Art of the Possible – M&A Roll-ups in Tech and Software (1/2)

February 2024

The Rise of Tech Roll-ups

In recent years, the mergers and acquisitions (M&A) landscape has significantly changed, with roll-ups emerging as a preferred strategy for growth. Roll-ups involve acquiring and consolidating smaller companies to create scalable growth platforms.

The macroeconomic context has played a crucial role in shaping this shift. Although borrowing costs are expected to decline, interest rates remain elevated compared to the historically low levels seen in 2021 and 2022. As a result, M&A activity has shifted toward smaller, more focused transactions that prioritize value creation and require less reliance on debt. Notably, roll-ups have become prominent in the mid- and lower-middle-market software sector, accounting for approximately 70% of deals in this space.

The appeal of roll-ups goes beyond financial prudence. Both strategics and investment funds are increasingly attracted to this M&A model for its ability to unlock synergies, efficiently build scale, and leverage existing operational strengths. However, executing a successful roll-up strategy necessitates careful consideration of key factors, including identifying suitable acquisition targets, managing integration, and ensuring alignment with overall business goals.

This emerging trend highlights the importance of strategic foresight and disciplined execution for those considering roll-ups as a pathway to growth. Whether motivated by cost optimization, market expansion, or enhanced competitive positioning, roll-ups offer a compelling blueprint for sustainable success in today’s evolving M&A landscape.

Types of M&A Strategies

Private equity investments, diverse in their goals and execution, often align with three primary strategies: venture, growth, and buyout. Each represents a distinct pathway to unlocking value, shaped by the nature of the businesses they target and the outcomes they aim to achieve.

Venture strategies are rooted in the promise of innovation. These investments focus on new technologies, groundbreaking business models, or other disruptive ideas. The allure lies in their potential to redefine industries and deliver outsized returns. While risky, the rewards for successfully backing the next transformative idea are unparalleled, making venture investments a catalyst for change in the market.

Growth strategies adopt a more measured approach. Here, the focus shifts to proven business concepts that require capital to scale. Whether expanding operations, entering new markets, or optimizing resources, growth strategies enable businesses with solid foundations to reach their next phase of success. These investments often bridge the gap between potential and realization, fostering sustained development.

Buyout strategies, by contrast, emphasize transformation. They aim to acquire and enhance existing businesses, often through restructuring or operational improvements. A prominent subset of this strategy is the buy-and-build approach, commonly known as a “roll-up,” “add-on,” or “bolt-on” strategy. This method identifies a core acquisition target that serves as a foundation, with subsequent acquisitions folded into it to create a larger, more cohesive enterprise.

The buy-and-build approach exemplifies the synergy-focused mindset of private equity. A typical implementation might involve acquiring a strong regional business and augmenting it with complementary companies from other areas to establish a nationwide presence. The success of this strategy lies in its ability to create scale, streamline operations, and leverage shared resources for exponential growth.

In recent years, add-on deals have surged in popularity, reflecting their growing importance in private equity portfolios. According to Bain & Company, add-ons accounted for 72% of all North American buyouts by deal count in 2022, with a significant portion supporting buy-and-build strategies. This trend underscores the appeal of combining multiple businesses into a unified entity, unlocking efficiencies and driving competitive advantage.

Ultimately, each of these strategies—venture, growth, and buyout—offers unique pathways to value creation. Yet they all share a common thread: the pursuit of opportunities to reshape businesses and markets, leaving an indelible mark on the industries they touch.

The Rise of Serial Acquirers

The trend of serial acquirers in mergers and acquisitions (M&A) is gaining momentum, with many companies choosing to grow primarily through acquisitions instead of relying solely on organic expansion. Successful serial acquirers have consistently delivered impressive returns for early investors, thanks to distinct strategies that can be analyzed across two key dimensions: the degree of integration of the acquired companies and the industry focus of the acquirer.

Based on these dimensions, serial acquirers typically fall into three main archetypes: roll-ups, platforms, and holding companies (HoldCos).

Roll-ups concentrate on consolidating a single, homogeneous industry, often with a geographical focus, in order to achieve synergies driven by scale. The advantages of this approach include the ability to dominate the market and, as a result, potentially increase prices or reduce costs without compromising demand. Roll-ups can also benefit from back-office consolidation, procurement efficiencies, and opportunities for cross-selling. Additionally, the focused nature of their strategy allows for faster execution, simpler due diligence, and quicker integration, enabling success to be measured in a shorter timeframe. However, challenges do exist, such as a limited total addressable market (TAM) that can constrain long-term growth and strong competition that may hinder the necessary scaling.

