The IPO Roll-Up As a Play On Arbitrage: The deal technique relies on valuation differences between the public and private markets to create value in fragmented sectors.

The strategy of a roll-up consolidation coinciding with a simultaneous merger/IPO relies on the difference in valuation between public and private markets to create significant growing companies in large but highly fragmented industries. Valuation models favor growing concerns with larger price-to-earning multiples. Few companies can sustain greater than 15% to 20% annual revenue growth, particularly in mature industries. But if the firm combines internal growth with the acquisition of additional companies, such growth can be sustained for some time and, therefore, be rewarded with higher multiples in the public markets. With the IPO roll-up, this strategy is implemented by forming a Delaware-incorporated holding company which exchanges public stock for the stock of private companies that become wholly owned operating subsidiaries contemporaneous with the IPO. Typically, a sponsor group leads the process. The sponsor group is an independent organization founded for the sole purpose of selecting the management, acquiring the constituent companies, and managing the professionals (underwriters, accountants, and lawyers) involved in orchestrating a simultaneous merger/IPO. A roll-up consolidation creates a company almost overnight. In the early growth stages of the business, as with all consolidations, the resulting company assimilates still more companies from the highly fragmented industry to fuel earnings and sales growth beyond the critical starting mass obtained in the initial round of acquisitions. One of the most significant benefits of the simultaneous merger/IPO sponsor group is its ability to capture the entrepreneurial spirit. Other consolidation players, such as private equity investors, often displace the management of their acquisitions and install their own operating plans. But in the IPO roll-up, the sponsor group permits the joining managements to remain as executives of the operating subsidiaries and infuses them with the “best practices” of all the founding companies. Thereby, the new company relies on an emergent strategy formulation process and captures the dynamic and flexible spirit of the entrepreneur. U.S. Office Products Co., contract distributor of stationery and office products, began as a roll-up IPO in 1995 and by 1997, through growth and numerous add-on acquisitions, had annual sales of $3 billion. The aspect that makes the roll-up consolidation the ultimate opportunity for the financially oriented entrepreneur is that a sponsor requires little capital and nothing more than sweat equity to found a company. The roll-up requires the sponsor group to develop the central business concept and unite the founding companies, yet demands essentially no capital investment. Consolidation deals reimburse the sponsor for their legal and accounting expenses out of the net proceeds of the offering. Furthermore, the sponsors are given a significant equity share in the newly created public company. Therefore, the sponsor’s success is tied directly to the performance of the company. In July 1997 Notre Capital Ventures received $47.5 million (22.9% of outstanding shares) in stock as compensation for creating Metals USA Inc., a 1997 IPO which is putting together a network of metals service centers across the country. Before exploring the IPO roll-up in greater detail, it is useful to touch on two rival formats being used to consolidate mature, fragmented industries. Public Consolidators The polar opposite of the IPO roll-up, which creates an instant company, is the public consolidator, basically a publicly held company with existing critical mass for an initial platform and, more importantly, management expertise. A prime example is Service Corp. International, a leader in consolidating the funeral services industry with a present market capitalization of $8 billion, which already held some critical mass and industry experience before embarking on its acquisition quest. Public consolidators typically possess the capital and management expertise to consolidate an industry but generally lack flexibility. Often, the bureaucracy and size of public corporations creates barriers to change. A variation on the public consolidator concept is Consolidation Capital Corp., a creation of Jonathan Ledecky, who was instrumental in founding U.S. Office Products. Consolidation Capital went public as virtually a blind pool since it was largely a corporate shell that intended to execute consolidating acquisitions in a not-yet-selected industry. Subsequently, the company targeted the building and electrical service fields, making acquisitions with a combination of cash generated by the public offering and the firm’s newly tradable stock. Private Equity The private equity play, sometimes called the leveraged build-up, develops its platform one acquisition at a time using the sponsor’s own funds (plus borrowed money, if needed) to finance the deals. The key concept in this application of the roll-up strategy is integration. Typically, the former management is removed as a newly acquired company is assimilated into the operating structure. Under this format, the company has the ability and time to maximize operating synergies among its subsidiaries. However, the greatest drawback, as with the public consolidator, is the potential loss of entrepreneurial creativity. Paragon Family Service Inc. was a private equity-backed roll-up in the funeral services industry sponsored by the former Golder, Thoma, Cressey, Rauner Inc. It was sold to a public consolidator, Loewen Group Inc., in 1986 for $295 million. A more recent Golder, Thoma venture is National Equipment Service Co., a heavy-equipment rental firm which