Private equity is known for industry consolidation through buy & build. Mostly, these investment strategies are based on a scale or scope investment thesis. Scale efficiencies drive profitability. Product & service expansion results in upselling and sustainable revenue. Buy & build is a proven investment strategy in mature industries. Yet, this is rapidly changing.
In addition to the conventional buy & build plays, a new buy & build phenomenon is emerging. Heavy capitalised scale-ups that only exist for a couple of years are turning to M&A to accelerate growth and to consolidate emerging, yet fragmented ecosystems. The emergence of transformational buy & build platforms.
In this idea in brief, I will describe how transformational buy & build strategies could provide an alternative growth avenue for scale-ups as an alternative to a cash burning scaling path.
Venture capital backed scale-ups are turning to M&A
In Europe, the private equity investments in buy & build deals are plateauing at 2,000 to 2,500 deals per year (source: Pitchbook). Contrary, in venture capital the number of European buy & build deals is rapidly increasing to over 300 deals per year. For comparison, in the US, this number of is twice as high: over 600 venture capital backed M&A deals. Notable, is that in Europe some 30% of all investor backed buy & build deals are completed by companies that didn’t exist five years ago.
The transformational buy & build thesis
The transformational buy & build opportunity starts with a technology platform whereby ad-on acquisitions will port their operations to the core platform. This results in operational efficiencies, larger development budgets, and improved user experience & data analytics.
The transformational buy & build platform strategies result in five levers driving new sources of value creation:
- Scale & accelerated growth: acquiring customers via acquisitions.
- Pooled development budgets: creating a pooled budget for continuous development, important to stay competitive.
- Profitable growth: achieve profitability from day-1 as the newly acquired companies are profitable.
- Unit economics: CLTV (Customer Life Time Value) of the customer base is expected to be higher than the acquisition price of the company divided by the number of customers. Acquiring customers via M&A is shifting customer acquisitions costs from Cost of Sales to Capex.
- Multiple arbitrage: the target companies are expected to be acquired at a lower multiple than the platform valuation multiple.
A note on valuation: multiple arbitrage
Multiple arbitrage for technology enabled buy & build platform companies starts with a ‘high-multiple’ technology acquisition followed by ‘lower-multiple’ ad-ons which if transferred to the platform will benefit from the higher platform multiple. In private equity backed buy & build strategies, the multiple arbitrage is more scale related.
Key considerations for the transformational buy & build model
A transformational buy & build strategy requires both venture capital and private equity expertise. The venture capital model is tuned for primary investments to fund development and to accelerate autonomous growth. The private equity model is primary meant for secondary buy-outs or add-on acquisitions.
Combining the private equity and venture capital model is not easy but pivotal to success. Either a scale-up will end up with both private equity and venture capital investors on the cap table, each having its own and sometimes conflicting terms & conditions. An alternative is working with investors, often family offices, that have expertise and a mandate to operate both investment models.
In pursuing successful transformational buy & build strategies, investors need to consider the following conditions for succes:
- How to deploy simultaneously primary & secondary capital? Primary capital is needed for investments in development and autonomous growth. Secondary capital is needed to fund add-on acquisitions.
- How to deal with different valuation perspectives from founders, venture capital and private equity investors?
- How to deal with the control requirement from private equity investors versus the minority position that is common in the venture capital model?
- How the build an executive team that has both the founder spirit and the expertise to acquire and smartly integrate newly acquired companies?
- How to secure a disciplined organisation maintaining a ‘technology first’ platform approach needed to drive value creation? Smart integration is key and if managed poorly potentially value destroying.
- How to build an attractive equity story for investors, talent and potential add-on acquired leadership? This should be about a 10x value creation opportunity.
- How to fund future acquisitions?
- How to keep founders of acquired companies motivated to stay on?
Deal structuring considerations: the ratchet mechanism
A blended model of private equity and venture capital is needed to accommodate transformational buy & build strategies. Depending on the platform investment opportunity and the risk-return characteristics, a different structure will be needed. To overcome mentioned challenges, it is in my experience best to start with a return based scenario analysis and deal structuring in stead of the default multiple valuation approach.
To facilitate a balanced deal structure for founders, investors and add-on acquisitions, the ratchet mechanism is the latest innovation in deal structuring and growing in popularity. A ratchet is a return based shareholding allocation and as such overcomes different valuation perspectives from venture capital, private equity and founders. The cap tabel will be retroactively determined at the exit. The ratchet mechanism facilitates different risk-return requirements from different types of investors such as down side protection or upside maximisation.
A final note …
Transformational buy & build strategies may provide you with a 10x value creation opportunity that comes with different growth path compared to the ‘heavy burn rate’ venture model. It requires though investors to flex their default deal structuring approach. In this article, I have provided a couple of perspectives and considerations to successfully design and operate a transformational buy & build platform.
Picture: Show case Vitra Hause, Rein am Weil