To navigate the roll-up landscape effectively, it is essential to assess the market share of consolidators, the quality of prospective acquisition targets, and trends in EV/EBITDA multiples. Furthermore, exploring potential expansions into international markets or adjacent industries can be beneficial.

Platforms find a balance between roll-ups and holding companies. They typically operate within a specific industry or business model while allowing for some decentralization across the organization. Some components of a platform may even function like mini-roll-ups. One advantage of platforms is that they offer broader TAM expansion than roll-ups and have standardized M&A processes that streamline sourcing, due diligence, and management. Nevertheless, they may face a slower path to establishing credibility compared to their roll-up counterparts. For platforms, key considerations include assessing their scalability to manage a high volume of deals—typically more than ten annually—without facing bottlenecks.

HoldCos take an agnostic approach to industry or business model and maintain fully decentralized structures. They often aggregate various platforms, roll-ups, and diverse businesses, similar to models exemplified by Berkshire Hathaway. The advantages of holding companies lie in their limitless potential for expansion across different industries and the cost-effective exposure they provide to skilled capital allocators. However, the challenges here include the difficulty in standardizing processes for discovery, valuation, and integration, given the heterogeneity of their targets.

Additionally, they may experience a slower M&A velocity and a reliance on large, high-priced deals, as well as a heavy dependency on the quality of leadership, which can create succession risks. It is important to note that holding companies are particularly prevalent in emerging markets, where family businesses tend to reinvest in a diverse range of industries. Successful examples can also be observed in the United States and Europe.

Over time, the distinctions between roll-ups, platforms, and HoldCos can blur. For instance, roll-ups may evolve into platforms by expanding their TAM or diversifying their acquisitions. Conversely, platforms may begin to resemble holding companies as they start to operate across various industry groups.

The Roll-up Strategy

The buy-and-build, or roll-up, strategy has become a hallmark of private equity investment, providing a transformative approach to value creation. At its core, this strategy involves establishing a "platform" company—a foundational business with the potential to integrate additional acquisitions within the same industry, creating a larger, more competitive enterprise. Its success hinges on achieving economies of scale, operational synergies, and enhanced market positioning, all of which can redefine an industry landscape.

At the outset, investors select a target company that will act as the core investment for future acquisitions. This target could be a private firm, a public company that can be taken private, or a division of a public company poised for a private spinoff. The goal is to identify a company with strong growth prospects that may currently be underperforming due to issues such as excessive expenses, poor management, or lack of focus within a larger corporate structure.

It's essential that the chosen target can accommodate a business model that includes multiple acquisitions down the line. For this reason, the general partner (GP) in a buy-and-build scenario seeks specific characteristics in the initial target, such as a capable management team, up-to-date technology, excess capacity, or a solid brand reputation.

The industry sector plays a crucial role in the strategy's success. An ideal industry is one that supports the rise of a new key player, ideally one that is fragmented and lacks a dominant competitor. Moreover, it should offer potential acquisitions that could enhance the core business when combined.

Ultimately, the enterprise created through this strategy is likely to be either taken public or sold, providing a viable exit strategy for investors.

The roll-up strategy in private equity has seen a significant shift in perspective regarding service businesses. Traditionally, there was a belief that acquiring these businesses was not a viable option since they often lacked what was deemed a "secret sauce." This term referred to specialized products or unique attributes that created barriers to entry, making such companies more defensible in the market. As a result, roll-up strategies typically focused on product-oriented companies with distinctive features that could be consolidated.

However, insights into the software and service sector, particularly within the lower middle market, unveiled a different narrative. Many of these service businesses struggled with basic operational functions such as accounting, billing, and collections, which often left money on the table. This weakness, once viewed as a drawback, transformed into an opportunity for savvy investors. Though these businesses may not have had a unique selling proposition, they presented a chance for aggregation, professionalization, and eventual resale.

This inversion of a commonly held opinion that what was once seen negatively—a lack of unique features—could actually be a strength. The service aspect, which fosters customer loyalty and repeat business, became the cornerstone of this strategy. This evolving understanding has driven the resurgence of roll-up strategies in a sector that had previously been overlooked.

