The Ties That Bind In Roll-Up Plays That Work:More than industry fragmentation may be needed to execute a successful roll-up. Does the industry really need to be consolidated?

In 1907, a man named Vail was wanted in towns throughout the American West. People did not want to lynch him; they wanted to give him money, and lots of it. Theodore Vail, manager of the struggling American Bell telephone company, was embarking on one of the most influential industry roll-ups of the 20th Century. His strategy involved entering a town that already had a local telephone company and offering his proprietary long-distance phone service to those who switched to his local service. The value of the existing phone company plummeted, allowing Vail to buy out the assets of wires, poles, and phones at liquidation prices. Once he owned the assets, he converted them back into a going concern by doing nothing more complicated than plugging them into his system. The plan was easily replicated across a nation of fragmented, local competitors. This strategy created tremendous value for Vail and his shareholders, the most notable of which was J.P. Morgan. This example illustrates the basic concept of an industry roll-up, the integration of a large number of small businesses in the same industry into one company. In most cases, the resulting company is then taken public through an IPO. Far from being a lost strategy, industry roll-ups have remained as topical as telephones. The roll-up strategy offers the potential to restructure an industry, thereby changing the nature of competition and resulting in tremendous shareholder value creation. In order to improve our clients’ abilities to create shareholder value through roll-ups, LEK Consulting has developed a six-step process for devising and implementing roll-up strategies. These six distinct steps are: * Industry Evaluation * Acquisition Screening * Target Due Diligence * Postacquisition Planning * Valuation Analysis * Postacquisition Integration Industry Evaluation Value Chain Analysis By executing an industry roll-up, the competitive dynamics of the industry will be altered. As such, an ordinary study of the existing industry environment is not sufficient. You should analyze the fundamental economics of the industry and understand how the customer and competitive landscapes will look after it has been changed (see Figure 1) Key questions include: * Is the total size of the industry, allowing for realistic growth assumptions, large enough to create cost reductions through economies of scale in purchasing, marketing, or sales, general, and administrative costs (SG&A)? * Will consolidation create opportunities for “value-cost leveraging” whereby you introduce a more cost-efficient process that is simultaneously more valuable to your customers? * As a significantly larger player, will you have the ability to redefine the product or service in a way that creates a sustainable competitive advantage for your company? * Who will be your competition for acquisitions, and is it reasonable to assume that you will be at a competitive advantage when bidding on potential targets? Figure 2 illustrates several examples of successful roll-up strategies where one or more of these conditions were satisfied. In each case, the consolidator was able to significantly improve its cost position or fundamentally redefine the market in achieving a successful roll-up. A principal role that LEK plays in assisting clients in identifying roll-up opportunities is evaluating the key activities within an industry to determine how value can be created through consolidation. This typically involves a detailed analysis of both an industry’s cost structure and revenue enhancement potential. For example, in our analysis of the roll-up potential in the dental industry, we determined that consolidation created value not only through the potential cost savings in the back-office functions but also through increased bargaining leverage with third-party reimbursement organizations. Similarly, our evaluation of the health club industry concluded that value could be created both through implementing best-demonstrated operating practices and through improved “share of mind” within a metropolitan area. While it may seem that any industry can benefit from consolidation, there are many industries that face diseconomies of scale which prevent the successful implementation of a roll-up strategy. Conditions that lead to diseconomies of scale include: * If the customer interface represents a high percentage of the costs, the opportunity for economies of scale is limited (e.g., dry-cleaning businesses and bed-and-breakfasts). * If the value to the customer depends on the business being new or unique, then the value would decrease with cost reductions through consolidation (e.g., 5-Star restaurants or dance clubs). * If the product or service can be defined better by smaller players, then roll-ups offer little ability to innovate (e.g., customized distributors and specialized, brand-name universities). If the economics of the industry do favor a larger, consolidated player, there are still two other industry criteria required for a successful roll-up strategy: the availability of a platform acquisition with an experienced management team and the availability of add-on acquisition opportunities. Platform Availability Although platform acquisition strategies have become increasingly common, identifying the right platform is a difficult task. The platform will be the center of your operations and will serve as the benchmark against which add-on acquisitions are measured. An optimal platform possesses the following characteristics: * An innovative and efficient business model that will serve as a sound foundation for value creation. * A business model that