Roll-upsUntangling a Growth Vehicle of the 90s
The "roll-up," a 1990s buzzword for industry-specific consolidations that began in the '70s and '80s, is perhaps most popularly evidenced by Wayne Huizenga's activities in both the waste collection and video rental industries. During the '90s, fueled partially by the explosion in equity investment capital, roll-ups found their way into many sectors of the American economy as entrepreneurs identified value-creating opportunities. Utilizing a basic formula of 1) fair market value acquisitions and 2) subsequent cost elimination through integration and consolidation, these entrepreneurs targeted industries ranging from office products and hardware to employee leasing and food service. Though many have been successful, recent reports of accounting irregularities, subsequent financial restatements and the resulting stock price deterioration illustrate that roll-ups do not always sustain their market goals. What are the contributing forces and issues at play in today's roll-ups?
Geography and Market Concentration
An assessment of geographic considerations is the key starting point in reviewing a prospective roll-up. Though new geographic regions may present enticing revenue opportunities, they also represent significant pitfalls. To begin, the unique attributes of a new market often dictate changes in both the sale and control of the product's delivery. The new markets, satellite to the company's core business, also magnify control issues. New geographies place stress on existing distribution channels and cost structures that must be thoroughly considered in a financial proforma.
Though the roll-up typically anticipates synergistic benefits, the entity must also give careful consideration to oversaturation within existing markets that can result in the cannibalization of its customer base. Ultimately these geographic considerations can materially impact the underlying value of the entity.
Infrastructure Requirements and Operating Practice Integration
An economic fundamental of the roll-up is the ability to reduce and/or eliminate costs through the consolidation of overhead infrastructures. To accomplish this objective, the core entity must possess well-developed corporate support services capable of handling the increased volume. The core company's accounting, human resource, management information systems and general administrative staff all play a critical role in the successful integration of the acquired companies. Therefore, department infrastructures must be capable of handling the new demands.
The adoption and implementation of standard operating practices is also important. To accomplish this objective, the core entity must first clearly define its own standard operating practices. The integration plan should include a communication conduit for understanding the acquired entity's operating practices as each acquisition represents an opportunity for enhancing the aggregate's "best practices." This communication process is also an important part of merging the cultures of newly combined entities while stimulating and motivating the individuals involved.
Customers and Employees
Roll-ups affect people too. Changes in district coverage and/or new managers raise concern for existing customers. Customers are often adversely affected by ill-planned integration plans or understaffed corporate infrastructures. Communication among the entities at the onset is essential in minimizing damage to customer relations.
Employees from both entities typically feel stressed during the acquisition and integration process; the understanding of their needs is essential to the underlying health of the new entity. The myriad of benefits-related issues, including medical and dental plans, retirement packages, vacations, evaluation and promotional progressions and stock option plans, are all elements of uncertainty. In the tight labor market of the late 1990s, leadership must give extensive consideration to all of these issues as the stabilization and preservation of the collective employee base is fundamental to entity valuation.
Timeline planning is essential in all phases of the roll-up progression. To begin, the strategic planning for conducting multiple acquisitions must be orchestrated against the backdrop of the realities of the corporate infrastructure's ability to absorb. This sequencing also impacts supply and distribution channels, span of control coverage and financial reporting requirements, and as a result, the importance of time planning cannot be overstated. Additionally, a realistic understanding of the timeframes associated with the implementation of integration programs is essential to attaining proforma valuations. Delays directly result in increased cost and decreased value. These issues place pressure on working capital requirements and must be carefully considered in the capital structure planning of the roll-up entity.
The economics of roll-ups center on two key issues: fair market value acquisition and cost elimination through integration. Fair market valuation can be distorted in a variety of ways. To begin, pressures to deploy capital and/or achieve revenue growth objectives can cloud leadership judgment. Forays into new geographic regions or new product lines also strain internal technical expertise and often distort valuation judgment. Inefficient overhead structures, underdeveloped infrastructures, union or other wage-related issues and extraordinary contractual obligations all affect the appropriate valuation of targeted acquisitions. Roll-ups must maintain a technically proficient and disciplined approach in considering these issues to ensure realization of proforma value.
Cost elimination is the second cornerstone issue to roll-up economics. In concept, these opportunities can be found in the consolidation of overhead coverage and the elimination of duplicate corporate functions such as accounting and human resources. To begin, the company must first assess reporting methodologies to confirm accuracy in cost analysis. In fourth quarter 1998-99 acquisitions, the core entity must also fully analyze and quantify year 2000 technology issues. The technical expertise associated with product offerings, the reality-based accuracy of cost elimination and the timeframes associated with their realization directly impact both working capital requirements and underlying realized values associated with acquisitions.
The "Watch" Signs
In most cases, roll-ups possess many of the traits found in failing businesses and, therefore, are inherently high-risk ventures. These common risk factors often include the following:
- rapid growth
- excess leverage
- customer service and product quality deterioration
- competing goals associated with multicultural integration
As a result, the importance of technical and infrastructural planning cannot be overstated. Further, in the instance of an existing roll-up, an assessment of the issues associated with the above identified risk fundamentals is imperative in turnaround planning.
Valuation & Viability
The valuation of existing roll-ups presents many objective and subjective challenges in the context of reorganization. Past financial performances may not accurately predict future costs during a time of rapid growth. These issues can be further distorted by the multitude of reporting methodologies particularly evidenced in the consolidation process found within a roll-up entity. In most instances the existing troubled roll-up has underdeveloped internal infrastructures. The methodologies to be deployed in the development of these infrastructures as well as the timing of their execution directly impact both capital expenditure requirements and future earnings potential. In the aggregate, these issues must be carefully considered in developing estimates of anticipated future stabilized cash flow streams. Additionally, these issues must be considered in establishing the appropriate risk premium rates to be utilized in the application of discounted cash flow valuation techniques.
The question of viability, inherent in all turnaround situations, requires careful consideration in the context of roll-up restructuring. Underpenetrated markets in widely disparate locales are indicators of high market risk. Underdeveloped infrastructures, ill-defined integration plans and poorly communicated standard operating practices contribute to suboptimal operating margin performance. Additionally, a greatly expanded customer base and the corresponding growth in internal human resources place high demands on external and internal communication methodologies. Timing sequence, particularly in the instance of yet-to-be-developed infrastructures, or cost elimination, greatly impact both near-term and stabilized cash flow streams. Lastly, the capital structure employed to initiate the roll-up may not effectively address the needs of the current entity. In the aggregate, these issues represent the multitude of forces at play in determining viability of a roll-up entity.
While the concept of roll-ups is sound and a number have been successful, recent history shows that many have been overvalued principally as a result of inadequate due diligence in understanding infrastructure needs, operating practices, and in particular, anticipated cost savings. In addition, those entities considering the so-called "troubled" or "underperforming" roll-up must assess the economic risks in executing integration plans and achieving cost savings. Far too often, the troubled company's integration plan has taken much longer and this has resulted in a far higher investment than initially intended.
1 William D. Forrest, CTP, is currently a contract professional with Buccino & Associates. He specializes in the crisis management, turnaround and restructuring of troubled companies. Return to article