When examining how the buy-and-build strategy creates value, several mechanisms come into play. First and foremost, acquiring add-on companies and integrating them into a core business can yield significant operating efficiencies and economies of scale. Moreover, the experienced management teams from these acquisitions can enhance overall operations.

Combining smaller players at lower valuations into a singular, more formidable enterprise can lead to multiple expansion, allowing the consolidated entity to achieve a higher earnings multiple. Profit margins also stand to improve as the newly strengthened, competitive company benefits from a more consolidated market presence. Additionally, there may be opportunities for cross-selling among the client bases of the merged firms, further enhancing value creation.

 In essence, the buy-and-build strategy not only capitalizes on the synergies that arise from consolidation but also leverages the inherent strengths found within service-based businesses, transforming them into valuable assets.

Mechanics of Roll-up Strategy

At the core of this approach lies the principle of multiple arbitrage. In the market, larger enterprises often receive higher multiples of EBITDA, which creates an opportunity for multiple arbitrage—one of the central drivers of value in roll-up strategies. In a typical roll-up, the sponsor acquires smaller businesses, which generally operate at lower EBITDA multiples, and integrates them into a larger platform company. The resulting combined earnings are then valued at a higher multiple, allowing sponsors to unlock significant value and amplify their returns upon exit.

To illustrate, consider this simplified scenario: A platform company generates $10 million in EBITDA and is acquired at a multiple of 10.0x, leading to a purchase price of $100 million. Subsequent add-on acquisitions, which contribute an additional $10 million in EBITDA, may be acquired at an average multiple of 5.0x, totaling $50 million. Once these entities are integrated, the combined platform with $20 million in EBITDA is valued at the platform multiple of 10.0x, resulting in an enterprise value of $200 million. This substantial uplift in value is driven primarily by multiple arbitrage. This scenario illustrates how the sponsor’s initial investment can double in value purely through the integration process, without factoring in operational improvements or synergies.

The success of a roll-up strategy heavily relies on selecting the right platform company. Attractive characteristics for a platform include a strong management team capable of ensuring the smooth integration of add-ons, healthy financials that support debt financing for future acquisitions, and scalability potential to foster growth. Generally, the platform is purchased at a higher EBITDA multiple than the add-on acquisitions, highlighting its foundational importance in the strategy.

The roll-up process typically unfolds over time, with add-on acquisitions being sourced and integrated during the platform’s hold period. The smaller businesses are often acquired at lower multiples, facilitating value creation through their integration into a more efficient, larger platform. Integration offers several benefits, such as economies of scale, where redundancies are reduced and operational efficiencies achieved, and cross-selling opportunities that emerge from combining customer bases to expand product or service offerings.

Furthermore, one of the key advantages of roll-ups is leveraging debt to finance add-on acquisitions. As the platform grows and builds credibility, lenders become more inclined to provide capital. This approach enables sponsors to reduce their equity investment while maximizing the equity value of the combined platform. For instance, using debt to cover the $50 million cost of the add-on acquisitions can lead to enhanced equity returns, resulting in a 2.0x return on equity—achieved solely through multiple arbitrage.

While multiple arbitrage stands out as a central value driver, successful roll-ups often yield additional benefits, including operational synergies that enhance profitability, market consolidation that strengthens competitive positions, and cross-selling opportunities that generate incremental revenue streams. When combined with the financial leverage obtained through debt financing, roll-ups present an appealing strategy for creating significant value. A well-executed roll-up can transform fragmented market players into a dominant, high-value enterprise ready for a lucrative exit—be it through a public offering or a strategic sale.

M&A Roll-up in Tech & Software

Notably, many sectors are experiencing roll-up strategies, with a marked shift in focus toward technology and healcare services. When it comes to the software industry, a rollup refers to the process of acquiring and merging smaller companies within a specific market segment. This strategy aims to achieve economies of scale, streamline operations, and claim market dominance. Although commonly utilized by private equity (PE) firms, software companies also embrace rollups as a means of strategic growth within their niche.

Key components of a successful software rollup include the establishment of a platform company, which serves as the backbone for acquisitions. Generally, this is an established firm with strong infrastructure in areas like human resources, finance, and marketing that can effectively integrate complementary or competitive companies.