went public in July 1998. Despite competing against corporate giants such Hertz Corp., Prime Service Inc., U.S. Rentals Inc., RDO Equipment Corp., and Rental Service Corp. which had public capital to use for acquisitions, National Equipment closed six of the largest deals in the heavy-equipment industry during 1997, suggesting that private equity can compete very well with public financing in the consolidating acquisition sector of the m&a market. (Consolidation in this capital-intensive area is so strong that Prime was acquired by Atlas Copco AB in 1997 and U.S. Rentals agreed to be acquired by United Rentals Inc., another public consolidator, in mid-1998.) Drivers of Consolidation Public Capital Availability The question remains as to whether companies created in IPO roll-ups exist to take advantage of the bullish IPO market or simply use the recent IPO phenomenon as a platform to launch a new business. The answer to this chicken-and-egg situation is less important than the aforementioned role played by the differences between public and private valuations which create financial arbitrage opportunities that attract bankers and financiers who can orchestrate a simultaneous merger/IPO. More importantly, the opportunity for value gain attracts professional management that would never consider managing a small mom-and-pop operation. Moreover, the success of U.S. equity markets in recent years encourages sponsor groups, which typically receive their compensation in the spread between public and private valuation, to pursue roll-ups, and tempts private equity investors to harvest some liquidity from roll-ups in their portfolios. Public capital availability certainly has been a significant catalyst for a large number of consolidation deals in a short time frame. However, private equity firms and sponsor groups still would pursue roll-ups even in cold equity offering markets due to the underlying demographic and technological trends in the United States. That is because both the demographic shift toward an older population and the increasing number of benefits available through economies of scale have forced the consolidation of highly fragmented industries. Demographic Shift Toward an Older Population Consolidators focus on becoming the dominant player in an industry with at least $5 billion in sales. A highly fragmented industry consists of thousands of small mom-and-pop businesses. None of these small businesses possesses a significant share of the total industry. In a mature industry, it is more economical to acquire the small components of a critical-mass player than to build the company from the ground up. It is remarkable how long it takes to complete a consolidation in some fields. Even after more than 100 acquisitions in the past two years, U.S. Office Products still competes in an extremely fragmented industry with 3,000 independent contract office suppliers, of which only 750 have annual revenues of more than $10 million. Coupled with the great fragmentation is the fact that many of these smaller firms are owned and managed by Baby Boomers people in their ’50s and ’60s, many of whom were born after World War II and are looking to sell in search of retirement liquidity. The optimal exit strategy for an aging entrepreneur involves selling the business at the best possible price, and roll-up ventures often are ideal buyers. They can afford to pay more for these businesses for two reasons: operating synergies and public-private valuation differences. Assimilating a target acquisition into a model platform allows management to remove redundant functions, thereby reducing expenses at the very least. Increasing Benefits of Economies of Scale A large base of operations enables a roll-up to profitably utilize an infrastructure investment that is beyond the grasp of small businesses in fragmented industries. Roll-ups typically spread the costs of training programs, technology, and state-of-the-art equipment over a larger competitive landscape. In addition, consolidated companies reduce costs through purchasing in volume. The increased capacity of technology, especially with the global reach of telecommunications, also has increased the potential value of small businesses to a certain extent. The current state of technology allows a business to locate its headquarters anywhere in the world and still conduct business on a global basis with only a small investment in information technology. By contrast, small businesses lack the capital to invest in larger, more sophisticated information systems. American Medical Response Inc., a consolidator of ambulance service companies prior to its acquisition by Laidlaw Inc. in 1997, exemplifies the benefits of leveraging mass for improved technology and operations. The company’s Oklahoma City operations were prominent in caring for victims of the bomb blast at the Alfred E. Murrah Federal Building. In an address to the Industry Roll-Up Conference in New York City in October 1997, co-founder James E. McGrath reported that within 90 seconds of the blast, AMR had five ambulances at the site and within 90 minutes of the blast, its people had treated 517 casualties and transported 210 patients to hospitals. AMR’s service was based on both technological and operational excellence that would be hard for small private ambulance companies to achieve. AMR utilizes a global positioning satellite link to all of its ambulances that enables a central dispatcher to mobilize all units and orchestrate a unified emergency plan amid a crisis. Additionally, the company had developed a national training program which includes effective management of people injured in disasters. The economies of scale in the ambulance service industry created a synergistic effect in which a large public company could provide better service than small private