Don't Get Rolled Up by Rollups!

Every business owner should be extremely skeptical of the latest hot merger and acquisition fad: the roll-up deal.

In a rollup an organizer consolidates a fragmented industry by acquiring small private participants, melding them and taking the entity public. The best-known practitioner is probably Wayne Huizenga (Republic Industries, Blockbuster and Waste Management – not the Florida Marlins).

You should be skeptical because the image and reality of rollups are distinctly different. The image: roll-up promoters pitch value creation through synergies, economies of scale and other benefits of size. The reality: small businesses are unique, depend heavily on owner-managers and cannot be easily homogenized in a corporate mold. This entails major changes in personnel, policies, and procedures that drastically alter the acquired businesses. Consolidators must be exceptionally adept since they often have to buy and operate dozens of businesses to become large enough to qualify for public offerings. Businesses under $50 million in sales are too small to attract larger investment bankers. A rollup of $5 million enterprises requires 10 successful acquisitions and integrations to achieve critical mass. This is clearly a highly risky proposition.

The motivation of roll-up organizers is the perceived opportunity to buy at low multiples and sell via an IPO at high ones. Rollups are, in the final analysis, a financial technique to reallocate wealth, not a business strategy to create it.

Rollups also have a second, subtle image versus reality conflict based on an erroneous appraisal of their rewards and risks. A business owner participating in a rollup will typically sell for a higher price than he/she might otherwise achieve. A tax-free exchange of stock sweetens the deal. The rollup then goes public at an even higher price, creating a major gain. Premium prices, liquidity and tax deferral are very powerful incentives, indeed.

But big rewards entail big risks! The reality of rollups is that owners trade control positions in successful businesses for minority interests in others. Right off the bat they surrender authority, not only over their companies but also over the sale of the rollup's equity. To make matters worse, they receive illiquid stock. It is often subject to significant restrictions on sale before and after the IPO (because owners are insiders subject to SEC regulatory and disclosure requirements). Rollup stock prices are subject to major pre-offering risks, mainly that IPO's may never happen! This is the worst-case scenario: an owner trades control of his/her business and primary asset for unmarketable, potentially worthless pieces of paper.

Rollups are a modern variant of the 1960's-style conglomerate, whose rationale was that combinations of businesses in different industries insulated stockholders from many risks and created value-adding synergies between divisions. In addition, capital could be “redeployed” from under-performing to growing businesses, creating more value. It turned out that few people could manage disparate businesses well. (Jack Welch and General Electric are a prominent exception.) Conglomerates were also attractive because, due to old accounting rules, acquisitions increased earnings per share, which could be perpetrated by issuing yet more stock to finance yet more deals. The subsequent well-documented decline of the conglomerate (LTV, ITT and Litton Industries) fueled another fad – the leveraged buyout.

Rollups are conglomerates specializing in one industry. They are premised on the organizers' ability to create value from and manage a large business composed of many small, diverse parts, an issue on which the jury is still out. Conglomerates and rollups require the availability of suitably priced acquisitions and high and rising stock prices. Neither lasts indefinitely. There are only so many car dealerships to buy and the stock market does not go up forever.