The Slap-Dash Roll-Up Sits On Shaky Ground: Overuse of the lucrative roll-up strategy threatens to leave many consolidators building on wobbling platforms.

Private-equity investors and bankers continue to roll up companies in fragmented industries through stock and cash purchases. However, the roll-up is not new, and in its maturity it is getting riskier. There is a danger that the roll-up is becoming a wobbling platform as an investment technique, past performance notwithstanding. The reason lies in its overuse, especially by practitioners who do not understand the difficulties of doing them. Although roll-ups are slowing, they were all the rage by 1998, after several years of slow growth. At present, there are consolidations under way in markets as varied as parking lots, autos retailing, office products, diagnostic imaging centers, plastic products, printing and graphic arts services, funeral parlors, veterinarians’ practices, pharmacies, and physician’s practice management firms. While the record of roll-ups generally has been positive, their very popularity may be the cause of their demise as a heavily used investing concept. There is not an infinite supply of companies available for roll-ups, and it is becoming more common for marketplaces to be picked over. The idea behind a roll-up is what limits it. Consolidators find companies in a fragmented industry and merge them into a larger, more efficient firm. Conceptually, this makes sense. Practically speaking, it is enormously difficult, and the difficulties are well known: * The founding companies in a roll-up may be too competitive to work well together. * The speed required to stifle competition and gain marketplace valuation is difficult to achieve when many parties have a say. *An industry may not be big enough or growing fast enough to give a roll-up a chance to be a growth company. * Former owners of constituent companies might not get on board. * The growth concept behind a proposed roll-up might not be clear to investors. * Management might not be up to the task of melding different cultures while integrating the businesses. * A roll-up that is the second in its industry to come to market may suffer as a result. * The systems needed to achieve efficiencies may be weak. The secret behind viable roll-ups is really no secret at all. Quality companies with quality management backed by sophisticated lenders in fragmented industries are the best candidates for roll-ups. A roll-up was never designed as a popular private-equity or venture-capital investment. The catch is that there aren’t enough quality companies available for roll-ups to be anything more than an occasional play for private-equity and venture-capital investors. While private companies are often targets for roll-ups, publicly held firms also are candidates, and studies show how limited the opportunities are there. From 1996 through 1998, there were fewer than 4,000 IPOs brought to market, excluding ADRs, mutual funds, and penny stocks. While this might seem to be a large number for consolidation, it doesn’t tell the whole story. Companies that are candidates for roll-ups typically are firms whose stock price is at or below the IPO offering price and that have a positive operating cash flow. There are never many of these firms available, and they are not always in the same industry. In fact, an examination of the primary SIC code designators for such companies reveals that few industries, other than business services, appeared regularly. Other companies were in diverse markets. These included miscellaneous retailing, rubber and miscellaneous plastic products, industrial machinery and equipment, automotive dealers and service stations, and eating and drinking places. Of course, automotive dealers have already been rolled up, and eating and drinking establishments are in constant consolidation. The percentage of fallen companies with the quarter-ending stock price below its IPO offering price ranged from a low of 32% in March 1996 to a high of 53% in September 1998, when the market crashed. This cuts the number of potential candidates to an average that was fewer than half of the IPOs in the time period. The percentage of fallen companies with positive operating cash flow was a fraction of the fallen companies – averaging just 15% – and they were spread evenly across the IPOs brought to market from 1994 through 1998. To those who look upon the raft of Internet companies brought to market as potential roll-up candidates, it is unlikely, in our view, that many of these will become traditional candidates for roll-up. Many Internet firms have yet to demonstrate viability as long-term businesses earning positive operating cash flow from quarter to quarter. We expect that many Internet firms will merge into healthier enterprises, and those companies might be candidates for roll-ups at a later period. However, this means there will be fewer companies overall available for roll-up. Compensation in these firms often is heavily weighted toward stock options. However, it is increasingly evident that many options will be worthless and management teams will be left with little. When that happens, what will keep them focused on the growth of their firms, and how will they lift their companies out of the post-IPO doldrums? Recent experience indicates that Internet stocks are not immune to the infamous S-curve that occurs after speculative IPOs are floated. The curve typically consists of a post-IPO period of wild trading followed by a swift dive, often to a point below the offering price. The drop is followed by a long period in which the stock rises or falls slowly. It is among the investment wreckage of such companies that private-equity and venture-capital investors try to find roll-up candidates. When Internet companies reach the post-IPO doldrums, it will be interesting to see how many of them keep their original management teams and remain viable. If there is one lesson to learn about roll-ups it is that they are hard to do well. Studies of mergers and acquisitions continue to show that merged firms often do not achieve efficiency or long-term success. What can go wrong in a roll-up is exponential. In light of post-IPO studies, it would be fair to say that many IPOs are wobbling platforms. Those that fail are usually businesses built on a poor business premise with inappropriate management or with lenders who don’t let managers move quickly to take advantage of acquisition opportunities. These businesses may have temporary success and may continue operating for the long-term, but they will be overshadowed. The hidden value is just not there. It takes an especially astute private-equity or venture-capital investor to find the one firm that can be restructured or repackaged with others in its industry. It does the field little good when consolidators slam together companies with little due diligence or care, because the resulting stock market disappointment