1. Discussion
Demian Berchtold
July 6, 2018

2. Context & contribution
Background
To create value, PE firms should move from cost cutting to growing the business (BCG 2012).
PE firms seem to buy platform firms and implement buy-and-build strategies (Hammer et al. 2017).
Smit (2001) suggests a real-option framework to price the option value included in platform firms.
Research paper empirically explores whether option value of buy-and-build strategies drive the price of platform acquisitions and finds evidence thereof.
Contribution
Synergies in focused merger deals are well documented (Devos et al. 2009).
Acquiror shareholders’ gain is close to zero, i.e., they pay for synergies. Same for PE firms?

3. How PE firms create value
Theoretical considerations
How PE firms create value
Operational improvement
Organic growth
Inorganic growth
Leverage and cost-cutting / pure arbitrage
Fine-tuning core business / expanding geographically or in new product markets
Buy-and-build strategy when there is uncertainty about industry consolidation
Does PE firm pay for operational upside?
Does PE firm pay for growth options?
Does PE firm pay for synergies?
Depends on relative bargaining power, i.e., competition among PE firms, incentives to close a deal, expertise of PE firm relative to target firm to implement value creation.
Theoretical considerations are not convincing
What is the control group? Operational improvement / organic growth?
How do the different strategies affect the buyout price?
The so-called moderating factors apply to all buyouts, except acquisition experience that is specific to inorganic growth...
(next slide: how do you measure/classify different buyouts?)

4. How to measure buy-and-build?
“The flexibility of a buy-and-build strategy can provide great benefits to the investor when there is major uncertainty about the consolidation” (Smit 2001).
Flexibility
Realized follow-up acquisitions are a poor proxy for potential add-on targets.
Anecdotal evidence of propensity to exercise buy-and-build option?
Use regression approach to predict expected add-on targets.
Consolidation
Anecdotal evidence on consolidation after PE investment?
Industry-specific variables to identify consolidation potential, e.g., fragmentation and competitive setting (Smit 2001)
Firm-specific variables to identify platform firms, e.g., leadership role (Smit 2001)
PE sponsor or fund variables to identify consolidation skills, e.g., operating partners or in-house teams (BCG 2012)

5. Baseline regression Price premium Control variables Standard errors
Industry price multiples vary over time
Compute industry-year specific benchmark multiple to capture deal premium using market values from Compustat / Datastream or transaction values from SDC Platinum.
Control variables
Debt financing
Sponsor fixed effects and control variables
Standard errors
Cluster by industry / sponsor because deals are concentrated within industries and PE sponsors

6. Endogeneity
Causal link between expected follow-up acquisitions and initial buyout price.
Reverse causality
Price premiums and need to create value through growth are rising (BCG 2012).
I’m not sure whether excluding highest transaction prices takes care of reverse causality.
Other endogeneity concerns
Unobservable factors, e.g., market timing, regulatory shocks, capital liquidity drive up buyout prices and merger activity.
Include industry-year fixed effects. Is there sufficient variation?
IV-regression using instrument local market B&B share
Alternative instrument? Local market B&B share depends on PE firm competition for platform firms and availability of platform firms; both should affect the price

7. Channel
Authors argue that link between expected follow-up acquisitions and initial buyout price is due to synergy potential.
This seems difficult to prove, e.g., Blackstone acquired Hilton at a substantial premium because «real estate was cheaper on the screen that on the streets»; later Hilton expanded into Asia and luxury segment (Bloomberg).
Alternative interpretations
Industry life-cycle: at the beginning, uncertainty about future profitability raises values. Over time, firm exit through bankruptcy and takeover increases.
Firm CEO skills: great CEOs should receive the highest share price and more assets under their control.
Explore news buyout announcements using Factiva for 128 buyouts classified as B&B or all 1,155 buyouts, e.g., «The investor justified this price by arguing that the firm provided a platform for developing the food business in Europe» (Smit, 2001)

8. Follow-up question
Why do the platform firms themselves not conduct the acquisitions, i.e., why does it require a PE investor? Apparently, the platform firms have prior merger experience (Hammer et al. 2017).
Lacking expertise provided by PE firm (BCG 2012)
Incentive issue, e.g., short-term horizon of current CEO or shareholders
Risk aversion of current CEO or shareholders
Financing constraints, i.e., PE investor might lower debt financing costs
What is the risk of implementing buy-and-build strategies for PE firms, e.g., if option is not exercised?