M&A Rollups with Matt Lynch
This article was adapted from a podcast interview, the original content has been edited for readability
[Jim Milbery]
So, Matt, you have a great background; give us a quick commercial on yourself and DCP so the listeners know who we're talking to today.
[Matt Lynch]
I started as an investment banker at Solomon for about 11 years and then had an opportunity to run corporate development at a tech company in Washington, DC, called Blackboard. I was there for a few years, and that's when the lightbulb went off for DCP. DCP is a merchant bank, meaning we have an advisory and investment arm and are almost entirely buy-side-focused. We take an in-house perspective to everything we do, which we think is a differentiated niche. When considering starting DCP, I looked for a similar model; there's not much out there. There are many brokers and outreach firms, but no one we've found who manages the entire buy-side process from start to finish. We work with clients on a programmatic level, meaning we can drop in a team and support, build, and manage a playbook. Or we can work on an episodic basis, i.e., execute a single deal, as you would typically expect an adviser to do. We manage a portfolio of investments based on DCP advisory deals, and I think it reinforces the empirical nature of what we do. We're not trying to get any deal done for the sake of doing a deal. We want to get the right deal done, and often, we have our skin in the game to emphasize that point.
[Jim Milbery]
So today, we will talk about roll-ups. First and foremost, let's define what an M&A roll-up strategy is. Define roll-up for us from your worldview.
[Matt Lynch]
An M&A roll-up is a strategy for acquiring a platform company. Then that platform will often acquire numerous smaller companies, which drives a lot of value creation in the form of financial returns. It sounds simple, but there are multiple paths to do this. First, the platform is typically the foundational acquisition. But you can put that together either with a significant initial investment, or you could put a couple of smaller subscale companies together and Frankenstein the platform into being and then go off and find add-on acquisitions.
[Jim Milbery]
So, what's the platform deal's minimum size?
[Matt Lynch]
It varies by market size and fund size. Different private equity firms are going to go after different market niches. But I would say, on a relative basis, the add-on acquisitions are probably somewhere in the range of 5% to 40% of the enterprise value of the platform. If you think of the platform as the basket you're putting all your eggs, that should give you a sense of size.
[Jim Milbery]
Now, let's talk about different roll-ups. So when you look at this, are you buying features, taking out smaller competitors, or buying market share? How do you see it from a market standpoint? And does that vary between an industrial company and a tech company?
[Matt Lynch]
I would probably put them in the buckets you described. I'd say there's the acquisition of direct competitors. So you're looking to acquire market share in your existing market. You're adding customers. You're taking out direct competitors like JetBlue's pursuit of Spirit Airlines or the T-Mobile Sprint deal, where you're directly complementary. And then the second bucket is a vertical acquisition—something where you're building or adding on features that are missing in your product. When eBay bought PayPal, that was a deal where they debated making their payment mechanism and decided instead to buy it. That would be a vertical expansion or add-on acquisition. And then another bucket is adjacencies, which is extending your product into new markets or geographies. What was your customer doing five minutes before or five minutes after using your product? And buy that. Facebook bought a company called WhatsApp, which was outside its core business. They had a messenger but were trying to build adjacent market share, which is another good way to expand your total addressable market. And those are the three big ones.
[Jim Milbery]
Yes, and indeed, the economics will vary. I could buy some tiny competitor, but if that feature is a feature I could potentially sell to every one of my customers, I can make money on the arbitrage. If I think, "Wow, I can get 50% of my existing customers to buy this feature," then it's super simple. We had a portfolio company that did a ton of that. They bought features for a dollar, sold them to customers for two bucks a piece, and made solid margins. The customers got value from the new features bundled into the platform.
[Matt Lynch]
I think that's fair, and we did that at Blackboard too. One of our clients, Diligent, is a textbook study for this strategy. They started in a board portal space, which was highly fragmented. They bought up many of the other board portals, then expanded their category in the governance angle. And that's another example of fundamentally changing the aperture of your company. I firmly believe that 2023 will be the year of the add-on acquisition. I think we'll see a lot of carve-outs where you've got non-core assets to divest. As businesses reevaluate what they have and want to move forward, you will find many non-core assets they would much rather monetize in this market environment and get the capital to deploy elsewhere. So consolidators can take those non-core assets and either create them as add-on acquisitions or make them the platform. Another company we've worked with called Probation was a carve-out of a large healthcare conglomerate that wasn't interested in participating in software. It turned into a very successful platform for Clearlink.
