Roll ups in M&A transactions

A roll up (Roll Up) is generally thought of in the context of mergers and acquisitions is where a group of businesses are combined for the purpose of building an asset base capable of being listed on a stock exchange.  The reason for this is that the larger asset base is more likely to create an exit event in the form of an Initial Public Offer (IPO) more quickly than a business can grow organically.  Putting my MBA hat on the other benefit is the economies of scale that can be achieved because of having a centralised infrastructure and common branding (for example) usually in a common vertical market.  Whilst on the road to the goal, there exists the opportunity to leverage systems and infrastructure to extract synergies for the newly merged business.  The economic rationale for a Roll Up & List (Roll Up & List) is simple, all things being equal, shares which are readily tradeable on a stock exchange are generally more valuable than those that are illiquid.

The “Roll Up & List”

If the goal of the Roll Up is to achieve an initial public offer (IPO) then the entity (Acquisition Vehicle) which makes the initial public offer of its securities must be structured to achieve this goal.  In the context of unlisted entities, the rights and obligations of the shareholders need to be such that there is an unimpeded path towards a listing.   Further, the model by which businesses (Targets) are acquired needs to be carefully considered in the context of both the financial ratios that will result but also in terms of whether the acquisition synergies will be realised.  The structure of the Acquisition Vehicle needs to keep the end goal in mind so that it can satisfy the ASX Listing Rules. See – How big does your company need to be to list on the ASX?

The characteristics of the Acquisition Vehicle which must be broadly considered in the context of the goal to Roll Up & List are:

• structure of the Acquisition Vehicle;
• capital adequacy of the Acquisition Vehicle;
• acquisition Model and Strategy;
• acquisition synergies;
• management team;
• financial ratios; and
• ASX Listing Rules.

Structure of the Acquisition Vehicle

The corporate foundations of the Acquisition Vehicle are critical to ensure the long term goals of the equity participants are achievable.  In this regard if there is an opportunity to establish the structure from the beginning it may be well worthwhile exploring.  Significant cost consequences can result if (for example), decades after building a successful business, the controllers want to list the assets of a discretionary trust!   Another issue is the need to consider a capitalisation plan from the outset where indicative prices are ascribed to the securities in the Acquirer with the end valuation in mind.  A reconstruction of the capital in the company is often the result of poor planning.

Capital adequacy of the Acquisition Vehicle

In the context of completing a Roll Up & List one of the issues is the extent to which Targets can be acquired from cash flow and whether a capital raising by way of debt of issuance of securities needs to be completed.

No discussion on business acquisitions would be complete without mention of the issue of dilution and control.  When issuing securities it’s likely that the control exercised by all equity participant will “dilute”.  This dilution will have an effect on the extent of control that a major shareholder may be able to exert over the board, which can have catastrophic consequences for the direction of the Acquirer.  Of course each case will depend on the availability of capital for the Target to achieve its goals.

Balancing the requirement for capital with control over equity holders also needs careful consideration.

Acquisition Model and Strategy

On a practical level acquiring businesses for the purposes of a Roll Up & List sounds good in theory, but what if the Acquirer needs the ongoing support of the proprietors of the Target(s)?  It may be good in principle to buy a Target for a multiple of profits of 3 (for example), then to list on a stock exchange twelve (12) or so months later on debut with a P/E of 9 may leave somewhat of a bad taste in the mouths of those people that need to be motivated!

The requirement for motivation will of course depend on the nature of the industry, capital adequacy and the checks and balances which are in place or could be put in place over the securities in the Target and the Acquisition Vehicle.

In short, any Acquisition Model needs to consider how to motivate proprietors of the Targets that have been acquired, which may involve any of the following:

• an employee share option scheme – see our commentary;
• part cash and part script (shares) in the Acquisition Vehicle;
• an earn out (in cash and script) depending on the achievement of future business unit and group profits;
• participation on the Acquirer’s board; or
• the tax consequences of the acquisition for the owners of the Target.

Conversely if the assets of the Target do not involve motivating or empowering “people” such as in the case of real property (for example), then any discussion of motivation is redundant.

Will the Acquisition work?

