Consolidation Strategies Require Flexible Financing

RMA Journal, The, March, 2001 by Troy Oder

Consolidation strategy must be grounded in sound investment fundamentals in industries where there is a compelling need for consolidation. Genuine cost savings and synergistic opportunities should result. Before a company aligns itself with an industry consolidator, it is important to ensure that the consolidator's strategy is sound and that it is properly capitalized.

Over the past 10 years, the strategy of consolidating fragmented industries has been widely employed by private equity firms engaged in a "buy-and-build" or a "leveraged buildup" approach. Similarly, investment bankers and promoters have arranged for a number of companies to combine in a "roll up" in conjunction with either an initial public offering of stock (sometimes referred to as a "poof IPO") or a high-yield debt offering. Regardless of what the strategy is called, the concept is essentially the same: to build a leading company in an industry through a combination of acquisitions and organic growth. For private equity firms, the strategy often begins by acquiring an established firm in the industry to use as a "platform" to which subsequent acquisitions are added.

Recently, however, it's been proven that bigger isn't always better, and that some industries are fragmented for a reason. While a consolidation strategy has broad applicability, not all industries are ripe for it. It is important that the consolidation strategy be grounded in sound investment fundamentals in industries where there is a compelling need for consolidation with genuine cost savings and synergistic opportunities. Industries that may benefit from consolidation are those where acquisitions can be strategically and effectively integrated and where the synergies of consolidation include both revenue enhancements and cost savings.

An Enticing Proposition

Regional companies face increasing pressure from their customers to supply goods on a national and, in some cases, international basis. Private equity firms and investment bankers may offer a seemingly attractive solution to the issues that the company is confronting through a leveraged buildup or rollup. However, owners should exercise caution before relinquishing control of their business or becoming a platform for an industry consolidation.

Aggressive Growth May Have a Downside

Unfortunately, not all industry consolidation strategies work as planned. One service company with operations in 22 states learned that even the best proposals fail when executed too quickly. In about a year and a half, beginning in 1997, the company spent approximately $250 million in cash and stock for 56 add-on acquisitions. While their expansion plan reflected the financial benefits an aggressive growth strategy would offer the company, it gave management no framework to deal with differing management styles and conflicting cultures in the acquired businesses. The constant addition of a new company hampered management's ability to focus on the business before being forced to integrate a new arrival.

Managers were also expected to consolidate back-office operations, even though they had no previous experience. As a result, they invested in a costly, inflexible software system that failed to reduce costs. The problems were further magnified by the fact that many of the entrepreneurs who sold their businesses received stock in return. When the company's stock price fell, owing to poor operating results and rollups falling out of favor with Wall Street, these former owners became disenchanted and distracted in performing their jobs. To make matters worse, just when the company needed liquidity the most, the company's cash flow lenders reduced the company's borrowing availability to what was already outstanding.

Need for Proper Capitalization

Buying multiple companies at fair prices and integrating them simultaneously and effectively makes a consolidation strategy a challenging business model, even for the best management teams. One reason is that the capital structure must have enough flexibility to address the liquidity needs of the business. These needs could arise if:

* The consolidation strategy hits a bump.

* The acquisitions don't occur fast enough to cover the level of corporate overhead that has been built to effect the strategy.

The financing for a leveraged buildup or rollup typically comes through a combination of capital raised from a private equity firm or other investors, public capital markets, and senior secured loans from commercial banks or finance companies.

A key success factor is to have adequate availability tinder a senior credit facility to address the working capital needs of the business. If there is a private equity firm involved, it should be committing sufficient funds not only to support acquisitions but to provide an injection of capital to shore up the company's liquidity position. If the plan is to use the company's public stock as currency to make additional acquisitions, contingency plans should be developed, in case the company's stock price deteriorates.