A failed roll-up and five reasons why

Roll-ups were all the rage on Wall Street throughout the early 1990s - the "merger wave of the millennium," in fact. And why not? Take dozens of small companies in a fragmented industry, buy out the individual entrepreneurs and create a single entity gain economies of scale, lower costs and better

In theory, not much. But the cup often turned out to be a little too far from the lip. A recent study found that more than half the roll-ups examined had lost more than half their market cap since June 1998. With roll-ups in industries ranging from HVAC, tour operators/vacation packagers and auto body shops through floral distribution and ambulance services to funeral homes, there have been dozens of disappointments (Waste Management, U.S. Office Products Co., AutoNation) and only a handful of successes (Quest Diagnostics, Sysco Corporation). Results have been so unsatisfactory that turnaround consulting firms are hearing more and more calls for help from failed strategic roll-ups.

A case history: Good beginning, unhappy ending

The Company came into being in mid-1997. By mid1998, it encompassed 11 companies across the country which performed high-quality commercial printing for a wide range of customers, from Fortune 100 to local businesses. Results for the second quarter seemed to bear out the wisdom of the roll-up philosophy in spades. Revenues were up approximately 1000 percent over second quarter 1997, $38.5 million as against $3.9 million.

And the roll-up rolled on, acquiring four more small printers and floating a $130-- million bond offering before the end of 1998. A press release announced year-end 1998 financials: revenue up 310 percent for the year; gross profit up 499 percent; net earnings of $.60 per share. The next year promised more of the same: five more acquisitions, one of which even floated its own IPO; a "strategic partnership" with a major player, and record results for the first quarter of 1999.

But the sun was ready to set. In June 1999, the company announced that second-quarter earnings would fall below expectations, possibly even below zero. That turned out to be an understatement. By the third quarter the company was reporting a loss of $5.2 million; the new millennium brought delisting. With that, a $7.5 million net loss for the first quarter, and a missed bond payment of $7.5 million, the end was in sight. The lenders' patience had run out, and the Board elected to file for protection under Chapter 11 in July 2000.

That's where a turnaround consulting firm came in. Its restructuring team's job was to guide management in the formulation of a plan to take the company out of Chapter 11 with minimum disruption to its operations and maximum return to its creditors. The plan, filed in the United States Bankruptcy Court, contained typical provisions designed to achieve these ends prudently: securing continued financing, conversion of debt to equity, and divestiture of noncore operations - selling off some of the divisions to their original entrepreneurs or to somebody else. All pretty standard, but miscues in the original process of rolling up those companies into the far-flung empire made the job much more difficult. The turnaround firm was trying to rehabilitate a company with no financial assets and a group of original owners with widely differing agendas and no sense of the overall business.

Mistakes not to make when doing a roll-up

Don't pay in cash. Perhaps the single biggest factor that crippled this printing company roll-up was buying out the individual entrepreneurs in cash-only transactions. Good capitalists know that the best incentive is to give a player a piece of the action; ownership confers a sense of responsibility. Here, the roll-up simply bought the players off (with one exception), leaving them with a wad of cash and no stake in the continuing enterprise. If somebody dropped $4 million and no equity in your lap for your company, would you stay the course and help make the changes necessary for the company to flourish? Or would you fly down to Rio?

Don't underestimate the complexity of the transition. Complete integration of the component companies is an extremely difficult task. A perfect example, and one that helped drag this Company down, IT integration. Combining different, often-incompatible hardware platforms and operating systems is daunting and, without planning and hard work, the result can be a jerry-built system nobody can use effectively. If management cannot obtain accurate, timely financial and operations information, the enterprise is doomed.

Don't ignore economies of scale. Size does matter, or you wouldn't be doing a roll-up in the first place. Size is supposed to confer value in purchasing, production, operations and financial management. This doesn't happen by magic, however, so integration must be carefully planned and implemented to achieve economies of scale, such as:

> consolidation of facilities;

> unification of the sales force (for example, each of the units had a different commission scale for its sales personnel, a disparity that was never eliminated);

> institutional purchasing;

> control of cash and capital expenditures;

> unification of financial operations (for example, different acquired companies may operate under different accounting standards and be on different general ledger systems).

Don't sustain the status quo. This roll-up foundered because the consolidator simply cobbled together too many shops too quickly, and failed to create a new organization to manage it. Three rules to keep in mind:

> Insist on a new structure, one designed to unify the amalgamation of formerly separate entities and to develop and nurture a new culture.

> Do not leave the original owners in place, especially if they were bought out in an all-cash deal. We all know how important entrepreneurs are - without them, there would be no small companies to roll-up. But the qualities vital to creating and building a $15-million firm do not translate into successful management of a $285-million corporation.

> Make sure you have an outside professional manager driving the new enterprise, and this includes control of the Board.

Deal discipline is crucial. A successful roll-up is not a helter-skelter grabfest. It is a carefully prepared and executed battle plan, conducted by a disciplined force. Set the parameters of the deal and manage to that plan. The basic rules should contain all of the caveats outlined above.

Example: The "do not pay all cash rule" must be followed, no matter how badly you desire that next acquisition. It's easy to fall in love with that little jewel of a company that would fit in so well, but don't give in to the owner's demands for cash.

Example: The plan should have a maximum rate of absorption, a limit to the number of acquisitions possible in a given time frame. Given the complexities of successful integration, you just cannot afford to accelerate the roll-up.

Example: Although the owners are now your newest best friends and shareowners in the newly consolidated firm, do not make them Board members. I he Board must be able to maintain an independent, objective view.

Conclusion

Roll-ups can work in theory and, in some instances, have worked in reality, when special features of the industry permitted. But even then, there are so many opportunities for disaster that a roll-up should only be undertaken when there's real value to be realized by all parties involved.