What not a lot of people realise is that not all acquisitions proceed to completion. Further whether or not the culture of the combined businesses will fit together or ‘clash’ meaning that the synergies will not be extracted is important for Acquirers to consideration.  Like marketing, it all comes back to having a sound strategy in the first place.  If you have to sell the Acquisition Model to a target then it’s likely that Acquisition Strategy that it is based on is flawed.

Legal issues

There are generally a multiplicity of legal issues to consider in any merger and acquisition activity.  In the context of a Roll Up & List in a vertical market it’s likely that further care needs to be taken to consider:

• competition law issues in terms of combined market share;
• representations made in the course of making the acquisition – avoiding misleading and deceptive conduct;
• the effect of the Acquisition on the control of the Acquirer (if script is used as part consideration);
• compliance with any particular industry codes of conduct; and
• Legal Due Diligence on the Target.

Dundas Lawyers has developed a framework for the analysis and classification of such risks which is used in the process of M&A activity.

Acquisition Synergies

It would be an unusual Roll Up which would not attempt to leverage the opportunity for common branding and investments in shared infrastructure.  Depending on the nature of the business, benefits can often accrue from having dedicated Accounting, Human Resources, IT and Legal staff in house.  The question is whether there is any barrier to obtaining the benefit of the synergies?  There may be a personality barrier or a link to a legacy system (for example) which will limit the opportunity to extract the synergies which needs to be addressed.

Management team

The expertise of the management team in putting together a solid Acquisition Model to extract the Acquisition Strategies to achieve the benefits of a Roll Up & List cannot be underestimated.  The skills of the Management team in implementing appropriate levels of corporate governance (given that the extent and level of corporate governance will vary depending on the size and scale of the enterprise)  whilst focussing on delivering an improved value proposition for customers and aligning the Financial Ratios required to satisfy the ASX Listing Rules cannot be underestimated.  In short, different skill sets will be required at different points in time and controllers need to understand the issues associated with flexibility of the management team.

The composition of the management team will largely depend on the existing skills and capabilities of those on the existing team.  See our commentary on the capability of the management team for acquisitions.

Financial ratios

In implementing the Acquisition Strategy the final position of the Acquisition Vehicle in terms of its consolidated balance sheet must align and survive scrutiny by potential underwriters and investors.  In simple terms it’s relatively easy for the Acquirer to “pay too much” for the Target resulting in a situation where the Financial Ratios for the business are not competitive for an entity listed on the ASX (or anywhere for that matter).  In this regard the Acquirer needs to consider the involvement of a skilled corporate advisor as well as a good management accountant to contribute towards the development of the Acquisition Strategy.

The ASX Listing Rules

To obtain admission to the official list on the ASX, the Acquirer needs to satisfy the rules for admission as contained in Chapter 1 of the ASX Listing Rules.  Compliance with the provisions of the Corporations Act 2001 (Cth) is also mandatory.  The enterprise must satisfy the profit test or the assets test – see our commentary on “how big your business needs to be to list on the ASX”  for further general commentary on the threshold requirements to list on the ASX.

Links and further references

Legislation

Competition and Consumer Act 2010 (Cth)

Corporations Act 2001 (Cth)

Corporations Regulations 2001 (Cth)

ASX Listing Rules

Cases

Lifehealthcare Distribution Pty Limited -v- Stewart Allen Nicholas [2011] NSWSC 661 (29 June 2011) – warranties that financial information disclosed were not misleading or deceptive – damages for breach of warranties.

About the Author

Malcolm is Principal and Founder of Dundas Lawyers, a boutique commercial law firm that aims to enhance and protect the value of equity for business owners across Australia.  Prior to being called to the law, Malcolm was the Founding CEO of http://www.quickbeds.com/ which was sold to Flight Centre Limited.  He has also held various executive level roles in the Software, Tourism and Media sectors.   As a lawyer he has worked for top tier, mid tier and boutique law firms prior to founding Dundas Lawyers in 2010.

Further information

If you need further information in relation to a Roll Up & List or on buying and selling a business feel free to contact me personally for an obligation free and confidential discussion.

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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