Buy and build and multiple arbitrage

Key takeaways

• Smaller companies trade at lower multiples because they carry more concentration, key person and financing risk, and fewer buyers can bid for them.
• The blended entry multiple is total purchase price divided by total acquired EBITDA; for Crestmoor it falls from 11.0x for the platform alone to 9.23x after three add ons.
• Re rating the acquired EBITDA from 9.23x to an 11.0x exit multiple creates $113.0m of value; EBITDA growth and synergies at the exit multiple create $197.9m.
• The split depends on ordering, as in any EBITDA and multiple bridge, so state the convention used.
• If synergies never arrive and the exit multiple stays at the blended entry level, the sponsor's IRR falls from 25.4 percent to 15.9 percent: the arbitrage is only real once the group is sold as one business.

Platforms and add ons

The platform is the first acquisition and the base for everything that follows. It needs a management team that can run a larger business, finance and IT systems that can absorb new companies, and enough scale to finance the add ons, usually through an acquisition facility agreed with the lenders at closing. Sponsors often pay a full price for a good platform, because the platform is what makes the cheaper add ons possible.

Add ons are typically founder owned or family owned businesses with EBITDA of a few million dollars. Many have never run a sale process and some have only one or two realistic buyers. The sponsor's pitch to them is liquidity, a home for their staff and customers, and often a chance to roll part of their proceeds into the group's equity.

Fragmented markets suit the strategy best: many small providers, no dominant player, customers who value national coverage or a broader service offer, and costs, such as purchasing, insurance, software and back office, that fall per unit as the group grows. Commercial services such as fire safety, testing and inspection, veterinary practices, dental groups and insurance brokerage are common examples.

Why small companies trade at lower multiples

A multiple is the price of a dollar of EBITDA, and a buyer pays less for a dollar that is riskier or harder to finance. Small companies usually depend on a few customers and on the founder, have thinner management, less reliable financial reporting and less negotiating power with suppliers. Each of those raises the chance that EBITDA falls after the sale, so the buyer discounts it.

Fewer buyers can bid, too. A $5m EBITDA company is too small for most large sponsors and for many corporate acquirers, while lenders offer less leverage and at higher spreads. Less competition and less debt both mean a lower price. As the business grows, each of those discounts narrows: more buyers can bid, more lenders compete, and the earnings look more durable.

Worked example: Crestmoor Fire and Safety

Crestmoor Fire and Safety, a hypothetical installer and inspector of fire protection systems, is bought as a platform for $440.0m, 11.0x EBITDA of $40.0m. Over the first two years it buys three regional competitors: Add on A with $8.0m of EBITDA at 6.0x, Add on B with $6.0m at 5.5x and Add on C with $10.0m at 7.0x. The three add ons cost $151.0m in total for $24.0m of EBITDA, an average of 6.29x.

The blended entry multiple is the total paid for the group divided by the EBITDA bought. It is the number that matters, because it is the average price of every dollar of EBITDA the sponsor will try to sell at exit.

Integration risk and synergy realisation

Multiple arbitrage is not automatic. A buyer at exit pays the platform multiple only for a business that looks like one company: one brand or a coherent set of brands, one finance function, one set of systems, consistent pricing and a management team that runs the whole group. A loose holding company of acquired businesses still reporting separately will be valued closer to the sum of its parts, at multiples near what was paid for them.

Synergies are where plans most often fall short. Cost synergies, such as shared purchasing, insurance, software and back office, are more reliable than revenue synergies such as cross selling, but even cost synergies tend to arrive later and smaller than the acquisition model assumed, and they cost money to achieve. The Crestmoor case assumes 70 percent of the targeted savings, a deliberately cautious figure. The equity view below shows how the return moves when integration goes worse.

When buy and build works

The strategy works when four conditions hold together: a fragmented market with a deep pipeline of willing sellers, a platform management team that has integrated businesses before, a lender group willing to fund add ons on agreed terms, and a credible exit buyer who will value scale. Remove any one and the return leans on hope.

It also works best when the sponsor is disciplined on price as the strategy becomes visible. Once competitors see a roll up working, other sponsors start buying in the same niche, add on multiples rise, and the gap that created the arbitrage narrows. The blended multiple is a running number, and the board should see it after every deal next to the exit multiple the plan assumes.