Add-On Acquisitions in Lower Middle Market Private Equity
By Paul Wolpert
According to industry surveys, while the second quarter of 2020 continued a COVID-propelled downward trend in M&A deal activity, there was a sharp increase in the proportion of sponsor-backed “add-on” acquisitions relative to overall deal volume. One survey found that deal value and deal count declined 41.1% and 24.2% compared to an already anemic Q1 2020 (See Pitchbook’s North American M&A Report for Q2 2020). But the same survey found that add-on deals accounted for just over 70% of all buyouts for the quarter. This represented a significant increase from pre-COVID-19 levels.
While add-on acquisitions have gained increased prominence among larger buyout funds as a result of the pandemic (as they seek to deploy capital in lower-risk transactions and at lower multiples), many lower middle market private equity funds have long made use of add-ons as part of a “buy and build” strategy. This strategy involves the purchase of a platform portfolio company followed by strategic (typically smaller) add-on acquisitions which complement and grow the platform company.
Depending on the specific circumstances of the transaction, the add-on acquisition may be legally structured as:
- a stock purchase, in which the platform company purchases the add-on company’s stock (or membership interests) and makes the add-on company its subsidiary;
- an asset purchase, in which the platform company acquires all or some portion of the assets of the add-on company; or
- a merger, which can be structured as a direct merger, forward triangular merger, or reverse triangular merger.
In order to be successful, the private equity model requires, among other things, significant growth in a short period of time. To achieve this, buyout funds seek to acquire platform companies that have strong organic growth potential – companies through which the fund can build value by increasing operating efficiencies, lowering costs and expenses, and growing revenues. In order to supplement and accelerate this organic growth, funds pursuing a buy and build strategy (including many lower middle market funds) will seek add-on acquisitions for the following reasons, among others:
- incremental revenues which are achieved more quickly and efficiently than generating additional business organically;
- synergies that can lower costs and increase profit;
- potential for increased geographical footprint;
- potential for increased product offerings; and
- lower valuation multiples as compared to larger platform deals.
Lower middle market business owners also derive benefits from an add-on sale. The prominence of the buy and build strategy among lower middle market and other buyout funds has created a market for small business targets that would not generally meet the criteria for a platform or traditional buyout deal. In addition, since an add-on deal has characteristics of both a strategic and a private equity transaction, sellers can benefit from the usually more favorable valuations associated with strategic acquisitions (due to adjustments associated with anticipated synergies) while also potentially sharing in the upside through PE-style equity rollover arrangements.