can be replicated in several geographic areas. * A strong local market position that demonstrates proof of success. * A cultural fit with your organization and philosophy which allows smooth integration at an operating level. * A strong, experienced management team. Of course, every list of optimal characteristics has a parallel list of characteristics to avoid: * Lack of standard operating procedures. A veterinary service business that has not yet standardized its own operating procedures can offer little value as a roll-up platform for other veterinary service businesses. * Reliance on a unique local asset or capability. Many producers of alternative energy have been dependent on ideal wind, sun, or water conditions and as such have been unable to create broad market penetration. * Unproven ability to succeed. A high-tech firm with promising R&D but no successful products may have little value to offer other firms in the same situation. * Differing business philosophies or short-term commitment of key operating managers. Silicon Valley has pushed stock options to try to overcome this problem, but you will be vulnerable to this in any industry in which your most valuable assets walk out the door every night. Add-On Availability The availability of add-on acquisition opportunities is the final factor in evaluating the attractiveness of an industry for a roll-up. While the total number of firms in an industry may seem adequate to complete a roll-up, multiple criteria should be applied to create a realistic list of appropriate candidates. Using purely illustrative numbers, this winnowing process may reduce 10,000 seeming candidates to 200 actual candidates (as illustrated in Figure 3). The necessary number of potential add-on targets in order to make an industry attractive is dependent on several factors, including: * Average revenue per company. If recovering your investment will require an IPO, it is likely that the total revenue of the combined firms will need to be at least $50 million to $100 million for the roll-up to be practical. * Number of companies required to achieve critical mass. Each acquisition requires an investment of management time and financial resources. A roll-up strategy can fail if the number of required transactions is overwhelming. nLevel of value creation created by the roll-up strategy, and hence the ease of reaching consensus on purchase prices. Since the amount of synergy determines the available room to negotiate, the presence of significant synergies creates the ability to reach mutually agreeable terms quickly while still creating value for shareholders. * Maturity of industry and resultant average age of owners/operators. This will be a key driver of the number of available acquisition candidates. * Difficulty and cost of executing due diligence. Cost of Due Diligence The last point on the difficulty and cost of executing due diligence is essential. For an industry to be viable for a roll-up strategy, the benefits of the roll-ups must far outweigh the costs of performing the acquisitions. These costs include market research, management time to approach and evaluate candidates, professional fees (consulting, legal, tax, audit), financing, customer due diligence, and operational integration costs. While transaction costs are unavoidable, you can minimize them by looking for an industry with reduced levels of uncertainty. For example, in performing the financial analysis, transaction costs will be minimized if firms have simple historical and projected financial statements that can be verified easily, and if business forecasts are not highly dependent on local demographics and economic trends. In analyzing the operations, attractive industries will be characterized by a high percentage of the firms’ values coming from existing products and not from new products under development. Lastly, industries that have a low vulnerability to consumer or corporate litigation are significantly easier to evaluate, value, and acquire. Acquisition Screening After it has been determined that an industry is ripe for a roll-up, acquisition candidates must be screened by methodically narrowing a large number of potential targets to the few that match your m&a strategy. To screen possible acquisitions, you will need to do four things: * Develop screening criteria. * Identify the universe of companies. * Narrow the list of companies based on the screening criteria. * Develop company profiles. Developing Screening Criteria Broad screening criteria may include SIC code, size of firm (by revenues), ownership structure, and region of operations or sales. More detailed criteria may include corporate strategy, specific product or service focus, current market share, or key management skills. In all cases, the screening criteria must be consistent with the roll-up strategy (as illustrated in the examples in Figure 4) Identifying the Universe of Companies Though this may seem a simple step, it is important to avoid any preconceived notions about which firms should be considered. Begin by using general sources to identify all companies that might fit the screening criteria; such sources might include Ward’s and Dun & Bradstreet. Starting from a general list maximizes the chance that you will finish with the most appropriate available candidates. The second step is to utilize industry-specific sources, such as manufacturing association membership lists, conference attendees, or trade journal listings. The purpose of this step is to ensure the inclusion of smaller niche players that may have been misclassified or not listed at all on general SIC code listings. Narrowing the List Based on Screening Criteria Several tiers of criteria can be iteratively applied to cull the list of companies. Beginning with broad criteria, you will