Strategy for the Middle Market: How to Ace Your Add-Ons

March 29, 2022 | Blog

Strategy for the Middle Market: How to Ace Your Add-Ons

By Bill Myers, Vice President, Sales - Private Equity

Opportunities, Challenges, and Shifts in the Market

In 2021, mid-market deal activity and PE-backed exits blew the doors off all previous records. Add-on activity, in particular, grew by 67%. At the same time, disruptions like the conflict in Ukraine and the Big Quit are throwing the market some curveballs. 

Moderator Abby Roberts - Datasite’s Senior Director of Product Marketing - asked what issues most concern the panelists, and what trends have them excited.

The conflict in Ukraine loomed large, and all the speakers expressed hope for a swift resolution. Though they agreed with audience respondents that domestic headwind issues are having a greater impact on dealmaking, they noted that the war feeds into other difficulties like supply chain challenges.

But there are also positive trends to track, many linked to the ongoing changes in how people buy, sell, and work. 

David Proctor of Milestone Partners noted that shifts like labor shortages and increasing regulation are driving investment in productivity solutions. On the consumer side, Abraham Hidary at Carlyle talked about the boom in online shopping and work-from-home technology; businesses across the spectrum are seeing opportunities in tech trends like remote conferencing, big data, and asset-light distribution.

Add-Ons: The Benefits and Risks

Why are add-ons seeing such a surge in activity? 

Hidary offered one answer: with skyrocketing valuations for platform businesses, add-ons can be more cost-effective. They often trade at accretive multiples and/or offer the potential for revenue and cost synergies. Add-ons can also have the added benefit of further capital deployment behind a team and company you’ve already backed. 

Aytan Dahukey, the Private Equity Leader for the law firm Sheppard Mullin, added that add-ons offer an important path to inorganic growth.

“Not everybody can just do organic growth over the lifecycle of a fund,” he said. “You can’t just go five years or seven years and build from within.”

The second audience poll question looked at the other side of add-ons, asking what were the biggest risks with this type of investment thesis. 

Gretchen Perkins, Partner at Avance Investment Management, cited insufficient integration planning as the biggest pitfall, and nearly 68% of the audience agreed. Proctor also emphasized the need for buy-in, saying that a deal won’t work if employees can’t see how an add-on fits into the company vision.

The Value of Diverse Teams

Another interesting trend in the private equity world is that teams are getting bigger. Perkins mentioned that at the formation of their new firm, the founders committed to hire a Head of Research and a Head of Human Capital as key positions in contributing to create shareholder value - something few, if any, middle market PE firms would have done a decade ago.  The third poll question asked what’s driving this kind of expansion.

Close to 60% of the audience said that it’s due to the record amount of fundraising. Proctor agreed and added that fierce competition drives bigger teams.

 “One of the ways to be able to compete and get things done quicker,” he said, “is just to throw more smart bodies at it.”

Hidary said that bringing more functionality in-house doesn’t just allow sponsors to move more quickly on deals - it also provides an important resource for increasing value in new acquisitions after closing.

Best Practices in a Fast-Paced Market

The audience Q&A segment kicked off with a question about how strategy differs for similar-size add-ons versus smaller tuck-ins. 

In the experts’ view, the difference lies in how you handle the talent. Dahukey remarked that the goal for similarly sized add-ons is often to build a team of equity-holders invested in growing something together. That means you need a clear vision for how sellers can contribute - one that will motivate them not to exit.

Another important shift in mid-market M&A is the sheer speed of dealmaking. Datasite’s platform shows that median diligence time has dropped by 39 days in the past year. Roberts asked how the panelists mitigate those risks.

Their unanimous answer: doing your research ahead of time. 

“One of the principal ways…is to make sure that the first time you hear about a business is not when you get the teaser,” said Hidary. Extensive prep work to scout out companies in sectors of interest long before anyone starts discussing deals can allow sponsors to later complete diligence in condensed timeframe.

Proctor noted that not all companies are equally ready to be acquired. Publicly traded or PE-backed companies are used to preparing reports and disclosures, while private owners may have to scramble to get relevant information together. 

Dahukey suggested that Representation and Warranty insurance offers a powerful tool for incentivizing a seller to enable proper due diligence. 

“You have underwriters that need real diligence reports in order to underwrite the risk,” he explained. “So you can use Rep and Warranty insurance as a carrot and a stick.”

Proctor addressed one final question about best practices: knowing when to exit from a portfolio company. 

“To me, the ideal time to exit is when you start to get inbound, unsolicited inquiries from strategic buyers,” he said. Better to sell when offers are knocking on your door than when you have to work to convince buyers to take a look. 

In a Competitive Environment, Strategy is Everything

With rising valuations and cutthroat competition for targets, savvy strategies can make all the difference for middle-market firms. This discussion suggests a few actionable ways to get that edge:

Do your research well in advance. Respect the human side of integration. And invest in top talent for your dealmaking team. If you follow these best practices, 2022 has the potential to be another lucrative year.