In this era of sky-high valuations, PE firms seeking inorganic growth are increasingly looking at an alternative to acquiring fully built out platform companies.
The strategy is to buy a platform that is not fully built out yet and available for a lower price and then “add on” other small companies. Not only are these acquisitions cheaper, but they are also easier to transition into the platform, which helps accelerate growth.
This trend has also led to increasing adoption of two unique M&A insurance products that have been available for a couple of years but were not widely used until now.
More on that in a moment. But first, why are valuations so high?
Well, 2021 was a banner year in M&A, with 8,624 deals with a combined value of $1.2 trillion. That’s 50% above the previous record for deal value in a single year.
What brought about all those deals? As Pitchbook in the 2021 US PE Breakdown:
“GPs were motivated by the availability of debt, the wave of sellers coming to market to avoid anticipated tax hikes, and the urge to deploy capital quickly in order to return to the fundraising market. Many industries, if not most, experienced intense competition for deals as a result, and multiples elevated to 2019 levels or higher in 2021.”
On other words, it’s a seller’s market, with intense competition for target companies pushing prices higher.
A compelling trend has emerged out of all, says the Pitchbook report:
“The current deal climate has been particularly conducive for buy-and-build strategies, and add-ons as a proportion of the number of total US buyouts reached an all-time high of 72.8%. During the market dislocation in 2020, firms had turned to add-on dealmaking to continue deploying capital with diminished risk, because add-ons are typically smaller deals and the GP has a firm grasp on its platform.”
As I’ve written before, PE firms these days use Representations and Warranty (R&W) coverage to protect their deals as a matter of course. It’s become standard. So, it’s no surprise that they’ve sought out similar insurance products when doing add-on acquisitions.
Add-On Insurance
For transactions under $20M in deal value, PE firms use Transaction Liability Private Enterprise (TLPE) insurance. For example, I recently brokered TLPE coverage for a deal in which a sports apparel manufacturer bought a high-performance glove wholesaler for under $2M. The process took two days and cost just $20,000.
By having this TLPE coverage in place, the Seller was able to reduce their holdback from $140,000 to $14,000— matching the policy retention. The standard retention level for TLPE is 1% of enterprise value or $10,000, whichever is higher. Compared to the usual escrow or holdback of 10% of purchase price, no wonder TLPE is so popular.
As this manufacturer looks at other add-ons, they will again look to be covered by TLPE insurance, which offers six-year policy periods with a limit that is 100% of enterprise value. TLPE isn’t just for Sellers. Now Buyers can be named as Loss Payee in a TLPE policy which ensures faster collection from covered losses.
What about strategies where the planned add-ons are expected to be above the $20M TLPE threshold? CFC Underwriting has created an innovative coverage called a Portfolio Policy where an initial portfolio platform is underwritten and insured by CFC consistent with a standard R&W policy. The Portfolio Policy can grow as companies are added to the platform at a discount.
Under the Portfolio Policy, R&W coverage is arranged for the PE’s platform investment. As add-ons are brought in, the Portfolio Policy is amended to add new limits for each new entity brought on board. Each new Limit is independent of the other acquired entity Limits, so there’s no dilution as companies scale.
The thinking is that the Underwriters who underwrote the original platform acquisition will be familiar enough that it will save time and money on the underwriting process (lower UW fees and discounted premium rates.)
They can see how the new add-ons fit on the platform and will understand the investment theory of the PE firm making the decision to acquire the add-on. In other words, they are already familiar with the key players and aren’t coming at this fresh.
With familiarity comes comfort and Underwriters can add new companies to a platform for a fraction of the underwriting fee because they’ve already done most of the legwork. Considering the increasing costs for R&W, a scalable product should be a welcome alternative. Another perk: processing time will be cut down as well, with the underwriting call cut in half at least.
If a PE firm is going into an acquisition and knows upfront that add-ons will be bought, the Portfolio Policy is the correct route.
Otherwise, they should go with traditional R&W insurance for the platform. For add-ons they could go with another R&W policy if the enterprise value of the add-on is above $20M. If it is lower than $20M, TLPE is the way to go.
When seeking out this specialized and relatively new M&A insurance, it’s best to reach out to an insurance broker experienced in this type of coverage
I’m happy to help. You can contact me here at pstroth@rubiconins.com.