be able to narrow the list to a reasonable group. Then, using detailed criteria, you can identify optimal candidates. (Figure 3 shows a typical application of this approach.) Developing Company Profiles After narrowing the list to a manageable number, develop company profiles by performing detailed studies of optimal candidates. These profiles should highlight their strengths and weaknesses relative to the roll-up strategy. The information in the profiles should be sufficient to prioritize candidates for approach. Examples of company-specific information that should be included are an estimate of revenues, total employees, number and location of offices, biographical information on key managers, and current ownership. Target Due Diligence After identifying a potentially attractive candidate, due diligence must be performed in a range of the target’s functional areas. There are several areas that should be investigated, including: Legal Contracts or leases, patents, law suits, antitrust issues, etc. Accounting Audited financials, unusual recognition policies, accruals, etc. Environmental Current sites, past and potential problems, etc. Strategic Market position, competitive position, customer satisfaction, unanticipated strategic issues, valuation analysis. Other Employee satisfaction or likelihood of retention, compensation, cultural fit. Of these functions, strategic due diligence can provide the highest incremental value to the acquirer, for several reasons. First, unlike many other due diligence areas, the target has fewer legal requirements to disclose potentially troublesome strategic issues. The burden is mainly on the acquirer to ask the questions and to evaluate the answers. Second, the non-strategic areas tend to be “deal-killers,” where the presence of a problem terminates the deal, while strategic problems (or opportunities) require management insight to change the offering price. Finally, while the other due diligence areas are sunk costs incurred specifically for one acquisition candidate, the knowledge gained during the strategic due diligence process will be applicable to evaluating future candidates. It will also provide a useful set of industry-specific intelligence. Strategic due diligence involves examining all components of the target’s business to identify opportunities and vulnerabilities, as illustrated in Figure 5. External to the target, two key areas of focus are customer relationships and the threat of competition. Customer Analysis In order to conduct a thorough customer analysis, you will need to segment customers according to appropriate products or services and prioritize those segments based on their impact on profitability. Once this is completed, you can evaluate customer satisfaction within each of these segments. We suggest selecting the most important customers in each segment and interviewing a representative sample on such questions as: * What are their key purchase criteria? * How does the target company perform on these criteria relative to the competition? * What improvements in the service or product offerings would they like to see? * From whom else does the customer purchase? If relevant, why does it use multiple vendors? * How will their buying behavior evolve? Given these expected changes, what changes would they like to see in the way they are served by the target company? The number of interviews needed is a function of both the concentration of the target’s revenue among its customers and the variability of the responses received in the initial interviews. The more concentrated the customer base and the less variability in responses, the fewer the number of interviews that need to be performed. In addition to conducting key customer interviews, this component of strategic due diligence should include interviews with non-customers and ex-customers. It is these two categories that often provide the most dramatic insight into the target’s true competitive position and the long-term viability of a roll-up strategy. Figure 6 illustrates three recent examples in which detailed customer interviews conducted by LEK uncovered significant exposures. In the most extreme cases, thorough customer due diligence may expose issues that torpedo a potential transaction. However, the short-term cost of beginning the process again with a new target is far less than the potential value-destruction of completing a poor deal. Competitive Analysis The most obvious threats are current, direct competitors. These threats should be prioritized according to the customer segmentation scheme already developed. Once again, paying the most attention to the most profitable segments is important. In addition, you need to evaluate the barriers to entry of new competitors (including supplier integration) as well as the threat posed by substitute products in the future. The best way to determine barriers to entry is to step through a product launch plan at the operational level. For example, in traditional heavy industries, large initial capital expenditures usually are the most important barrier to entry; with smaller information-based firms that may have developed very loyal, highly profitable customers, customer lists are often a key barrier for new entrants. What is most often missing in competitive analysis is the threat posed by substitute products or services. Evaluating this threat requires both creativity and a comprehensive understanding of the customers’ needs and perspectives. For example, many manufacturers of traditional surgical thread were surprised by the development of surgical staples and tacks as competition. The companies viewed themselves as suture manufacturers while their clients viewed their products as a means of wound closure. Typically, any product that meets the underlying customer