concerns. Consolidation tends to lead to more consolidation. Examination of a company’s relative position in the value chain shows that consolidation may be a necessity. For example, as construction companies consolidate and focus their efforts, they increasingly look to outsource their non-core business operations. Heavy-equipment rental companies are forced to consolidate to maintain their competitive edge by servicing national accounts with local market expertise. As construction companies conduct international business, they seek a supplier that can meet all of their equipment needs at multiple locations around the world. Furthermore, as competition for business intensifies, due to consolidation, customers demand state-of-the art service and products. Hertz, Prime Service, Rental Service, United Rentals, and U.S. Rentals are consolidators of the heavy-equipment rental field that did IPOs in 1996 and 1997 in order to obtain the capital necessary to service national accounts with a state-of-the-art fleet using the latest information technology for customer service. A small private business without the economies of scale or adequate capital is left behind as consolidation intensifies the competitive aspects of an industry and increases the barriers to entry. Selecting an Industry The primary influence in selecting an industry for a roll-up venture is the acquisition plan. The industry universe must be conducive to providing the growth through acquisition outlined in the company’s strategy. A fragmented industry is one in which a large number of companies share a dispersed portion of the total industry sales over a vast geographic territory. In addition, a dominant player does not exist on a national scope. Fragmentation exists because traditionally the industry concentrated on serving local markets. Even while creating mass, the successful roll-up strategy preserves this local market knowledge and direction. Economies of Scale The next step is determining how to leverage the strength of the newly combined entity. An industry’s small companies represent the only available components to build a foundation in the industry. However, these companies must be combined to establish substantial economies of scale that support the need for consolidation through superior operating performance over small private businesses. Only if the consolidation offers a significant opportunity for postacquisition synergy is it worth pursuing. “The Synergy Spectrum,” which identifies opportunities available through consolidation, was developed by David Scharf and Michael Moe of Montgomery Securities and featured in their September 1997 report, “Main Street Meets Wall Street: Mom & Pop Give Way to the Consolidators.” The Spectrum is shown in Table 1. Existence of a Suitable Platform The next step in launching a roll-up is developing a solid platform as an entry into the industry. The companies that comprise the founding entities in this venture define the future operating model. If the roll-up seeks to consolidate the industry’s “best practices,” the consolidator should seek the most innovative and cutting-edge companies. Furthermore, local market strength should be a top priority in the criteria for selecting acquisition candidates. Fragmentation is driven by the need for geographic coverage of markets with local market expertise. Therefore, the founding members consolidated into the platform should represent the most innovative companies with strong local market positions that set a solid base for future performance. The number of available targets must be sufficient to fuel the roll-up’s growth plan over the first years of existence. Performing as a growth stock in a mature industry requires that a sizable pool of potential acquisitions be available. A reasonable schedule of add-ons that will allow the roll-up company to sustain growth and create value is shown in Table 2. As the table indicates, the number of acquisitions required to sustain a growth rate of 20% increases as the entity expands. U.S. Office Products, to reiterate, still has 3,000 potential acquisition targets after three years of acquiring at a feverish pace. The population of targets should be large enough so that the roll-up will not have to acquire a majority of the companies in the industry to maintain its rate of growth. Due Diligence While uncovering all the legal and accounting issues involved in these acquisitions is vital, the most important aspect of the due diligence process is understanding the strategic issues relative to each acquisition. This process revolves around the ease of integrating the potential acquisition into the roll-up company. Important positive aspects of an ideal target include entrepreneurial and cultural fit, management interest in participating in an innovative organization, proprietary technology, and local market expertise. Consideration of each target should be based on its contribution to the operating plan and its ability to offer synergies. Managing the IPO Roll-Up as a Public Company Preserving the Entrepreneurial Spirit One of the most frequently used and effective tools in preserving the entrepreneurial spirit of the founding companies is aligning the interests of the business owners with the performance of the roll-up as a whole. The sample of four deals shown in Table 3 illustrates how sponsors typically use stock as the largest component of the consideration package offered to founding members. Stock not only provides them with a performance incentive but also allows them to participate in the growth of the roll-up as owners. Time Is the Enemy The roll-up concept has been sold to investors on the basis of an intensive acquisition plan that corresponds to internal growth in earnings. During the registration process for the IPO the company is restricted from entering