The strategic goals of a software rollup often involve two main types of acquisitions: complementary and direct competitor. While the former aims to build synergies by integrating related software applications, the latter poses higher risks due to potential code compatibility and customer base alignment challenges. There are various benefits to pursuing rollups, including the ability to drive innovation and attract talent by acquiring startups with innovative technologies and skilled teams. Cost efficiencies can be realized through the consolidation of operations, which eliminates redundancy in functions like marketing and research and development. Furthermore, entering faster-growing market segments can inject life into stagnating businesses, and integrating complementary software solutions can significantly enhance enterprise value.

The trend of vertical SaaS accumulators, which gained traction through Constellation Software, continues to expand rapidly, spurred by a growing demand for industry-specific software solutions. Although some might view this sector as saturated, given the emergence of over 120 serial acquirers—75 of which have entered the market in the past decade—the abundance of potential targets and the ongoing market growth present substantial opportunities.

Currently, there are approximately 150,000 vertical software businesses worldwide, with between 7,500 and 15,000 sold each year. High-quality acquisition targets typically exhibit characteristics such as a diversified customer base, strong retention rates, and a high degree of scalability. Constellation Software itself is a notable player in this space, acquiring over 100 vertical SaaS companies annually, underscoring the market's vitality.

Despite the rising competition, new acquirers can carve out their niche by honing in on specific industries, geographies, or SaaS ecosystems, as shown by companies like AscendX, Unaric, and Appfire. While there are debates surrounding the total addressable market (TAM), the continuous growth of the software sector indicates that there is still ample room for expansion. Although replicating the success of early pioneers like Constellation may be challenging today, the ongoing fragmentation and growth of the software market render this strategy viable for disciplined and focused acquirers.

Another promising acquisition model gaining traction is the facilitation of management buyouts (MBOs) and employee ownership transitions, allowing retiring owners to pass their businesses to their employees. This approach is characterized by a combination of economic incentives and social impact, promoting long-term value creation.

Consider the Teamshares model: they acquire 90% of a business at an EBITDA multiple of 4 to 5 times, leaving the retiring owner with a 10% stake while distributing 15% in newly issued shares to the employees and the newly appointed president. As for distributions, cash flow is allocated into shareholder dividends (one-third) and buybacks (two-thirds), transitioning business ownership to employees over approximately 20 years. Ultimately, employees would own 80% of the business, while Teamshares retains the remaining 20%, benefiting from equity growth and royalties from portfolio services, such as unified payroll systems.

This model has found success in the U.S., where the cultural ethos values equity ownership. It aligns the interests of employees, management, and investors, enhancing performance and resilience. While adapting this model to different regions may necessitate cultural and structural adjustments, it remains an appealing framework for socially responsible and financially rewarding acquisitions.

Emerging alongside these trends is the rise of generative AI (GenAI) and large language models (LLMs), which are revolutionizing service industries by introducing unique opportunities for automation and efficiency. This shift is accompanied by serial acquisition strategies reshaping how industries consolidate, scale, and optimize for growth.

Generative AI is particularly instrumental in unlocking value within service sectors by automating cost-intensive processes, especially in businesses where significant portions of their cost of goods sold (COGS) can be automated. For example, it is successfully applied in call centers through advanced AI chatbots and natural language processing to handle customer interactions, in medical billing firms to enhance claims processing and error detection, in managed service providers to increase the efficiency of IT support, and within accounting firms to automate routine tasks like bookkeeping, compliance, and reporting.

Typically, acquirers in this domain possess strong tech teams that can either develop proprietary automation solutions or adopt leading-edge tools from the outset. This fusion of scalable service models with the potential for automation makes these businesses highly attractive acquisition targets in a landscape shaped by innovation and efficiency.

However, software rollups are not without their challenges. Issues may arise from code compatibility during integrations, cultural mismatches between merging companies, and operational inefficiencies that may lead to a loss of agility. Retaining customers also becomes a risk, especially when the acquisition alienates existing customer bases.

Successful rollups hinge on several key factors: having a clear strategy that focuses on acquiring complementary products or customer relationships, ensuring each acquisition stands independently on its financial merits, fostering long-term planning for sustainable value creation, and balancing decentralization with efficient oversight.

