Do Private Equity Firms Pay for Synergies?

It is a commonly accepted view that strategic acquirers incorporate synergistic value into their bids for targets, while private equity (PE) funds presumably do not because they lack operating similarities with the portfolio firm. Empirical evidence provides some support for this view but is limited to PE bids in so-called public-to-private buyouts which account for only 7% of the overall buyout market.

The so-called buy-and-build (B&B) value creation strategy is somewhat unusual for public-to-private buyouts and any possible bidding implications are thus unexplored so far. However, we believe that there are bidding implications as the sources of value creation in B&B strategies are typically no different from those that strategic acquirers incorporate into their valuations when bidding for related companies. That is, in B&B strategies, the initial buyout serves to acquire a platform for one or several smaller add-on acquisitions which are subsequently merged to integrate operations and create cost efficiencies as well as improved market power. Such operating synergies, in turn, are typically associated with a price premium for the target shareholders in non-PE mergers. This raises the question of whether similar premiums for synergies are observable in buyouts with B&B strategies. We address this question using a sample of 1,155 global PE transactions that, next to public-to-private buyouts, also cover all other relevant entry channels such as private-to-private, secondary, and divisional buyouts.

Testing for our main hypothesis implies two identification issues. First, we need to find a proxy for the operating synergy potential of a B&B strategy. This task is not trivial given the opaque PE context in which both the platform and its add-on acquisition are non-listed entities. Because information availability is scarce, we cannot use the synergy proxies that are available for public firms, such as measures of individual and combined market valuations of the target and acquirer, long-term abnormal operating performance, or present values of cash flow forecasts. Instead, we assume that synergy potential is in place if the portfolio firm acquires add-ons in the same industry (the “industry restriction”). This is consistent with prior literature suggesting that operating synergies are greatest in focused mergers that involve firms with the same industry classification code. Second, we need to distinguish between add-ons that are an ex ante part of the deal strategy, and those that are ex post determined during the holding period. Whereas the first group gives rise to pricing effects at entry, the second group may be endogenously determined by the observed deal performance. Following previous studies, we expect that add-ons that are realized within two years after the buyout (the “time restriction”) are unlikely to be the result of adaptive behavior. This leads us to expect that buyouts in which the portfolio firm makes add-on acquisitions in the same industry within the first two years of the holding period will exhibit a price premium at entry.

Our results provide strong support for our main hypothesis. In our baseline regressions, we find that PE firms pay a sizable enterprise value to sales (EV/Sales) premium of 15% to 20% when add-ons are realized in the platform’s industry within two years after the buyout. This premium cannot be explained by unobserved time-invariant PE firm characteristics. Note that it also holds when controlling for a variety of determinants of buyout pricing discussed in the literature, e.g., PE firm characteristics (fund size, “dry powder”, experience, institutional affiliation), deal characteristics (entry channel, syndication, management participation), portfolio firm characteristics (size, M&A experience), as well as investment conditions (financing conditions at the time of the buyout and time-varying competition for targets across industries). Furthermore, and consistent with our identification strategy, we find that economic and statistical significance of the B&B price premium is reduced when add-ons are realized outside the platform’s industry and/or later than two years after entry.

Next, we carry out several additional analyses to address endogeneity concerns and alternative explanations. First, we explore the sensitivity of our results to alternative model specifications with various combinations of fixed effects. Second, we use a counterfactual research design to estimate treatment effects based on propensity score matching (PSM). Third, we test whether measurement error drives our results by re-estimating matching models with alternative time and industry restrictions for our B&B indicator. Fourth, we use two-stage endogenous treatment regressions that incorporate exogenous variations in the suitability of B&B strategies across markets and years as an instrument. Fifth, we explicitly address reverse causality and sample selection bias by running regressions on subsamples that exclude overpriced deals and underrepresented countries. Finally, we test the EV/EBITDA multiple and its log as alternative dependent variables. Our main result remains intact across all these estimations. The size of the B&B price premium varies somewhat, and shows that our baseline estimates may actually be conservative. For example, the PSM estimates suggest an entry EV/Sales premium from B&B of up to 47%.

Finally, because prices paid in PE buyouts are the result of a negotiation process between the management of the buyout target and the GP, we explore bargaining power as a channel for the size of the B&B premium. Previous literature identifies competition, time pressure, and expertise as key antecedents of perceived negotiation power in buyout transactions. Perceived negotiation power, in turn, should affect the price upon which the portfolio firm and the PE investor eventually agree. We thus model these three determinants and test whether our estimates are sensitive to the inclusion of various interaction terms with our B&B indicator.

We find that the B&B premium increases when the PE sponsor faces higher competition for deals in the portfolio firm’s industry. This is because the target will be less inclined to make concessions during the negotiation when there is a substantial number of outside alternatives. We also find a significantly greater B&B premium if the PE sponsor has “dry powder,” as this coincides with relative investment pressure and thus with a weaker bargaining position. Finally, the B&B premium is greater when the portfolio firm has M&A experience at entry. This finding is consistent with the idea that platform targets can counter GP’s negotiation power and capture a greater part of the synergistic value from B&B when they have comparable M&A expertise.

Our paper makes several contributions to the literature. First, we depart from prior studies by investigating a sample of PE activity that is not limited to public-to-private buyouts. This allows us to contrast the notion of segmented bidding, because our findings indicate that targets with growth opportunities may similarly appeal to financial investors. Beyond that, we present novel evidence that financial investors can incorporate synergistic value from add-on acquisitions into their bids. This may enable them to outbid strategic acquirers in auctions, which may help PE firms capture a larger share of the M&A market. Second, our findings have important implications for the literature on buyout pricing. To the best of our knowledge, this paper is the first to show that it is necessary to control for B&B strategies, and thus the intended source of value creation, when estimating buyout prices. Furthermore, our results indicate that operating value creation potential from synergies can at least partially explain rising prices in the PE industry. Third, we also add to the growing literature on B&B strategies in PE. In contrast to the previous studies, this paper relates B&B to entry pricing rather than to deal-level returns. Moreover, it studies determinants of the documented price premium rather than determinants of add-on acquisitions themselves. Our approach allows us to show that platforms command a price premium because they have strategic importance for B&B strategies. We also document that the extent to which platforms can capitalize on this strategic importance depends on their relative bargaining power. Finally, we contribute to prior literature on bargaining power and contracting in buyouts. The novelty of our paper lies in the introduction of empirical proxies for the qualitative bargaining power determinants that prior studies identified using survey data.