Over the past decade, private equity firms have increasingly turned to roll-up strategies as a way to generate returns for their investors. Roll-ups have been particularly popular in fragmented industries such as healthcare, professional services, and industrial services. By consolidating smaller players, firms aim to create a more efficient and profitable business that can command a premium when it comes time to sell.
However, these types of transactions are becoming more challenging to execute, and new approaches for generating returns are required, as well as new people to implement such strategies.
Challenges Facing Roll-Up Strategies Today
Despite the success of roll-up strategies in recent years, firms are now facing headwinds when it comes to these types of deals.
1. Economic Factors. As McKinsey notes in an analysis titled “Bridging Private Equity’s Value Creation Gap,” recent changes in the macroeconomic environment (high interest rates, in particular) pose challenges for PE firms to rely solely on financial engineering to generate returns in roll-up deals—or any deal for that matter. For the last several decades, firms were, according to McKinsey, able to take advantage of “declining interest rates and rising asset prices to create value through financial leverage, enhanced tax and debt structures, and increasing valuations on high-quality assets.” Not only has capital become more expensive, but it’s also more scarce, making it more difficult for firms to execute add-on transactions as part of roll-up strategy.
Another big challenge is the lack of attractive acquisition targets, as many industries have already undergone significant consolidation, and more buyers with lots of “dry powder” have flooded the market. According to an analysis by the National Association of Insurance Commissioners, the number of PE funds grew from just 24 in 1980 to more than 19,000 in 2022.
Speak with an owner of a veterinary clinic, HVAC services firm or family dental practice, and you understand just how many inbound calls they receive from hungry investors. This is great for sellers, but makes it harder to find good deals and generate investment returns as a buyer.
2. Regulatory Factors. PE-sponsored deals are also coming under increased regulatory scrutiny, particularly in the healthcare industry. From Congressional hearings to agency inquiries, to new state competition, quality, access and cost laws, healthcare transactions are facing additional requirements and hurdles.
Some states now require parties to a healthcare transaction to provide notice to the state attorney general or other regulatory body at least 30, 60, or even 90 days before the transaction is set to close. During this pre-closing period, the regulator may request additional information from the parties, conduct interviews or hearings, and solicit public comment on the proposed transaction.
If the regulator determines that the transaction is likely to have a negative impact on competition or patient care, they may seek to block the transaction or require the parties to agree to certain conditions in order to obtain approval. These pre-closing notice requirements, and other required steps, can create significant delays and uncertainty in the deal process. Even if a transaction is ultimately approved, the lengthy review period and potential for conditions to be imposed can make it harder for firms to achieve their desired economies of scale and synergies.
And it’s not just healthcare transactions that are under the regulatory microscope. The Federal Trade Commission and Department of Justice recently launched a public inquiry into serial acquisitions and roll-up strategies that may have harmed competition, consumers, workers, and innovation across “all sectors and industries in the U.S. economy.”
These regulatory headwinds, combined with the scarcity of attractive targets, are forcing firms to rethink their approach to roll-ups. While some firms will undoubtedly continue to pursue roll-up strategies in untapped markets, the reality is that even these deals will likely require a greater focus on operational improvements and organic growth in order to create value.
The Shift Towards Operational Value Creation
In this new reality, a greater focus on operational value creation strategies, such as revenue growth and margin expansion, is necessary in order to deliver desired returns to investors.
One of the key ways that firms can drive operational value creation when building a roll-up platform is by ensuring that their portfolio companies have the right leadership in place. As McKinsey puts it, “linking talent to value” is critical for success.
This means recruiting leaders who have the right combination of skills and experience to implement value creation strategies, improve internal processes, and build organizational capabilities. These leaders must be able to identify growth opportunities, drive efficiencies, and create a culture of continuous improvement within their organizations.
PE firms that are able to effectively link talent to value creation in this way will be well-positioned to generate strong returns for their investors, even in the face of economic challenges, increasing competition and regulatory scrutiny. By focusing more on operational improvements and organic growth in an era where the effectiveness of financial engineering is limited, these firms will be able to create real, lasting value where the whole (i.e. the roll-up) is truly greater than the sum of its parts.
