At a glance
Add-ons make sense because smaller businesses are cheaper than larger ones. Importantly, this multiple arbitrage holds even when overall multiples come down. Operating synergies add further upside.
A prerequisite for a successful M&A strategy is a degree of market fragmentation. We analyze this on multiple levels of granularity and also weigh in growth and profitability to unearth the most attractive niches.
Those more ‘pristine’ industries where PE ownership is still less penetrated is of particular interest to a differentiated investment thesis. We point out exactly those niches, factoring in their overall attractiveness.
Acquisitive upside
Before we dive into the details, let us take a step back. Why does buy-and-build actually work? The easy answer is that smaller assets trade at a discount relative to larger companies. So combining multiple assets and selling the bundle means an easy gain. Our transaction data confirms as much, showing that as EBITDA increases, multiples rise on average. However, what is interesting is that this is largely only taking place in the sub-€10m EBITDA space. The effect virtually wears off completely around the €25m EBITDA mark. This is important, as it underpins that multiple arbitrage from add-ons either requires a small cap strategy or, to make a significant impact in the large cap space, a rather high volume of smaller tuck in acquisitions.
Figure
31
Adding on smaller assets to a larger platform enables multiple arbitrage
Notes: Based on an 'everything-else-equal' analysis isolating the role of EBITDA size in transaction multiples. Source: Gain.pro
Importantly, there is another benefit to M&A. As our data shows, operating synergies are real. In fact, businesses engaged with continuous acquisitions managed to expand margins more than twice as much as companies that did not engage in M&A.
Figure
32
An active buy-and-build strategy drives operating synergies leading to margin improvement
Notes: Based on companies of all ownership types with reported revenue and EBITDA figures for 2017-2021. Source: Gain.pro
Slightly surprised by the significance of the result ourselves as well, we ran the following analyses which check whether this might be due to spurious correlations with overall performance (if you do well you do more M&A) or ownership type (PEs do more M&A). But as shown, the take-aways hold also when running such checks.
Figure
33
Companies pursuing M&A increase margins more than twice as much as others
Notes: Calculation based on companies of all ownership types with reported revenue and EBITDA figures for 2017-2021. Source: Gain.pro
Figure
34
The positive impact of buy-and-build holds also when looking at only PE-held companies
Notes: Calculation based on companies of all ownership types with reported revenue and EBITDA figures for 2017-2021. Source: Gain.pro
Fragmented markets
Now we know that well-executed bolt ons are lucrative, the question is where to find them. To examine this we calculate the Herfindahl–Hirschman index on the basis of our Gain.pro dataset. This data method gives a good indication of the level of concentration of a pool of companies.
Figure
35
Levels of market concentration strongly vary by sector
Note: HHI calculated by dividing revenue of companies through total sector revenue, squaring then summing it. Source: Gain.pro
Figure
36
On the sub-sector level differences are even more pronounced
Note: HHI index calculated by dividing the revenue of any company within a subsector by the total subsector revenue, squaring it and summing this figure. Source: Gain.pro
Consolidation is most advanced in the FS sector whereas services, consumer and TMT are most fragmented.
Going one layer deeper and looking at the market concentration on a subsector level, the HHI index logically indicates less fragmentation. As expected, the construction, manufacturing and professional services subsectors are most fragmented, leaving more room for consolidation. In contrast, raw materials, biotechnology and insurance stand out as the most consolidated subsectors.
However, the only sensible level to analyze concentration is at the granularity of specific niches. Hence why we go yet another layer deeper. In addition, we add in the axis of organic growth to illustrate the level of market maturity
Figure
37
Combining market concentration with organic growth unearths attractive consolidation candidates
Note: Average organic revenue growth calculation is based on the companies' last 5-year financial statements. Source: Gain.pro
This perspective immediately makes some interesting niches visible, such as insurance services which shows a fair bit of growth in combination with low levels of market concentration. But growth is not all that matters – industry profitability levels are equally interesting. When plotting this against fragmentation, less fragmented markets with higher profitability (e.g. business management software) and more fragmented markets with lower profitability (e.g. alternative proteins) become visible. Combining all three metrics (which goes beyond a 2-by-2 depiction of the data) enables investors to find industries that combine traits of growth, profitability and fragmentation. An interesting example showing these characteristics is the healthcare IT industry. Opposed to that, many VC-backed niches such as EV charging, show low market concentration and high growth but today often still lack profitability. Overall, the very differently performing industries across sectors and subsectors outline the need for an in-depth target analysis at the most granular level possible since fragmented industries with comparably high organic growth and profitability can be found across all sectors.
Figure
38
Plotting market concentration against EBITDA margins visualizes additional attractive niches
Note: HHI index calculated by dividing the revenue of any company within an industry by the total industry revenue, squaring it and summing this figure. Additionally, the average EBITDA margin calculation is based on the companies' last 5-year financial statements. Source: Gain.pro
Uncharted territories
Finding a fragmented space is one thing, but if there is already a strong presence of other PE houses, then it may not be that hidden gem that was hoped for. That is why we check for the level of private equity penetration on the same 3 levels of granularity as analyzed earlier. In addition, we check for the average number of add-ons per company within those industries. This serves as a proxy for the degree of maturity of already ongoing buy-and-build plays.
A first observation is that the degree of PE ownership heavily correlates with the level of buy-and-build activity that can be observed on a sector level. For instance, the services sector leads the curve with the highest PE penetration (roughly 35% of all companies) and also has the highest bolt-on volume with on average circa 3 add-ons per company. Materials & energy can be found on the lower end of the curve with the lowest PE penetration (around 20% of companies) and 1-2 add-ons per company on average.
Overall, the level of sector penetration is largely linked to the performance strength on previous analyses when we compared organic growth with cyclicality and EBITDA margins. Services, financial services, science & health and TMT lead the curve whereas materials & energy, industrials and consumer are on the lower end of the curve. One could think that those sectors are less popular among PE investors. However, industrials and consumer sectors demonstrate a very similar attractiveness to PE investors as services and TMT when looking at the number of PE investments.
Figure
39
The services sector is relatively the most penetrated by PEs
Notes: Calculation based on companies' last 5-year buy-and-build activity. Source: Gain.pro
Figure
40
Insurance and telco services are heavily penetrated sub-sectors
Notes: Calculation based on companies' last 5-year buy-and-build activity. Source: Gain.pro
The correlation remains unchanged on a subsector level where we see many services subsectors on the top right versus materials & energy and industrial subsectors on the bottom left. The subsectors show very similar PE penetration and buy-and-build activity as the sectors they are part of. However, a few outliers can be observed, for example biotechnology with roughly 15% penetration and around 1 add-on on average.
Figure
41
PE-penetration heavily varies on a granular industry level
Notes: Calculation based on companies' last 5-year buy-and-build activity. Source: Gain.pro
Lastly, on an industry level the picture becomes even more dispersed. We can find a lot of industries in the low PE penetration (below 30%) as well as the low buy-and-build activity (below 2 add-ons) quartile. There are also more outliers with a few industries showing very high PE penetration (50-60%) such as wealthtech, exhibition management and security systems. Also with regards to buy-and-build activity, some outliers can be found with high buy-and-build activity (more than 5 add-ons on average) such as ERP software development or media chains. In all, the true value is in the detail here, as some niches certainly look underpenetrated in relation to their relative attractiveness.
