Poof! And Small Outfits Change Into A Big Ipo

"Roll-ups" combine similar companies and profit by economies of scale. They can be lucrative--and risky

When Steve Harter was growing up in a poor town in Iowa, his family hit hard times and his childhood home was repossessed. Today, Harter is a successful Houston venture-capital investor who sports monogrammed shirts and fancy silk ties. But he hasn't abandoned his roots.

Over the past several years, Harter, 36, has popularized an unusual and innovative method of bringing groups of small companies in similar businesses, typically with tens of million dollars in revenues, to the public market. Using the funds from the initial public offering, the entrepreneurs are able to buy additional companies through a strategy known as a "roll-up." Harter takes particular pleasure in the fact that many of the employees and the management of the small-businesses have become millionaires through stock options.

Harter's offbeat financing, through his firm Notre Capital Ventures, works this way: He will approach several private companies in the same industry, such as bus companies or air conditioning contractors. He then arranges an IPO to buy the companies and combine them into a single operating unit. The owners receive a combination of equity and cash. Some investors describe the maneuver as a "poof IPO," a kind of magic act where several companies are transformed, poof, into one company.

Harter usually ends up owning only 12% of the companies he takes public--vs. the 50% to 75% stake most venture-capital funds retain. "We are able to leave founders in the industry a substantial piece of equity," he says.

Harter's strategy has attracted a lot of other players. These deals have already created companies with some $22 billion in market capitalization, according to Howard, Lawson & Co., a Philadelphia investment bank. But he worries that promoters are taking the idea to extremes. One investment banker recently raised $527 million for a blind "poof" pool designated for as yet unnamed roll-ups, now called Consolidation Capital Corp. "This is the year of excesses," Harter says.

Those who play the roll-up game, often known as consolidators, tend to seek fragmented markets with no clear market leader. The idea is to buy up lots of companies to boost revenues and earnings while saving money through economies of scale. So far in 1998, there have been 20 poof IPOs, with a still-modest average price-earnings ratio of 15 to 17. It's a strategy momentum investors love, since earnings usually blossom quickly.

But roll-ups have their detractors. Integrating dozens of companies can be a challenge. "They work for a while, but investors better be ready to get out of the thing before it collapses," says Howard Schilit, president of the Center for Financial Research & Analysis in Rockville, Md. He warns investors to look out for red flags in companies that grow too quickly: consistent one-time charges, declining growth in core companies, or ever larger acquisitions used to mask serious problems. Typically, says Schilit, "these stocks spike up and then, often with very little warning, the stock starts to collapse."

"It's the best and worst of capitalism," admits Harter. "Capitalism is a herd mentality.... What people don't understand is what happens the second, third, or fifth year out--how to position the business over the long period of time. What happens is, some of these businesses are going to blow up."

An example of a poof IPO failure is Telespectrum Worldwide, a telemarketing roll-up with revenues of $178 million last year. Its stock went from 21 7/8 in 1996 to 2 3/4 last March after it bought lots of companies at high multiples, and then lost its major customer.

Harter has scraped his knees as well. Take Physicians Resource Group Inc., an ophthalmology roll-up with sales of $411 million, whose stock at its high was trading at 33 in 1996 and is now quoted at 4. While Harter says the problems stemmed from confusion over national health-care strategies, critics say PRG grew too fast, its companies weren't integrated properly, and management was weak. "None of the physician consolidations are doing well," says Harter. "Is it an industry problem or a Steve Harter problem? But I am not going to tell you that this company had my strongest management team. They were replaced."

Of the seven other poof IPOs Harter has taken public over the past four years, all are now trading on the New York Stock Exchange. He has had such consistent winners as Comfort Systems USA Inc., a commercial designer and builder of heating and air conditioning, with revenues last year of $324 million. Comfort went public in June, 1997, offering 6.1 million shares at 13. Today, the stock trades at 24 5/16. Another Harter company is Coach USA Inc., a bus company taken public in March, 1996, with 3.6 million shares at 14. The key to boosting revenues at Coach was productivity: Buses that had been idle for part of the day were given new routes and trips to fill up time. Coach shares now trade at 50 5/8.

IFFY IPOS. In choosing deals, Harter says he believes in a tight focus: He never tries to add on any unrelated businesses after the IPO. Many industries, he says, are not appropriate for roll-ups because they are either too dependent on one major customer, or consolidation wouldn't provide any additional value to a customer or a distribution channel. Plus, Harter likes to keep the shares offered to the public through the IPO as small as possible since, as the company grows, more shares can be offered through a secondary offering at a much higher valuation.

But Harter is concerned about the current flood of poof IPOs. He cites the $527 million pool, raised by Jonathan J. Ledecky, the founder and former CEO of U.S. Office Products, with the assistance of Friedman, Billings, Ramsey, & Co., a Washington (D.C.) investment bank. The fund, called Consolidation Capital Corp., was a blind pool: Investors were asked to contribute, even though the promoters did not identify what industries would be rolled up.

Ledecky's previous company, an office supplies distributor, acquired over 200 companies from 1994 to 1997 in seven different industries. From the stock's split-adjusted 52-week high of 25.67 last October, the shares dropped to 17 this past May. "The wisdom of Wall Street was that there were too many moving pieces," says Ledecky about U.S. Office Products. "But I still think that's a bunch of bull." Ledecky did add, however, that integration was an issue. Four U.S. Office Products companies were later spun out this past spring.

ACQUISITION BLUES? As the shares began plummeting last fall, Ledecky left his CEO post at U.S. Office Products to start other new ventures like Consolidation Capital. Consolidation has since announced it is buying groups of companies in the janitorial, electrical, security, and pest-control industries, to name a few. "In my opinion it's another bunch of companies that don't make sense together. It looks like U.S. Office Products all over again," says Harter. With 30 million shares outstanding, and lots of cash to deploy, its investment task is enormous. Ledecky will need to make acquisitions fast, and integration could still be a problem for him, say some professional investors.

But Ledecky is quick to defend his roll-up practices: "I am so successful at doing this--the strategy I have works. But the people who don't follow that strategy are always gunning for me.... Most non-John Ledecky roll-ups don't work," he adds. Last October, Ledecky also started Unicapital, which raised $532 million in an IPO to buy equipment-leasing and specialty-finance companies.

Harter likens today's craze of poof IPOs and roll-ups to the leveraged buyouts of the late 1980s. "While there were good deals done by knowledgeable people, a lot of people did them who didn't understand the dynamics of LBOs," he says. "They got into a lot of trouble and bankrupted companies. The same thing is happening with consolidations today." In a word: Poof.

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