need is a competitive threat. Internal Analysis You need to analyze various factors that are present within the target company for both opportunity and risk. Among the factors to consider are: * The management team’s quality, seniority, and attitude toward your acquisition. * The cultural fit of the acquired organization with your organization. * The ease of integration of the target’s business with your roll-up strategy * Specific functional issues, such as compatibility of information systems, the level of employee benefits, unions, etc. Our experience shows that these items are often underemphasized in the due diligence process, and yet they can be extremely important factors in driving a deal’s ultimate success and its fit with your roll-up strategy. Postacquisition Planning Postacquisition planning is an integral part of the due diligence process. It is tempting to postpone or delay the planning for several reasons, such as the plan will be executed only after the acquisition, you will possess better information to construct the plan after the acquisition, and, if the acquisition fails, it will not be executed at all. However, failure to plan the postacquisition phase will increase the chance that the acquisition will fail to create value for two key reasons: valuation and timing. Valuation Analysis A realistic valuation is dependent on postacquisition planning and strategy. Operating synergies and revenue synergies often can be poorly estimated or double-counted during the valuation process. By explicitly defining their source and quantifying their magnitude, you can reasonably estimate the synergy value created by the deal. For example, you can reasonably estimate in advance the impact of bringing cost of goods sold (COGS) and SG&A to best-demonstrated practice levels, as well as the impact of increased marketing power on revenue forecasts. However, these estimates must be tied to specific, foreseeable, achievable actions and not attributed to generic “strategic reasons.” Overpaying is one of the most common reasons for an acquisition to fail, and the integration of postacquisition planning into the valuation process is a key process to use to avoid overpaying. Timing Even if you are confident that the acquisition is strategically sound and appropriately priced, at the time of the deal’s announcement you will need to convince many other stakeholders of this belief. Announcement of a change in corporate control creates uncertainty, and the employees, customers, suppliers, and investors will demand a strategic story. In particular, customer relationships can be especially vulnerable during the period of uncertainty — and competitors will use this to their advantage. However, while executing the acquisition, you will have little time for coherent planning and strategy formulation. For all of these reasons, postacquisition planning should be a pre-acquisition activity, so a communications plan and sequenced list of activities should be in place. In the context of industry roll-ups, the key emphasis in valuation analysis is the linkage to both the roll-up strategy and due diligence findings. First, the due diligence effort will have uncovered potential extraordinary costs or strategic risks, all of which should be expressed at their expected value in the cash flow forecasts. Second, postacquisition planning will have specified the source of operating and revenue synergies which should be added to the value of the target, but not entirely to the initial bid price. Finally, when those aspects have been linked together to determine a valuation, the competitors evaluated in the due diligence process should be briefly reviewed to ensure that no other candidate has changed its level of availability or is likely to be a higher-value-creating option. Postacquisition Integration The final step of a successful roll-up implementation is postacquisition integration. As with most management situations, the key to success is clearly assigning responsibility for achieving measurable outcomes. The first division of responsibility is between the acquirer’s team and the target company’s team. The acquirer’s team must communicate with employees, customers, and suppliers regarding the future strategic direction of the firm and provide assurances that operations will continue smoothly during the transition phase. The acquirer’s team will also need to design an organizational structure that reflects any required SG&A reductions but supports the necessary business functions. A management group must be installed at the local level that is capable of implementing the business strategy. These managers must be compensated according to an incentive plan that links their activities to the roll-up strategy, perhaps based on periodic comparisons of the target company’s operations and Best Demonstrated Practices (BDP) levels. Finally, the acquirer’s team is responsible for monitoring the realization of the specific synergies outlined in the postacquisition plan. Meanwhile, the target company’s team will be responsible for the implementation of BDPs throughout the organization and maintaining employee morale during the transition period. The target company also should educate the parent company on local market dynamics and offer assistance in identifying and valuing additional add-on candidates for the roll-up process to continue successfully. Management Challenge Through the restructuring of an industry, roll-ups can generate significant shareholder value. Relative to many other value-creating strategies, roll-ups involve a high level of management effort. Following the guideline of the six steps from industry evaluation through postacquisition integration, you can streamline your efforts to maximize the potential value creation for your shareholders.