[Jim Milbery]
I think you're correct; corporations who acquire a company that's acquired somebody who's acquired somebody, etc., now have an asset that's not core to their business. Now is the time to get rid of it. I also think we'll see a lot of walking dead on the venture side. They're not dead, but they won't get any more investment from their venture investors. Now it's time to decide what the best owner for them is. Customers like one throat to choke, and large companies like Oracle have successfully bought many features via acquisitions. Oracle customers would like to buy from Oracle. So maybe they bought a walking dead product from venture guys that wasn't the top product, but it was better for their customers because it is now tightly integrated with other Oracle products. So there are probably a lot of "feature" companies out there that will be for sale that wasn't going to be for sale in 2022.
[Matt Lynch]
I worked on the PeopleSoft defense, an old sale to Oracle. These are companies that aren't for sale. You look at Oracle alums and what they have done and what they have built. It's incredible how that organization has seeded a new generation of software behemoths.
[Jim Milbery]
The funny part is I worked for Ingres way back in the day and later worked for Oracle. Ingres, Informix, Sybase, and Oracle all hated each other back then. What's funny is we see the other side of it now. Many people who worked only for Oracle tried to come down to small Private Equity backed companies and struggled because they lacked the resources they had with Oracle.
[Matt Lynch]
And actually, that's another tie-in if you found a market niche that you think is reasonably attractive and ripe for this roll-up strategy. You have incremental resources, shared back offices, and higher margins for the most part. You can do the types of things that Oracle does on a much larger scale to push your competitors around.
[Jim Milbery]
As we start to talk about how you get started on an M&A strategy as an investor, should you have a hypothesis and market in mind before you even think about doing this? Or can I go to a provider like you to give me that hypothesis and get started?
[Matt Lynch]
You want to find a market that exhibits the suitable characteristics for a roll-up strategy, so I think it starts with market research. We have a whole framework that we put together for that rubric. You also want to find an entry point. If there is not a company of scale or multiple companies of scale, then it's probably not a market that you want to spend a considerable amount of time in because you're just not going to get the bang for your buck in trying to own that market. And from there, we look at a series of four stages. There's strategy, origination, execution, and value creation.
Strategy is identifying your platform and determining how M&A fits into that. I think it is dictated in many cases by the market, but it also depends on the legs of the stool for growth that you can augment through M&A. You've got to remain flexible and work with the right stakeholders at the portfolio company or your bosses in the senior leadership team to ensure you understand the business strategy. Then you, as a board member, private equity associate, or corporate development professional, are augmenting it with a very active M&A pipeline discussion.
[Jim Milbery]
That's the exciting line between having a roll-up strategy and just making an acquisition at one of your portfolio companies. We've done both. Something is opportunistic, comes to your door, and looks like a fit. But maybe you were growing just fine organically, and this is where we see strategy dictated by things other than the business strategy. We could say, "We've got to put some money to work. We're not seeing anything else that's great out there." That's very different than saying, "I've got this company, and my strategy is organic growth, but also growth through M&A." It's this idea that we have a budget to make multiple acquisitions, and we know what angle we're going after. We've started to map that out once we've got our platform company as opposed to an opportunistic acquisition that just happened to fall into our laps.
[Matt Lynch]
Absolutely. And what is also part of the strategy is you're going to fundamentally change the company from the platform investment you originally made to your ultimate exit so that it's not just a financial transaction. You are increasing the addressable market. You're adding customers and delivering more value to those customers. You have a higher degree of earnings power and benefit from the actual arbitrage you can get from an add-on strategy. Many cases show that M&A has overwhelmingly been the most significant driver of returns. It's not always the case, but strategic and financially prudent acquisitions are typically highly accretive to equity returns and enterprise value growth.
[Jim Milbery]
We consider platform companies with reasonable market share as a starting point. Typically -- the more straightforward thing to do is to buy features than it is to buy a competitor. Integrating two formerly competitive companies can be treacherous. When buying feature sets, there's less management team tension. But acquiring competitors is a safer strategy if you don't have enough customers to sell those new modules to. If I buy something that all of my existing customers would be interested in buying, mainly because it's coming from me and they already trust me, that's part of what we look at when you're buying features. That feature has to apply to your company, but it has to have some additional value now as part of your platform, or your existing customers would have bought one of those already. That tends to be the first driver of success, and it's easier to do that than it is to buy a competitor.
