforms] and almost impossible to do this without a big staff.”
One founder of a large buyout firm admits roll-ups have not been easy to implement, mostly because the strategy often involves creating a company with seemingly diverse products; he gives the example of Kohlberg Kravis Roberts & Co., which he describes as a smart firm, and its problems with Primedia (formerlyK-III Communications). KKR, which formed the business in 1989 to acquire information companies in media, information and education, brought the roll-up to an IPO in late 1995 at an opening price of $10 per share on the New York Stock Exchange. The stock at press time was trading at about $12.81 per share after falling to $9 per share last year.
Analysts say the company has failed to catch momentum on the public market because investors have had a difficult time understanding the company because of its diversity. Last fall, K-III tried to address this by splitting its magazine empire into three separate groups, but the company has still failed to generate much investor interest. Partners at KKR did not return calls.
Besides due diligence issues and questionable operating strategies, several G.P.s have also had problems in managing the large number of CEOs in its buy-and-builds or roll-ups.
Mr. Feldman says it is important for a firm to get teams at all the companies in its strategy to work towards the same goal, but that is often difficult to accomplish.
He says while G.P.s are busy cutting costs, they often do not relay a concrete plan on how to consolidate an industry to the heads of its add-on companies. “Without this, CEOs start floating back and do what they know best, and they lose focus,” he says.
Buyout firms also have different takes on who should manage a platform. Some hire a gunslinger who knows a particular industry and have that professional roll up companies, while others appoint a CEO from an already-existing management team.
Mr. Feldman says firms that go with the latter approach often make the mistake of naming the most likeable and dynamic manager as CEO, looking more at the individual’s short-term ability to keep staff together post-acquisition than at a long-term ability to lead the company through changes. The rest of the management teams can pick up on this quickly and may lose respect for the buyout firm and its master plan, Mr. Feldman adds.
However, industry sources suggest hiring a CEO from an existing management team is usually preferable to bringing in a gunslinger, whose best idea may be to acquire a former employer and try to fix everything that could not be fixed when he worked there.
Managing Your Personnel
Aside from choosing a leader, it can be hard for buyout firms to handle the former CEOs who are now just part of a larger management team.
“One of the most critical elements is allowing an interaction among business heads to allow them to benefit from what each other is doing, so the interaction should be free flowing,” Mr. Applebaum says. “I would like to think CEOs of all our businesses realize that a title is not a key and ego should not stand in the way of shareholder value, but that’s not always reality.”
When problems do arise, several G.P.s say they must be dealt with immediately for the platform to succeed. However, analysts like Mr. Evans say they do factor in the stability of management when pricing a platform or roll-up. “If the reason for departure is a clash with the financial group, it’s probably a bad sign,” he says.
Sources believe there will soon be a shake-out where firms will sponsor fewer roll-ups and buy-and-builds but those that are done will be of higher quality. “The number of deals will go down, but the quality of deals will go up,” Mr. Evans says.