Over the past several years, sponsors have increasingly relied on add-on acquisitions to increase the value of their portfolio company investments. As EBITDA and revenue multiples on larger platform acquisitions increased through 2021 and into the early part of 2022, many sponsors turned to consolidation and “buy and build” strategies, characterized by using smaller add-on acquisitions with lower price multiples to build value. The multiple arbitrage opportunity is realized when the EBITDA or revenue acquired at a lower price multiple receives a higher price multiple valuation often available for larger platform businesses upon a sale.

With interest rates at historic lows, the availability of inexpensive leverage made this add-on strategy increasingly attractive. By the end of 2022, add-on acquisitions represented more than 76% of all private-equity-backed buyouts, which was a significant increase compared to a decade earlier. The percentage of add-ons dipped by 1% in 2023 — a year when volume and value of buyouts dropped significantly — and reached 76% in the first three months of 2024.

As markets recover in 2024 and beyond, overall private equity deal activity is expected to pick up. Two factors are expected to contribute to the uptick: the need to deploy significant committed capital and the need to exit legacy investments. We expect add-ons to remain a significant driver of value creation for sponsor-backed companies, extending the trend of recent years.

Why Add-Ons Make Sense

Add-on strategies are attractive for several reasons, including the following:

• These smaller transactions are more often sourced through organic connections within the platform company’s industry rather than through competitive, banker-led auction processes, which assists in keeping the EBITDA and revenue multiples to lower levels.
• They are often financed through existing credit facilities (including through delayed draw features included in the facility at the time it was originally put in place), eliminating the added cost and uncertainty of employing new equity financing or new third-party debt financing; this becomes particularly valuable during periods of rising interest rates.
• Add-on strategies allow sponsors to bring the blended cost of acquiring EBITDA and/or revenue down either by balancing out an expensive initial platform investment with several lower-multiple add-ons or by completely avoiding the larger initial investment in favor of consolidating several smaller players within an industry.
• If executed successfully, the combined company would benefit from operational efficiencies and synergies because of the acquisitions.

Considerations for Practitioners

These smaller but recurring transactions require a different approach from sponsors and their advisers than larger platform deals for several reasons. The add-on market is characterized by a need for greater efficiency in the transaction process, with often less-sophisticated, first-time sellers and limited resources to digest complicated transaction structures and deal features and to respond to diligence inquiries. Sponsors are more likely to streamline the process to focus on critical items and rely more heavily on contractual protections for the underlying risks, rather than performing the same level of “deep dive” diligence used for platform deals. Relatedly, the smaller overall transaction value means the use of representations and warranties insurance is less prevalent, with sponsors often relying on traditional indemnification structures. Finally, sponsors face pressure to find ways to keep momentum to get to a closing and to avoid deal fatigue and frustration from sellers that will be key divisional players for the portfolio company moving forward.

Overall, executing on these strategies requires sponsors (and their advisers) to be more nimble and flexible in getting deals done quickly and efficiently and requires adjusting typical processes to accommodate a smaller check size.

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