[Matt Lynch]
I think that's the gold standard. If you can find a market leader to serve as the platform acquisition, I think that's the single best way to do this. At Blackboard, we would buy companies and quintuple their sales the following year because you put the new stuff in the bag of all the reps, and you'd go to the existing install base and sell it. I also think there are other ways you can execute this strategy. And we've worked on things as diverse as print media, industrial manufacturing, and even optometrist clinics, where you can rationalize back office functions and build scale through the bolt-on strategy and centralizing marketing spend. But I will say that the gold standard is what you're describing -- when you can buy the market leader and add additional products and features to sell to that customer base, all the better. You do need to preserve the pricing power of your acquisitions. For example, Provo would buy many companies and add their features to their platform. Yet, customers expected Provo to bundle those acquired features into the core offering. So they took the ASP of the acquired businesses down to zero. You must have some value-added perspective when making these calls and understand customer behavior when executing these deals.
[Jim Milbery]
My partner Devin would say we do two things at ParkerGale. We're buying something differentiated from the competitor for a genuine reason or buying and growing the business to get in the way of the gorilla. Ultimately, so the gorilla buys you out. And again, we often see that's a successful roll-up strategy; the gorilla wants to put a bunch of things together, but they can't do it. Oracle cannot buy and do anything with a $10-million software company. They'll crush it with their size. So they need somebody like us to build a $200-million software company that's got the package they want for them to have any hope of putting their hands on it.
[Matt Lynch]
That's very true. And if you know the road map of that consolidator, that you can build that $200-million market niche player, that would be very attractive to them. Another angle is if you can find a company with the best product. Often the most successful product is not the best, but if you can find the best product and provide the sales and marketing muscle to get them to where they need to be, that can be a very successful strategy.
[Jim Milbery]
So if somebody's sitting here today, how do they get started? How do they get started with you? Let's say they decide, "We got an idea of a market we're interested in, but we don't know what to do next." Do they contact you for some coaching to start building the strategy?
[Matt Lynch]
I think the right way to get started is that once you've decided on a strategy and identified targets, you're in full-on origination mode. That's the second phase where I think our firm spends a lot of time and differentiates us from other brokers. We define origination as relationship building across perspective M&A targets. There's a real benefit to proactive sourcing or staying in front of potential M&A partners. You want to be on their radar, and from an administrative standpoint, you want to have a pipeline document that manages all of the conversations you're having. The pipeline document is so crucial because if you don't have the pipeline document's focus, direction, and prioritization, then you'll be lost. You could be wasting your time on thousands of companies and want to be as efficient as possible when engaging with these companies on initial diligence. You must show you've done your homework on their market and company. You have to hook them engagingly and show why it's helpful for them to respond to you. You want to build trust and transparency in collaboration and pull it through like any other sales funnel. That's the most important thing when it comes to origination.
[Jim Milbery]
Let's talk about two questions before we get to execution. The first part of this question is, does the platform team at the portfolio company have to have experience doing roll-ups to pull this off? Number two, splitting the origination conversations because we've done it both ways; we've had some portfolio companies that know what they want to acquire and are very good at it. We may put target lists together, but they do the initial reach-out. Do you have any strong feelings either way about either of those questions?
[Matt Lynch]
With outreach, I think only two things matter. One is that they give it the requisite attention it needs. And number two is to ensure some executive sponsorship, meaning somebody will be responsible for this acquisition post-close to make it successful. I think that's important for a team that doesn't have as much experience on deals. And to your second question, I feel like it depends. When I was at Blackboard, I'd walk the conference floor or call a potential target, and as soon as they saw my number come up, the target would assume that Blackboard was interested and that they were in play now. So one of the benefits of using an adviser is that there's that agent-principal separation where DCP will often reach out and say, "Our mandate with X, Y, Z is to find interesting and compelling opportunities for acquisition. From where we sit, your company seems like a complementary fit; we'd love to learn more than what I can read on the website and see if you would talk to me for a few minutes." And then, I'll explain a process whereby I present to the company the ideas that DCP has found. So this isn't just an ambulance chase to see if I can spur up a deal or get hired by somebody. It's a mandate. And two, it doesn't signal that the company we're working with is interested. It just shows that DCP thinks there might be a fit, and let's build the thesis together, and then we'll come back and pitch this to our client. It builds camaraderie and provides some distance so that it doesn't signal dollar signs before we want to have that conversation anyway.
