Many small to midsize businesses struggle to stay competitive in today’s economy. Management is constantly maneuvering and shifting to stabilize their business and find the best position in the market. One maneuver potentially available to a company is to purchase, or merge with, one or more similar businesses in the same industry — thus decreasing operating inefficiencies and increasing economies of scale. A roll-up typically occurs when a larger company acquires several smaller companies — though two or more companies also might merge to form a new entity.
These roll-ups can be beneficial to everyone involved — including lenders. But they’re not without drawbacks. Help your borrowers analyze the pros and cons of entering into a roll-up to determine whether they’ll gain advantages, rather than take on further problems.
What kind of roll-up is best?
There are two general ways that companies approach roll-ups. Most start off by easing into a relationship, forming a “loose federation” without consolidating operations in any meaningful way. Each participating company continues to operate as an independent entity in its particular market, keeping its own brand identity and management team.
Alternatively, some acquirers jump right into the “marriage” by aggressively consolidating operations and actively seeking synergies among all participants. By combining operations and cross-selling products and services, the combined entity can reduce costs and grow revenue internally, resulting in widening margins and accelerating earnings.
Although there are costs involved in the consolidation process, especially if the combined privately owned entity plans to go to the public markets for additional equity financing, roll-ups can result in an immediate increase in value. But to achieve such benefits, all participants in a roll-up should be financially sound. And if the roll-up is to follow a loose federation approach, each individual management team needs to be highly competent — not to mention able and willing to collaborate.
What are the pitfalls?
Unfortunately, roll-up success is the exception, not the rule. Too often, participants focus more on getting the deal done than on challenges after integration. And inattention to consolidation issues can lead to disaster for the businesses involved — and the creditors that they default on.
During the bull-market years of the late 1990s and early 2000s, “poof” roll-ups — in which several smaller companies combined to create the appearance of greater size, with no real integration strategy — were common. Typically, the goal was a quick windfall. And almost invariably, these transactions failed because either their subsequent initial public offering (IPO) would tank or the management teams were unprepared to integrate and run the combined company.
If one of your borrowers is contemplating a roll-up strategy, it may need financing to complete the deal or your bank’s approval (per their loan covenants). This is your chance to play devil’s advocate.
Discuss whether management has compiled a detailed plan for every aspect of integration, including employees, facilities, sales channels and IT. And if the smaller companies’ former CEOs will lead divisions of the larger entity, it’s critical to clearly define performance measurements and incentives. The decision to centralize control or operate divisions as largely autonomous entities also will be critical.
If one of your borrowers plans to take the roll-up to the public markets to access greater funding, realistically discuss the costs that will be involved. Public entities must submit to Securities and Exchange Commission scrutiny and adhere to the provisions of the Sarbanes-Oxley Act of 2002, which typically means increased marketing, accounting and legal costs. And regardless of the fundamentals, your borrower’s value may fluctuate based on general market conditions and the opinions of investment analysts.
How to make it work
The potential advantages of a roll-up, such as expanded access to financing and lower overhead costs, may be negated by inaccurate financial projections or a faulty integration strategy. As a lender, your role is to assist in the financial analysis and point out possible weaknesses in your borrower’s planning. This scrutiny and assistance will help lead to a more successful roll-up that will stand the test of time.