Is bigger always better? For years it has seemed that way, as the number of private equity firms executing roll-up plays has grown. According to Bain, back in 2003 the number of add-on deals executed globally was below 500, with only 21% of those representing the fourth or later acquisition by the acquiring company. In 2023, there were 5,769 such deals, representing an increase of over 1,000%, with 49% of these deals representing the fourth or later acquisition.
So why do so many want to play the roll-up game? Multiple arbitrage is one reason. Since the market has long rewarded larger businesses with higher multiples, in theory, a private equity firm can acquire a solid platform company, add smaller firms to it like Legos, and exit with a nice profit. But in practice, if you approach a roll-up strategy without careful forethought, you may lose your shirt, because higher interest rates are making it more expensive to finance acquisitions than in the past. Multiple arbitrage is still possible, but a great roll-up play, one worthy of a master of the technique such as Bradley Jacobs, increasingly requires nuance and specificity rather than vague notions of “synergies” and “scale.”
Though it’s somewhat dated, a Harvard Business Review article claims that over two-thirds of roll-ups fail to produce any value for investors. And more recently, noted “Amazon aggregator” Thrasio, which garnered both investor and media attention by gobbling up third party sellers on Amazon, filed for Chapter 11 bankruptcy due to an unsustainable debt load.
That said, when roll-ups do work, they can work extremely well. But you need to understand what makes an industry ripe for a roll-up in the first place, and what processes make a private equity firm capable of executing such a strategy effectively. We will cover the former in today’s post, and the latter in a post to follow.
What Characteristics Make an Industry Ripe for Roll-Ups?
Think of the industry as a canvas on which you will be blending existing elements into an entirely new picture. The key to a roll-up is not simply achieving size, but achieving the right size at which you can make a profitable exit when and if you so choose. Timing is also critical, because successful roll-ups quickly attract copycats who can bid prices for additional acquisitions up to a level where roll-up strategies no longer work.
Roll-ups that do work generally require industries with certain identifiable characteristics. Traditionally, these have included sectors like business services, financial services, software, and healthcare services. But any industry that exhibits the characteristics below may have potential.
1. Sufficient Multiple Arbitrage
In your target industry, you should be able to verify that a business of the scale your strategy is trying to create will sell for a significantly higher multiple of EBITDA than the small firms you will have to buy to execute the strategy – preferably at least two turns more. In practice, a multiple of 5x or less for the small firms can make it less likely that the strategy encounters multiple “de-arbitrage” from an unexpected industry-wide downturn.
2. Significant Advantages of Scale
There should be specific, discernible potential for scale economies by way of levers like reduced overhead, increased purchasing power, openings for greater automation, lower cost of capital for financing, and opportunities for cross-selling to fragmented customer bases. Such considerations are often highly correlated with, and serve as justification for, the multiple arbitrage potential of an industry.
3. Substantial Fragmention
The industry should be sufficiently fragmented, with a “long tail” of potential acquisition targets, preferably hundreds, if not thousands. For typical roll-ups, these should be in the $5-20 MM revenue range. That said, an existing large player in the industry, or even several, is not necessarily a disqualifier. Selling to such a firm can make for an attractive exit strategy, and in some cases, such firms can make for a great initial platform acquisition. Another aspect to keep in mind is that if you are planning to roll-up the supply side of a B2B market and the demand (customer) side is currently undergoing consolidation, that can be a positive, because the consolidating customers will likely be interested in dealing with a larger, more sophisticated supplier.
4. Uncrowded with Consolidators
Consolidation is a party you want to arrive at early. The space should not already be crowded with existing “roll-uppers.” Industries such as funeral homes, veterinarians, and dentists, for example, have been heavily scraped over by consolidators in recent decades, meaning the most attractive targets have already been snapped up and any remaining multiple differentials are likely eroded by demand. A roll-up strategy in spaces like these would need a very novel strategy or very particular niche (whether in terms of business focus or geography) in order to be viable.
5. Growing, with Limited Cyclicality
Highly cyclical businesses often become cash strapped at the bottom of the cycle, which makes keeping the acquisition engine running—the key to a good roll-up—very difficult. What you want to see is an industry with stable growth in which multiples will not drop across the board in a downturn, killing the multiple advantage of acquisitions bolted on during the upcycle. That said, there has to be a balance, in that industries that are growing incredibly rapidly often trade at multiples that don’t make sense for many roll-up strategies.
Conclusion: Other Considerations and “Nice to Haves”
The above list should not be seen as an uncrossable divide between spaces where consolidation strategies always work and where they always fail. The real world is more nuanced than that. For instance, one geography or business model niche within an industry might be ripe for a roll-up while another isn’t. A private equity firm’s strategy can exploit such nuances. Some roll-ups focus on one region or specialty, while others try to build a substantial player at the national or global level industry wide.
Finally, some characteristics didn’t make our top 5 list, though they too can be good considerations to keep in mind. For instance, industries in which businesses have a similar structure and approach across the market can make integration easier, while industries with businesses which are heavily founder driven can be challenging to roll-up, because a founder stepping away after an acquisition often causes the business to lose key employees, customers, and market share.
Roll-ups—the good ones, anyway—are a complicated game. You have to go in with your eyes open, your head clear, and your strategy mapped out in advance. You also need to be very well acquainted with dealmaking and deal mechanics, as well as the dos and don’ts of integration. Understanding the nature of the industry should be one aspect of your strategy. Understanding the nature of your private equity firm, its strengths and weaknesses, should be another. We will explain that one in the next post. Stay tuned!
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