into any binding negotiations concerning possible acquisitions. Therefore, when a roll-up commences operation as a public entity it temporarily has lost momentum on the acquisition front and must re-ignite the acquisition program as soon as possible. Investors who have been sold on growth through acquisition are awaiting results. As time passes without action, investors may lose confidence in the management to execute an acquisition plan, and a decline in the company’s stock price may reflect this predicament. Since the success of a roll-up is heavily dependent on execution, any signal that management may falter impacts the company’s stock price negatively. Our research has indicated that the biggest declines in the roll-up company’s stock after it begins trading are caused by such firm-specific matters as failure to complete add-on acquisitions or disappointing earnings rather than industry conditions. This realization is critical to the IPO roll-up since stock is typically used as its acquisition currency. If the price begins to weaken, the company’s ability to use stock as an acquisition currency is diluted. The acquisition program and commensurate growth thus become increasingly difficult, which forces the stock price to weaken further, creating a downward trend. The time pressures support the need for scrutinizing the strategic fit of potential platform companies during the due diligence process. Therefore, platform companies must represent stable earnings going forward. As Carl Rauner of Golder, Thoma pointed out at the Industry Roll-Up Conference in 1997, this rules out inclusion of any turnaround situations among the initial members since they will take time to fix before they can contribute to value. A prolonged time period is the enemy of the cost of capital. The roll-up strategy to consolidate an industry appears simple in concept. However, only a select number of entrepreneurs have successfully applied the idea of creating growth in mature industries. The difficulty in applying the roll-up strategy is that it requires the leaders of a relatively big company to recognize and value the need for geographic focus which created the fragmentation to begin with and to preserve the local-market expertise that made the constituent businesses successful. Those who both understand consolidation and have the ability to implement the local orientation can create growth, even in a mature industry. The sponsor group roll-up that is simultaneous with an initial public offering provides a powerful means to inject capital into a dormant industry because this format financially supports the entrepreneurial spirit that made the local firms successful in the first place. It also offers flexibility in creating improved operating performance and economical growth. As an entrepreneur, one seeks to capitalize on opportunity. Facing a dynamic environment, the entrepreneur must strive for a creative means to accomplish an objective. As American business becomes more institutionalized in the 21st Century, the “best practices” now being developed will become the traditions and ways of business in the future. Developing a sustainable competitive advantage indefinitely is impossible, but the entrepreneurial mind-set is integral in evaluating the environment and implementing the policies for future success. Every consolidation opportunity provides an innovative challenge to strive for superior performance. Delicate BalanceThe IPO roll-up is a creative deal format used toquickly consolidate fragmented industries bymerging several small companies andsimultaneously taking the new entity public. Thegoal is to transform small private businesses intobigger, more profitable public companies and reap the benefits of higher public-market values. Although the strategy may appear simple in concept, the difficulty in applying the IPO roll-upis that it requires the managers of a relatively large company to value the need for geographicfocus which created the fragmentation to beginwith and to preserve the local-market expertisethat made the acquired businesses successful inthe first place. Table 1: The Synergy SpectrumSynergy Classification Areas of ActionLow-Hanging Fruit Eliminating redundant costs Eliminating redundant employees Merging MIS systems Reducing the number of service providers Upgrading quality of equipment and vendors Consistent employee training Economies of scaleAdvanced Cost Synergies National purchasing contracts National outsourcing contractsRevenue Synergies Cross-selling opportunities among acquired companies Market development initiatives for acquired companies Deploying new technology across acquired companies Regional or national branding opportunitiesSource: “Main Street Meets Wall Street: Mom & Pop Give Way to the Consolidators,” David Scharf and Michael Moe, Montgomery Securities, September 1997.<\TBL> Table 2: Roll-Up Venture Acquisition Model At IPO Year 1 Year 2 Year 3 Year 4 Year 5New Acquisitions Yearly 5 6 8 9 11 13Total Acquisitions 5 11 14 17 20 24Sales 300 360 440 530 640 770Operating Expenses 270 324 396 477 576 693Operating Income 30 36 44 53 64 77Rate of Growth 20% 22.2% 20.5% 20.8% 20.3%Operating Margin 10%Additional Acquisitions’ Sales 10Source: Authors’ calculations<\TBL> Table 3: Currency Mix of Acquisition Consideration Paid to Founders in Selected Roll-Ups American Residential Services Coach USA Total Consideration $76.9 $95.2 Cash 34.8 (45.3%) 23.8 (25%) Value of Stock 42.1 (54.7%) 71.4 (75%) Shares of Stock 2,805,065 5,099,687 IPO Price 15 14 Note: Dollar amounts are in millions, except for per-share prices.cont’d F.Y.I. PalEx $31.5 $47.5 7.1 (22.4%) 3.2 (6.7%) 24.4 (77.6%) 44.3 (93.3%) 1,878,933 5,910,000IPO Price 13 7.50Note: Dollar amounts are in millions, except for per-share prices.Source: Authors’ research of IPO prospectuses<\TBL>