Roll-ups: Take the organic route to create value

With M&A a less-attractive option, how can roll-up platforms create value? We believe that the organic route is the right way to go.

Inflation and rising interest rates are making it tougher for FS companies to grow via acquisitions. This is particularly true for private equity firms that have built roll-up platforms in wealth management and insurance brokerage, both of which are prized for their stable and consistent revenue streams.

With M&A a less-attractive option, how can these roll-ups create value? We believe that the organic route—i.e., maximizing opportunities with existing portfolio companies—is the right way to go.

How did we get here? Ironically, the current situation is a direct result of the PE industry’s success while rates were historically low from the Great Recession through early 2022. Deal volume and value soared as cheap, abundant capital kept financing costs down and pushed valuations and cash flows ever higher. Roll-up strategies thrived.

But the Fed’s aggressive tightening and the threat of recession have slowed the pace of activity. Buyers are being more selective and sellers expect valuations that no longer make economic sense. Debt servicing is much more expensive and many portfolio companies have limited access to financing.

Client conversations suggest that many roll-ups and sponsors intend to stay on the sidelines for at least the next few months. Deal making likely will pick up when buyers have a clearer sense of where rates will stabilize and what the economy will look like.

Creating value now. In the meantime, roll-ups and sponsors can adapt by creating more value from within.

They can begin with proven methods such as operational efficiencies via integration and cost reduction, and revenue synergies. They also can invest more in two areas in which they lag many other industries. The first is a robust treasury function that can benefit from rising rates by optimizing cash management and hedging against potential cash flow shortfalls. The second is a data analytics capability that can identify and evaluate potential value opportunities.

Addition by subtraction. Improving company portfolios by reducing them— i.e., pruning noncore or nonperforming assets—can be an appealing option for roll-ups and sponsors that don’t want to buy.

As we discuss in our recent paper, “Divesting in a Downturn,” divestitures have significant potential benefits. These include reallocating resources to strengthen businesses with better prospects; redeploying capital to higher- return activities such as share repurchases or deleveraging; and mitigating diversification discounts that can arise when portfolio companies have disparate financial characteristics. We expect interest in divestitures to increase while acquisitions wane. Spinoffs, carve-outs, and joint ventures are likely to be the most popular vehicles.

Just one piece, please. Sponsors that lack the appetite to acquire the whole pie should consider taking a slice instead. Partial, noncontrolling ownership stakes could take the form of straight or preferred equity, convertible debt, bespoke credit transactions, or debt-for- equity swaps, for example. Purchases could be direct or as part of larger consortia or partnerships.