What is an Add-On Acquisition?
An add-on acquisition is a strategy commonly used in private equity where a firm purchases a smaller company to merge it with an existing portfolio company, often referred to as the platform.
The main benefits of this approach include multiple arbitrage opportunities, synergies, inorganic growth, and LBO returns. Private equity firms and other investment firms pursue add-on acquisitions to create value for their investors and enhance returns. It’s a value creation strategy that can significantly impact the size, profitability, and market position of the combined entity.
Key Learning Points
- Multiple arbitrage, the platform company can acquire the add-on acquisition at a lower valuation multiple than its own, and then increase the combined value by applying the higher multiple of the platform
- Create Synergies by combining resources and capabilities, the company can achieve cost savings, revenue growth and operational improvements
- Provide non-organic growth the platform can expand its market share, customer base, product range, or geographic reach by acquiring the add-on, which may have complementary or niche offerings
- Strengthen LBO returns the existing debt capacity and cash flow can be used to finance the add-on, and then it can increase its equity value by paying down the debt faster and generating higher cash flows from the combined business
Why do Private Equity and Other Investment Firms do Add-On Acquisitions?
Private equity firms and other investment firms complete add on acquisitions to enhance their portfolio companies. It is also used to diversify their revenue streams, expand their market share, or enter new markets or segments. Assuming there is access to sufficient funding, private equity firms may seek bolt-on acquisitions to strengthen their holdings in preferred sectors and attractive investment areas. The end goal is to maximize returns on the investment portfolio.
Add-On Acquisition: Value Creation Strategy in Private Equity LBOs
An add-on acquisition can create value for the private equity firm or the investor by increasing the size and profitability of the portfolio company, reducing costs through synergies or economies of scale, enhancing technical capabilities, and expanding into new markets. These are similar to the benefits achieved by typical M&A activities.
Synergies from Add-On Acquisitions (Buy-and-Build Strategy)
Synergies from add-on acquisitions are a good source of value creation. Synergies are the cost savings or revenue enhancements that result from combining two companies. The private equity firm can achieve synergies by eliminating duplicate functions (such as head offices), leveraging economies of scale, cross-selling products or services, or improving operational efficiency.
Multiple Arbitrage: Platform vs. Add-On Acquisition
The value creation strategy of add-on acquisitions is based on multiple arbitrage. Multiple arbitrage is when the acquirer pays a lower valuation multiple for the add-on company than the multiple it paid for the platform company, and then revalues the combined entity at a higher multiple. This can generate an instant increase in value for the acquirer without having to instigate any operational improvements and prior to creating synergies. This is a key strategy for private equity firms undertaking leveraged buyouts.
How Add-Ons Impact LBO Returns (IRR and MOIC)
Add-on acquisitions can impact the LBO returns of the private equity firm by increasing the cash flows, the exit value, and the debt repayment capacity of the platform company. This will require significant due diligence and financial scenario modelling prior to the acquisition to ensure any add-on acquisitions are accretive to investors.
The LBO returns are measured by the internal rate of return (IRR) and the multiple of invested capital (MOIC), which are the key metrics for evaluating the performance of private equity investments.
How to Model the Add-On Acquisition
To model the add-on acquisition in an Excel spreadsheet, you need to:
- Start with the initial LBO or Platform model and create a separate sheet for the add-on company’s financials and assumptions. Create a third separate sheet to model the Base Case + Add on when merged.
- Link the add-on company’s cash flows to the platform company’s cash flows, using switches to adjust the timing of the acquisition and the synergies.
3. Calculate the purchase price and the financing of the add-on acquisition, using the same debt and equity assumptions as the platform company.
4. Calculate the exit value and the LBO returns of the combined company, using the same exit multiple and exit year as the platform company. Sensitivity analysis can be performed once completed to explore how to achieve optimal returns.
5. Compare the LBO returns of the platform company with and without the add-on acquisition (and the add on company alone).
This screenshot demonstrates returns to equity holders with the add-on acquisition:
This screenshot demonstrates returns to equity holders without the add-on acquisition:
To help create this type of model, download the bespoke Financial Edge template for combining Add-on Acquisitions to Leveraged Buyout analysis.
The Excel spreadsheet will provide all the necessary details to accurately model a base LBO and add-on acquisition with the flexibility to change assumptions to suit a bespoke case. It combines the acquisition assumptions for both deals as well as modelling the Income Statement and Cash Flow to service the debt. The template will derive returns to equity shareholders and enable detailed analysis or IRR of the deal along with year-by-year cash flows.
Conclusion
The strategic acquisition of add-ons by platform companies can significantly enhance their value through multiple arbitrage, synergies, and inorganic growth. By leveraging existing debt capacity and cash flow, platform companies can also achieve higher LBO returns, making such acquisitions a powerful tool for business expansion and value creation.
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