The Power of One
December 7, 2015
Nowadays, most borrowers are under extreme pressure to cut costs and minimize waste. Operating inefficiencies are one of the biggest struggles small and midsize companies face — and those that lose the battle may go out of business. A roll-up, where several smaller companies in the same or similar industries join forces to form a larger company, can reinforce a struggling borrower’s defenses.
The advantages of roll-ups go beyond economies of scale and synergies. From an underwriting perspective, a larger company is an easier sell than a smaller one, providing greater access to capital and more favorable loan terms. But lenders should also discuss the potential pitfalls with borrowers before they jump headfirst into a roll-up.
Loose federation vs. true merger
There are two general ways that companies approach roll-ups. Most start off by easing into a relationship by forming a “loose federation” without consolidating operations in any meaningful way. Each participating company continues to operate as an independent entity in its particular market, keeping its own brand identity and management team.
Alternatively, some companies jump right into the “marriage” by aggressively consolidating operations and actively seeking synergies among all participants. By combining operations and cross-selling products and services, the combined entity can reduce costs and grow revenue internally, resulting in widening margins and accelerating earnings.
Although there are costs involved in the consolidation process, especially if the combined entity plans to go to the public markets for additional equity financing, roll-ups can result in an immediate increase in value. But to achieve such benefits, all participants in a roll-up must be financially sound. And if the roll-up is to follow a loose federation approach, each individual management team needs to be highly competent — not to mention able and willing to collaborate.
Unfortunately, roll-up success is the exception, not the rule. Too often, participants focus more on getting the deal done than on post-integration challenges. And inattention to consolidation issues can lead to disaster for the businesses involved — and the creditors that they default on.
During the bull-market years of the late 1990s and early 2000s, “poof” roll-ups — in which several smaller companies combined to create the appearance of greater size, with no real integration strategy — were common.Typically, the goal was a quick windfall. And almost invariably, these transactions failed because either their subsequent initial public offering (IPO) would tank or the management teams were unprepared to integrate and run the combined company.
If one of your borrowers is contemplating a roll-up strategy, it may need financing to complete the deal or your bank’s approval (per their loan covenants). This is your chance to play devil’s advocate.
Discuss whether management has compiled a detailed plan for every aspect of integration, including employees, facilities, sales channels and IT. And if the smaller companies’ former CEOs will lead divisions of the larger entity, it’s critical to clearly define performance measurements and incentives. The decision to centralize control or operate divisions as largely autonomous entities also will be critical.
If your borrower plans to take the roll-up to the public markets to access greater funding, realistically discuss the costs that are involved. Public entities must submit to Securities and Exchange Commission scrutiny and adhere to the provisions of the Sarbanes-Oxley Act of 2002, which typically means increased marketing, accounting and legal costs. And regardless of the fundamentals, your borrower’s value may fluctuate based on general market conditions and the opinions of investment analysts.
A cautious approach is a winning strategy
A roll-up can be an effective way for a struggling borrower to lower overhead costs, negotiate lower costs with suppliers, expand access to financing and add value. But success isn’t guaranteed. Thoughtful planning can identify risks early, giving management extra time to devise a smart defensive strategy.
An outside advisor can help project post-integration financial results and poke holes in management’s financial projections. This insight is particularly helpful when management has limited experience with roll-ups or IPOs, if the roll-up plans to go public.
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