Here’s the Most Popular Way Private Equity Tries to Grow a Company

The following is adapted from The Private Equity Playbook.

The most popular way that private equity likes to grow a company is to use the “buy and build” strategy. With the internal rate of return (IRR) clock ticking, growth needs to happen quickly, and the other two levers for growth – organic growth and margin expansion – take time. The fastest way to grow a private equity owned portfolio company is to buy additional companies, called “add-ons”, and tuck them inside.

Organic growth and margin expansion still matter because they maximize value and create sustainable growth, but in the short-term, buy and build is king.

In this article, we’ll walk through everything you need to know about this strategy. If your company was just acquired by a private equity firm, consider this your primer.

Why Buy and Build?

There are three reasons why you typically seek to buy and build, also known as completing mergers and acquisitions. The first is to fill a strategic need. This helps the company pivot left, pivot right, find a new blue ocean and find new markets to serve.

The second reason is to build density in existing geography, and the third reason is to expand the geography that you cover by launching into new territories.

When I ran a laundry company, we purchased dozens of companies and folded them into the parent entity. They were essentially doing similar work, and it was beneficial to build scale in order to be more efficient operationally. We used these acquisitions to build our route density, enter new geography, and open new regions.

When you have a lot of guys in trucks, you want them spending their time working on equipment. Time spent behind a windshield driving is a productivity waster. That laundry company had so much density in some cities that our field employees (like a UPS driver) could literally spend their entire day working within a few mile radius.

You can use mergers and acquisitions to build density in existing markets, enter new markets, or solve strategic problems, but most importantly, it grows the company very rapidly. When you fold in another company, you get exponential growth.

Private equity typically uses additional debt to execute this strategy, I refer to it as OPM, “other people’s money”. Using additional debt to fund most of, or all of, the purchase price is efficient and preserves the private equity funds’ capital for other projects.

When a private equity platform buys a company with financing, it gets credit for pro forma EBITDA, including synergies. Synergies are positive gains that result from merging the two companies together. It can be like rolling two accounting departments or human resources departments into one, or it can be that you get a discount when purchasing parts because it’s a much larger purchase order. These synergies yield reductions in operating cost and increase profitability for the overall combined company. Lenders give the company credit for these synergies even before the deals are closed, which allows the company to borrow more money (debt) to fund the purchase of the acquisition target.

Let’s say the platform company has 5x EBITDA in debt but is itself a company that sells for 10x. If the private equity firm can buy an add-on company for 5x EBITDA, it can use 100 percent debt financing because that equals the leverage of the parent. It’s a very popular method and an efficient way to scale and grow. If the firm pays more than the current leverage, some additional equity may need to come in.

How does this translate to shareholder value created? Simple. If the target company has pro forma $5M in EBITDA and is bought for 5x, the purchase price would be $25M. If the parent company sells for 10x, then the shareholder value created by this acquisition is 10x the $5M EBITDA added ($50M) minus the debt required to buy it ($25M) for a total increase of shareholder value of $25M. In this example, we added $25M to shareholder value without spending one dime of the company’s or private equity firm’s money. That's what OPM is all about! Now you know why it’s so popular for companies to buy other companies. Virtually a day doesn’t go by without a news report involving some big merger or acquisition.

A Unique Skill Set

Mergers and acquisitions are an efficient method of scaling a business. It isn’t your only method. You need to use all components of growth, but this method, in particular, is critical for IRR because it can accomplish big things in a short time. It also requires the expertise of a deal team inside the company to sustain as a long-term growth strategy.

Acquiring companies requires a unique skill set: being able to identify targets, work with the owners and management teams of those targets, conduct due diligence, build financial models, draft nondisclosure agreements, draft indications of interest, draft letters of intent, evaluate operations, plan for integrations, and more. The private equity firm brings all of this to the table, making it beneficial after you partner with them.

Most companies do not have a team in-house that could execute a buy-and-build strategy on day one. That’s where a partnership with the private equity firm actually allows them to shine. They will flood you with analysts. They have built-in relationships with low-cost specialized law firms, brokers, and diligence partners to help you analyze benefits, liabilities, as well as wage and hour issues.

As the company grows, you’ll build your own in-house deal team and slowly transition the entire process away from the private equity sponsor as you develop capability.  

An in house deal team may include hiring a general counsel, a business development person, financial analysis (FP&A team), and some number of integration specialists. At my current company, we added all the required key players as employees and built an entire deal team in-house over a two year period.

Why not use consultants? We do for some tasks, but we added the dedicated staff because buy and build is not a one-time project for us—it’s a way of life for many years to come, and given the shareholder value it adds, having a skilled team on our payroll is critical.

Integration of Acquisitions

Like any action a company takes, an integration will go smoother when it’s well planned. You need an integration playbook that answers the following questions (and more):

• Are you going to remain two separate businesses or pull the second business in?
• Is the entrepreneur or management team sticking around to join your team?
• What are you going to do with the employees? Are the benefits different?
• Is technology different? Is the software different? How do you bridge those gaps?
• Is there an overlap between your customers and their customers?
• Are the contracts different?

This playbook will take the integration and break it down into Gantt charts and timelines with tasks, owners, and an orderly flow. It requires a skill that most private equity firms can help with. They can deploy assets and resources from their own organization. They can also help make introductions to consulting groups that specialize in integrations.

A generic integration playbook should be on the shelf and adapted for specific situations as soon as you identify a target. Begin to look at how to integrate the business and what things will look like after the deal closes. When we purchased a laundry company in a new country, we needed experts to help us with the new laws and contracts. We hired a consulting group to help us plan for that acquisition and integration. The money was well spent and added shareholder value. The consultants had experience with large-scale integrations, and they could help us clearly identify potential issues in a new country.

For more advice on the buy and build strategy, you can find The Private Equity Playbook on Amazon.

Adam Coffey has spent the last eighteen years as president and CEO of three national service companies: Masterplan, WASH Multifamily Laundry, and now CoolSys - all of which were owned and sold multiple times by private equity firms. Known for building strong employee-centered cultures, and for executing a buy and build strategy, Adam is highly sought after by private equity and is considered an expert in running industrial service businesses. He is a former GE executive, an alumnus of UCLA, and a veteran of the United States Army.