Roll ups may help kick-start the economy, but buyers beware
There has been much talk of the consolidation of assets that will follow the COVID-19 crisis. However, consolidation and roll up strategies are not a new thing. The private equity industry has been largely built on the notion of acquiring solid platform assets, bedding them in and adding value with bolt on acquisitions over time.
But the expectation is that there will be speedy, industry-wide roll ups of small businesses wilting in the fierce glare of Coronavirus. These ‘helter-skelter’ roll up processes are not so common, but there is precedent here in New Zealand.
In 2014, MinterEllisonRuddWatts helped two businessmen to buy 85 early childcare education centres from 39 separate sellers. The duo then raised $139m through an IPO to pay for the centres, and 34 of the deals were settled in the same week. That company became Evolve Education and is now listed on the NZX.
In 2015, the same team negotiated with eight education businesses, before buying five of them and creating the Aspire2 group (again, all settled on the same day when finance was raised from Australian PE fund, Archer Capital).
From 2014, our team also advised on a roll up of 17 dental clinics across New Zealand to form Dental Corporation (NZ) Limited. Dental Corporation was subsequently sold to Bupa. On that deal, unique bank facilities were put in place to fund each acquisition as it completed.
Each of these projects were characterised as offering slightly better than market prices for the constituent small businesses with an expectation of multiple arbitrage when the combined group was valued. They also meant much longer transaction timetables for sellers, as they waited for enough deals to contract to give the roll up sufficient critical mass to raise the necessary finance.
These were intensive, high risk strategies. In many cases, the targets were found, negotiated with and ‘contracted’ before the finance to buy them was obtained. Everyone involved took a risk on the outcome being successful. But successful they were, at least in terms of execution and the resultant creation of large industry groups.
Many of these projects also involved the vendors receiving a mix of cash and equity.
The success of these projects set off a mini boom in roll up attempts. MinterEllisonRuddWatts was also involved in projects looking at the transport, food, wine, security and animal health sectors. Some were successful, many didn’t get off the ground.
Several legal lessons were learned which will be important for anyone contemplating a roll up strategy in the current environment. Below are the top ten tips for a successful legal strategy.
1. Keep the legals simple
On one project, our client had already developed a bespoke template sale agreement. It was a well drafted 60 page document and it covered every single eventuality. The problem was that small business sellers wouldn’t sign it. That led to weeks of negotiations for only incremental gains.
In New Zealand, the vast majority of small business sales transact using the ADLS standard form Agreement for the Sale and Purchase of a Business. That is the document that their lawyers were used to. It’s not perfect, but it’s a reasonable, well balanced document and it provides a level of protection to a buyer that is commensurate with the size of a small transaction.
We realised that few legal issues encountered on small business deals, had a material impact in the overall context of a large roll up project and so we added a few important special conditions to the ADLS template and started using that instead. Negotiations were instantly quicker and relationships with sellers and their lawyers improved.
2. People and operational due diligence is worth a lot more than legal and financial due diligence
Legal due diligence is important. Clients need to know that the contracts say what they think they say. They need to know how long the lease is and how easy it might be to get out of it. Financial due diligence is also important. Last year’s performance and next year’s forecast needs to be checked and given the nod. But in the world of small business, legal and financial due diligence should be focused and succinct.
When rolling up small businesses, we rarely come across a single legal issue in due diligence that is material in the overall context of the project. The story is much the same on the accounting side.
In reality, it is the people and the operational environment that make or break a small business.
The roll ups we worked on in that period ensured that legal and financial reports were prepared by respected legal and accounting firms. That was what banks, investors and analysts wanted to see.
However, less time was spent on understanding the people and the operations that were being acquired. When things went wrong, it was in these areas that the issues emerged.
The lesson here is to simplify the legal and financial due diligence and concentrate on the things that will impact on value.
3. Don’t transact with people you don’t trust
Small business owners are generally an honest and impressive bunch. But there are exceptions.
We found that the sellers that were hard to deal with during the negotiation phase were generally the ones that left behind problems. Our clients spent a disproportionate amount of time and money on mopping up the mess left behind by these people. In most cases, the trouble they would cause was evident from the start.
