Buy `Em Out, Then Build `Em UpPhillip L. Zweig
Back in 1985, leveraged buyout firms were poring over spreadsheet databases looking for companies to buy and bust up. Now, many of those same firms, plus a whole new crop of others, are employing a strategy that's just as profitable and probably more productive: They're scouring the country for companies to buy out and build up.
Using a technique known variously as "platform investing" or "leveraged buildup," buyout concerns are jump-starting the consolidation of dozens of highly fragmented, inefficient, mom-and-pop industries. Sometimes, investors and entrepreneurs claim, they achieve returns that approach or exceed the 30%-plus levels earned by the LBO-breakup crowd in the 1980s.
COMMON THREAD. These mostly service-sector industries range from funeral homes, golf resorts, and health clubs to landfill sites, medical practices, and antenna towers. If there is a common thread, it is that these fields have traditionally lacked strong management and surplus capital. For the most part, they are industries where consolidation can yield big economies of scale that can be recouped by investors. Says Carl D. Thoma, co-founder of Golder, Thoma, Cressey, Rauner Inc. (GTCR), which pioneered these transactions: "It's one of the few niches today where you can get an above-average return."
While consolidation of U.S. industry is nothing new, several recent forces appear to be driving this new wave of grassroots combinations. First is the scarcity of large, undervalued public companies where quick gains can be realized through LBOs and breakups. Another is the vast amount of private equity capital that lately has been earmarked by public pension plans for nontraditional investments. Equally important, the Information Highway has not only created entire industries that can benefit from consolidation but has also provided ways to manage service businesses from central locations.
MAGIC NUMBER. The transactions typically work this way: Investors buy a small company--usually one with no more than $15 million in revenues--that serves as a "platform" to which smaller companies in the same industry can be added. Because big investors don't usually chase these companies, they can be bought for less than five times cash flow, compared with six times cash flow or higher for more competitive deals. With each new acquisition, the company wrings out more savings and boosts its leverage from, say, 50% debt to as much as 75% or more. And within a few years, backers hope, the company will expand to the magic $100 million revenue threshold where they can successfully take it public.
To be sure, the road to $100 million in revenues isn't always smooth. Investors have found that consolidation simply doesn't work in some industries. Three dogs: dry cleaners, service stations, and restaurants. Says Stephen Galante, editor of Private Equity Analyst, an industry newsletter: "Either the economies aren't there, or they don't lend themselves to centralized management."
Chicago's GTCR, which began packaging small companies in the early 1980s, now has about $400 million invested in such ventures, says Thoma. Its first and most prominent coup was Paging Network Inc. (PageNet), which began as a small acquisition in 1981 and now leads the pager industry. Others include Prime Succession Inc., a 135-unit funeral-home chain; a retail-propane distributor; and the nation's second-biggest lawn-care outfit. Says Thoma: "You get incredible synergies by combining three companies in the same market."
That's what's behind the plan by McCown De Leeuw & Co. to expand San Francisco's 24-Hour Nautilus Fitness Centers, a 34-unit chain in which it acquired a two-thirds stake late last year. The chain is now the dominant player in Northern California, but the firm wants to develop it into the nation's No.2 gym in two years. (Bally's Health & Tennis Corp. is No.1.) McCown De Leeuw is currently looking into heating and air-conditioning supply, and direct-marketing.
"LIKE HERDING CATS." While the move to merge health-maintenance organizations and hospitals is well under way, the consolidation of group physicians' practices into specialty companies has barely begun. One force behind the creation of nationwide physician companies is Welsh, Carson, Anderson & Stowe, a New York venture-capital and buyout firm that has invested in six such companies. Two of them--MedCath Inc., a cardiology-care company, and EmCare Holdings Inc., an emergency-care-management concern--went public in December. Two others, including American Oncology Resources Inc., a collection of 10 group practices, are in registration.
Deals involving doctors are not always easy to bring off. "Managing physicians is like herding cats," says general partner Russell L. Carson. But the economics are still powerful. Besides achieving cost savings through increased purchasing power, standardized procedures, and lower malpractice-insurance premiums, these companies are in a better position than single group practices to compete for third-party-payer contracts, Carson says.
MedCath, which started in 1988 as a mobile heart-diagnostic firm, has more recently focused on cutting costs by integrating cardiology practices with specialty heart hospitals. Last year, says Stephen R. Puckett, chairman and president, the company acquired its first practice--of 45 doctors--and in October, it expects to open its first hospital. This strategy, he says, will cut labor costs to 26% of revenue, compared with 55% at some general-care hospitals.
Build-up deals have their share of failures. Brentwood Associates, a 25-year-old buyout firm in Los Angeles, claims successes in the cellular-communication and trade-magazine businesses. But general partner William M. Barnum Jr. admits that its Acme Holdings Inc., a troubled equipment-rental concern in the Sunbelt, has not fared so well. Battered by recent California recession, among other woes, he says, the company last year defaulted on its $78 million in junk bonds. One lesson, says Barnum: "Geographic diversification is something you should strive for."
As it becomes more popular, the build-up game could become as risky as the bust-up game of the 1980s. But because of its more agreeable impact on acquirees, building up is likely to be a lot more beneficial for dealmakers' images.
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