[Jim Milbery]
So that brings us to execution. Define execution from your world.
[Matt Lynch]
So, typically, you have conducted initial diligence in this process. You have built the consensus internally at your investment committee or board level to pursue an acquisition. And in many cases, you have already begun price discovery and even outlined the structure of a deal through something like a letter of intent or a term sheet. And at that point, you are running a multifaceted due diligence exercise aligning to a specific timeline, with certain key milestones, and with a much more exaggerated list of participants than you had in the origination phase.
And you've stepped up the resource requirement, not only on the human side, but you're spending money. You are conducting a forensic evaluation of the company across many functional levels, and you need someone to quarterback that. And that is where DCP comes in. And the key at this stage is to establish a process where everyone is aware of the timeline, you are sending frequent process summaries, and you're getting weekly syncs with the working team. We have a document we put together at DCP called a transaction play card which includes an overall sense of the timeline and the functional groups and who's responsible for those. I mentioned earlier that a half dozen questions need answering to proceed with a deal. It provides updates on calls that have happened, scheduled calls, notes from said calls, new documents uploaded to the data room, and critical milestones on your side. This kind of communication allows you to communicate proactively asynchronously, meaning not everyone has to be on the weekly sync to know what's happening because they get that document.
[Jim Milbery]
So the place where we see this breaking down is twofold. One is if the private equity firm is buying into a new market or vertical space where they lack experience. The second is when we are dealing with a first-time seller. Maybe they've had some small angel investment, but this is the only time they've sold a controlling interest in the company. And if they've got less experienced advisers, that becomes a problem. So you start to get in these discussions around things working capital adjustments. Do you commonly see any other reasons deals tend to go sideways?
[Matt Lynch]
Oh, we see it all the time. And in fact, you have to take your adviser hat off and put on your therapist hat because you're effectively coaching them through the process. You mentioned net working capital. Describing to a family-run business that this is their baby and they're selling it for the first time, that has network and capital cyclicality, seasonality throughout the year, explaining why that adjustment could go either way. It's not us stealing money from you; there's a theory behind it and a theoretical premise as to why this adjustment exists, which is part of the job. And I think your demeanor at this point has to be very mindful and respectful of that dynamic. You're sending requests in advance. You have preview calls to let them know what's coming. You're transparent with the process. If you have a call coming up, send the agenda in advance so they can be prepared. You're there to make it successful for them. You have an organized diligence request list. And if you have that reputation, that helps you with the outreach. It also enables you to ensure that the deal progresses on time and without incident because those types of miscommunication derail transactions more often than you would expect.
I can think of two specific circumstances in the last two years where that's exactly been the case where they didn't have a transaction lawyer advising. In one case, they marked up the purchase agreement within an inch of its life into a very unreasonable position. And on the other hand, they recommended that our clients sign the first draft without any adjustments. Even with the smaller deals, you must assemble a financial model, a data pack, and all the customer analysis.
[Jim Milbery]
One of the big things we look at is, "Does our portfolio company have enough cash or debt to acquire on its own? Or are we putting dollars in?" Because we are a buyout shop and majority owners only. We do take co-invests from some of our investors, but we're not doing partnership deals for the most part. That could be a big thing from a "who's paying for this" perspective. Because if you need a certain amount of debt or you're expecting some free cash flow from the business, that may affect whether they can pay or not pay versus we're backstopping the thing. Being clear about that is essential.
[Matt Lynch]
That's why I think this coming year is the year of the add-on acquisition. There are some challenging market conditions concerning the debt financing environment, the amount of committed but undeployed capital on the private equity side, and the valuation challenges equate to longer hold periods. The market conditions are suitable for a more significant mix of add-on acquisitions. But to your point, you have to make sure you have the basics and make sure that group of decision-makers is updated throughout the execution process because the last thing you want to do is have a contract to sign and realize that you don't have the support of either your investment committee or your board or the executive sponsor or whoever. You have to pull the plug because that's a tough one from a reputational standpoint.