Timing is crucial in deciding when to pursue rollups. They make sense when there’s a strong platform company capable of leveraging synergies across customer relationships or product offerings and enhancing market presence in high-growth segments. Conversely, rollups should be avoided when acquisitions of direct competitors are motivated solely by the desire to eliminate competition, when efforts are made to scale for the sake of scaling without clear synergies, or when there’s a tendency to overpay in times of low borrowing costs or managerial overconfidence.

VC backed Tech M&A Roll-ups

The recent surge in interest surrounding VC-backed rollups, particularly with the integration of AI-enabled services, has generated both excitement and skepticism within the investment community. The concept of leveraging AI to transform traditional industries and consolidate fragmented markets presents significant potential; however, the challenges that come with such strategies, especially when fueled by venture capitalists (VCs), warrant careful examination.

At the heart of the VC-backed rollup model lies the strategy of acquiring service-based companies, implementing AI-driven efficiencies, and ultimately creating scaled, profitable enterprises. This approach holds considerable appeal for several reasons.

First, AI-driven transformation offers the possibility of automating many operational processes, thereby lowering the barriers to software product development. As a result, distribution and customer relationships emerge as the primary sources of value. Additionally, the "buy your customers" strategy redefines conventional sales approaches; instead of attempting to sell AI tools to legacy businesses—a notoriously challenging endeavor—software companies can acquire these businesses directly, securing control over the end-user relationship.

Moreover, many target markets remain highly fragmented, filled with inefficient, low-tech operators. By applying technology and scaling these businesses, it is theorized that substantial value can be unlocked. However, a significant portion of the enthusiasm surrounding this trend derives from the typical momentum investing seen in venture capital, often driven by successful case studies like Constellation Software and Transdigm. This has led many VCs to chase the rollup hype without a thorough understanding of its complexities.

Despite the inherent appeal, there are structural and strategic concerns that suggest rollups may not align well with the traditional VC model. One of the main challenges is the lack of expertise among VCs in executing a serial M&A strategy. While VCs are adept at underwriting high-growth, unprofitable startups, they often lack the necessary experience for navigating complex acquisitions, integrating diverse businesses, and driving operational efficiencies. This expertise mismatch often leads to suboptimal outcomes, much like when Wall Street professionals attempt to build startups.

Additionally, traditional VC fund economics are fundamentally misaligned with the objectives of rollups. Venture capital funds typically depend on a small number of high-reward investments to generate returns, taking on significant market, execution, or technical risks to foster differentiated and sustainable businesses. In contrast, rollups usually aim for steady growth via consolidation and operational improvements, lacking the risk-return profile required for the substantial returns VCs expect. Although rollups that focus on incremental AI adoption may tout capital efficiency and reduced risk, claiming ambitions to secure their final funding round, this very efficiency flags a fundamental cap on potential returns. Unlike venture-scale companies that continually reinvest in research and development and customer acquisition to create something unique and enduring, rollups bespeak a different operational ethos.

A further drawback lies in the flawed initial investments typically made by VC-backed rollups. Many start with small, sub-scale acquisitions structured like typical seed deals. This approach poses its own set of problems. For instance, starting small limits access to proprietary data and diminishes the capacity to develop transformative AI solutions. Moreover, the complexity of executing and integrating several small acquisitions can be time-consuming, particularly given the constraints of a VC fund’s ten-year lifecycle. Companies that succeed in achieving large-scale platform business models tend to amortize AI development costs more effectively, utilizing economies of scale to justify substantial upfront investments.

The allure of fragmented markets, often deemed ideal targets for roll-ups, also merits careful consideration. While consolidation can drive efficiencies and help professionalize operations, the very fragmentation that makes these markets appealing often reflects underlying structural realities, including weak network effects, low barriers to entry, and minimal economies of scale. For example, social media market consolidation has thrived due to strong network effects, whereas industries such as renovation remain fragmented due to the localized nature of services and the limited advantages offered by scale.

In many discussions, the integration of AI is framed as a key justification for rollups in fragmented markets. However, the simple application of AI does not ensure success. In fact, introducing new technology to legacy businesses can be more challenging than building a company from the ground up, particularly when simultaneously navigating the complexities of M&A.

For rollup strategies to find success, careful consideration of these dynamics is essential. It is apparent that while the vision can be compelling, the execution requires a nuanced understanding of both the market landscape and the unique challenges posed by merging and transforming businesses in this rapidly evolving environment.