A successful roll up strategy includes having the discipline to walk away from a deal in the early stages of discussions if the owner just isn’t the right fit.
4. Use warranty insurance
Rolling-up lots of small business means paying modest amounts of money to lots of people who then become your employees. You need recourse if what you get isn’t what you thought you were getting. But having to sue a mid-management employee because of a deal gone wrong is not an ideal position to be in.
For that reason, we recommend that you put a warranty insurance policy in place so that you have recourse for any genuine warranty claims and your relationship with your new employees can remain intact.
Insurers will consider umbrella policies for roll up projects. This is a complex area and you will need specialist advice at the outset to ensure the deal is structured in a way that can be covered by the insurers. Warranty and indemnity insurance can be really useful if you get the policy settings right.
5. Use lawyers that know how to project manage
These aren’t deals., They are projects – and significant projects at that. Ensure that you have the legal resource and processes to manage the volume of transactions that flow from a large roll up project.
When we first started on one project, we had the idea that we would run a whiteboard with basic details and status for each deal. Then we realised we would need nine whiteboards to cope with the volume of live deals! By the time we were finished, our processes and reporting were very slick, but it took a lot of work and planning to get them that way.
6. Get the seller’s lawyers involved early
When selling a small business to a roll up, the usual rules simply do not apply. The transaction will not follow normal timelines. There are aspects of the legal documentation that are not typically found in a standalone transaction.
We found that there could be big delays when sellers who had been in negotiations for weeks and who understood the commercial deal they were getting into, finally went to their lawyers for advice.
Those lawyers did their job and started to question the structures and commercial issues already agreed – bogging the transactions down as old territory was revisited. We found that asking sellers to involve their lawyers early allowed everyone the chance to get comfortable with the project at the same time and avoided delays down the line.
7. Be honest. Be up front
Kiwi business owners are a principled bunch. Overseas roll up strategies often rely on signing up options over businesses and then keeping their owners dangling on the hook and largely in the dark until the critical mass of targets can be signed up and the finance raised to buy them all.
Timetables often blow out and sellers and their advisers can get very frustrated. Kiwi business owners do not like being ‘played’. Upset and resentful sellers do not bode well for a happy post roll up relationship.
We found that being up-front and honest with sellers about the likely timetable for a project worked much better. There is typically a premium on pricing in a roll up situation and the trade-off is a longer timetable and some uncertainty of outcome. Business owners will accept that if you are honest about it from the outset. Constant communication as to the status of the project went a long way to building trust and patience when things blew out.
8. Think about information flows
Many roll up projects rely on part-paying sellers with shares in the combined group. It is natural then that sellers will want to see information about the other targets so that they are able to assess the value of the shares that are being offered.
This can present a real problem in a small country like New Zealand. Often, the individual target companies are arch rivals and we found ourselves hamstrung in our ability to provide sellers with information because of confidentiality agreements signed by our clients at the start of discussions.
A better approach is to work out from the start what basic information will and won’t be shared between the respective sellers and then get buy-in from each seller upfront. We were able to find the balance between providing enough information to assess the potential of the combined group while protecting sensitive information from competitors. Bespoke confidentiality agreements were then signed to reflect this.
9. Think about the Overseas Investment Office (OIO)
The acquisition of a small business is unlikely to trip consent requirements under the Overseas Investment Act 2005 (OIA). However, the acquisition of lots of small businesses might. The OIA requires an overseas buyer to seek consent before purchasing “significant business assets” (the current threshold is set, in most cases, at $100m) and this includes deals effected through a “series of related or linked transactions”. This should be looked at in the planning stages to ensure that you know what the requirements are.
10. Get the right team together
This lesson isn’t from our roll up experience, it comes from the many distressed transactions that we were involved in during the global financial crisis.
Distressed deals have all the usual issues associated with mergers and acquisitions, however they also have unique aspects to them that can be easily missed by M&A lawyers. For these reasons, we always had both an M&A expert and an insolvency expert on our team for these kinds of transactions. We were amazed to see counterparties advised by either a sole M&A lawyer (who would miss vital insolvency considerations) or a sole insolvency lawyer (who did not have experience in negotiating sale and purchase agreements).
If you are planning to roll up distressed assets, insist that your lawyers field a team with both bases covered.