Roll-Up Roll Up – Circus Tricks by Investment Master Class
A roll-up is effectively an arbitrage play. An acquisitive listed company buys another company [usually unlisted, but not necessarily] on a lower multiple which ordinarily is accretive to the acquirers earnings. The market/analyst community rewards the acquisitive company with high future earnings forecasts and a higher multiple to reflect this higher growth.
The acquisitive company is often consolidating a fragmented industry and the stock market puts a premium multiple on the company which allows the acquisitive company to raise equity or debt to continue to buy other assets [ie roll-up the industry] and drive earnings. It becomes a circular function. It all works well in theory until it doesn’t.
Over the years I’ve seen a lot of roll-ups blow up and usually there are a number of common factors involved.
David Einhorn described the process in his book ‘Fooling Some of the People All of the Time‘ when discussing his short position in ‘Century Business Services (CBIZ), a ‘roll-up’ of accounting service firms with lousy accounting itself’ …
[drizzle]”In a roll-up, a consolidator typically buys small, private companies at a lower multiple than the consolidator receives in public markets. Every acquisition is accretive to earnings, which drives the stock price higher and enables the consolidator to use its currency to do more acquisitions of private companies in a never ending virtuous circle”
The discussion on roll-ups is well explained by George Soros’s REFLEXIVITY theory in his book the Alchemy of Finance [see The Case for Mortgage Trusts – pg61]. In discussing the roll-up trend in mortgage trusts Soros notes..
“The conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price investors may be willing to pay for those earnings. This method is inappropriate to the analysis of mortgage trusts because the price investors are willing to pay for shares is an important factor in determining the future course of earnings”
The key difference between a roll-up and a normal corporate is that the roll-up requires an ongoing premium market multiple to continue to drive growth and maintain that premium multiple. Plenty of analysts overlook this FACT.
Most companies earnings are not reliant on the whim of the stock market [financials/highly geared companies can be an exception]. Seth Klarman explains this with reference to George Soros’s REFLEXIVITY theory in his book Margin of Safety..
"Stock price[s] can at times significantly influence the value of a businesses. Investors must not lose sight of this possibility. Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability and bankruptcy"
Poor acquisitions - M&A is not easy and most transactions fail. In the case of selling businesses, the vendors are in a position of power. They know the business better than the buyer.
"We have all the difficulties in perceiving the future that other acquisition minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking 'just fine'" Warren Buffett
Lack of Organic Growth - the roll-ups typically need acquisitions to fuel growth as pedestrian underlying growth alone will not justify the high multiple placed on the company. When management is largely focussed on acquisitions often their existing business are mis-managed and promised acquisition synergies may not materialise.
Accounting Issues - There can be questionable practices in regards to accounting of the acquired companies to boost EPS growth. While accounting earnings may look good often cash flow does not.
Law of Large Numbers - In the early days, a roll-ups acquisitions tend to represent a larger percentage of the underlying asset base so can be highly accretive. Over time, larger and larger acquisitions are required to move the dial on EPS growth as the asset base expands. As the industry consolidates, often imitators enter the market increasing competition and the prices to be paid for further business acquisitions. Larger acquisitions tend to increase the risk profile of the company and may require bridging finance.
Debt - Roll-ups often utilise debt as an interim measure to fund acquisitions prior to equity raising. As debt levels rise risk also rises. When combined with accounting issues [ie earnings higher than cash flow] this can be a deadly combination.
Marathon Asset Management remind us..
"When debt propels growth rates and equity returns higher, enthusiastic investors may too easily forget the dangers inherent in financial leverage"
"When conditions change, very quickly (and more often than not, very unexpectedly) debt, hitherto unnoticed takes centre stage. Those who comfortably applauded the results of leverage in the good times then find themselves caught in a negative spiral as the process reverses"
Fraud/Over Promotion - when management need to keep promising growth via acquisitions there can be a temptation to try and paper over underlying business issues to meet market expectations.
Overconfidence/Groupthink - when a management team has made a string of successful acquisitions they can become overconfident. Without a thorough unbiased review of the business, a board may overlook risks involved in the acquisition process.
"Of one thing, however be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairytales are emperors told they are naked" Warren Buffett
The end result is ordinarily an equity market de-rating of the stock. When expectations of strong growth slow the stock price can get decimated as analysts cut their earnings forecast and investors no longer are willing to pay such a high premium. A double whammy - earnings and PE de-rate. When equity prices sink below the price of previous capital raising investors often lose support for the stock. Stocks can enter a death spiral.
Both Warren Buffett and George Soros have discussed the conglomerate roll-ups in the 1960's. In the Alchemy of Finance, Soros noted ..
"The key to the conglomerate boom was a prevailing misconceptions among investors. Investors had come to value growth in per-share earnings and failed to discriminate about the way earnings growth was accomplished"
Warren Buffett's 2014 Annual Letter also touched on the subject.
“In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his “bold, imaginative accounting.” Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be.
Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice. Once again, it became evident that business models based on the serial issuances of overpriced shares – just like chain-letter models – most assuredly redistribute wealth, but in no way create it. Both phenomena, nevertheless, periodically blossom in our country – they are every promoter’s dream – though often they appear in a carefully-crafted disguise. The ending is always the same: Money flows