makes the next roll-up more difficult for everyone else. Some high-profile roll-ups that have gone awry have fueled the charge that consolidators are “financial cowboys” looking for a quick killing with little concern for investors. This hurts successful and careful practitioners who are concerned about building long-term value. If picking the right company in the right industry is increasingly difficult, picking the right management is no easier. Roll-ups require managers who are multidimensional, and such managers are never easy to find. More often than not, this may require parachuting a new team into a firm, but the samurai for hire are not engaged inexpensively, and they are not always successful. A reservoir of trust is required between a private-equity or venture-capital investor and the top management team, and trust is not always easy to establish. Management problems can open consolidators to the charge that roll-up executives are not operators and that they do not know how to increase sales profitably beyond acquisition. In fact, some critics of roll-ups point to the conglomeration movement of the 1960s as an analogous example of managers who could put companies together but could not run them. Roll-up executives have to achieve several feats at once, and some of these are nearly incompatible. They have to identify acquisitions that are inexpensive enough to acquire without draining investor resources. They have to make quick-fire purchases that achieve market impact and discourage competitors. They have to maintain flexibility to seize opportunity when it presents itself. They have to integrate companies quickly and efficiently. Finally, they have to run the combined operations and grow long-term value. There are executives who have achieved this, such as Charles Wang and Sanjay Kumar of Computer Associates International Inc., but they are the exceptions. Wang and Kumar concentrated on companies in an industry they knew well – mainframe and back-office operations software. They have acquired a number of competitors over the years and have integrated their products at lightning speed. Computer Associates largely has grown by acquisition. But more importantly, Wang and Kumar have proven their ability to run companies of any size, from the small startup that Wang founded to the multi-billion-dollar firm that Computer Associates is today. If such managers were plentiful, we would expect to see many more successful roll-ups than the number that develop presently. One of the key challenges to roll-up executives is due diligence. Larger middle-market companies accustomed to “open-book” accounting may be relatively well prepared to disclose financial and operational information. Smaller companies, especially private firms, may resist disclosure and may be unable to handle the requirements. The strain on a firm’s reporting machinery is evident, and the possibility of significant lapses in reporting rises. This is especially true in an environment in which firms are under pressure to show performance improvement. The temptation to misstate financials or engage in fraud increases. Due diligence, by its nature, cannot be done too quickly, yet roll-ups must proceed quickly. It takes an experienced roll-up practitioner to avoid due diligence disasters while putting companies together. Part of the experience is knowing when to walk away from a deal that does not seem to be quite right. A disaster like that which Cendant Corp. suffered can destroy momentum and reputations. The 1997 merger of HFS Inc. with CUC International Inc. to form Cendant overlooked the inflation of net income by $500 million over three years. A similar situation with Livent Inc. nearly wiped out the investment of Michael Ovitz, former super agent and president of Walt Disney Co., who spent $20 million to take control of the theatrical production firm. Even more important than considerations of fraud is identification of the actual advantages that the roll-up can achieve. It is easy to talk about savings that will result, but it often is difficult to realize them. Cuts and consolidations are often illusory. Consolidating under these circumstances often yields no gains, as the conglomeration mania of the 1960s and 1970s proved. It is notable, for example, that U.S. Office Products Inc. reversed its consolidation quickly by splitting itself into four companies providing different kinds of services. Successful consolidation is not the result of financial engineering but of hard-won operating experience. One has to know how to combine computer systems, purchasing functions, and human resources. One also has to know the hidden clauses that might make such combinations impossible to obtain, such as lease requirements, labor contracts, and long-term purchasing agreements. The final key in establishing a successful roll-up versus a wobbling platform is the lender. The lender must be flexible and able to move quickly when a roll-up is in progress. The lender must understand the company’s acquisition strategy and have confidence in the management team to control growth and achieve synergies quickly. The relationship between the platform company and its lender must be that of a partnership. This is difficult at best and requires well-trained and practiced specialists who can understand the details of a business and its market quickly. For every roll-up that does not work, lenders are justified in exercising caution about funding another one. They are also justified in requiring lengthy due diligence. The more roll-ups that fail, the narrower the window for roll-up lending will get. A roll-up is a potentially lucrative investing tool when used in moderation. It should be treated as one of several private-equity and venture-capital investing vehicles and used only when appropriate. This requires good judgment and exceptional skill on the part of the venture-capital and private-equity investor. It is too easy to give roll-ups a bad name, and there is a widespread fear that this is just what is happening. EVERYTHING IN MODERATION The industry roll-up was a hot investment vehicle last year. So hot, in fact, that its popularity may well be the cause of its demise. The technique can be very lucrative when used sparingly, but it is now overused. As the roll-up matures, it is getting harder to do one well, since there isn’t an infinite supply of companies available for roll-ups, and many industries are well picked over. Nonetheless, if you’re dead-set on doing a roll-up, you’ll have to be exceptionally skillful at choosing the right management to operate the companies, making certain that your acquisitions achieve market impact and discourage competitors, maintaining flexibility to seize opportunity when it presents itself, and integrating companies quickly and efficiently. The final key in doing a successful roll-up is the lender, which must be flexible and able to move quickly when a roll-up is in progress.