A Regulatory Perspective on Roll-Ups: Big Business for Small, Formerly Private, Companies

Article excerpt

Currently, there are several avenues to finance mergers and acquisitions. One method, known as "roll-up" or "consolidator" financing, has recently emerged as a vehicle for consolidating smaller firms. Banks are finding ways to garner some of the returns as well as some of the risk that would normally go to venture capitalists. This article looks at the roll-up's risks and rewards.

In recent years, roll-up financing has become a multi-billion dollar business. Since 1994, more than 100 roll-ups reportedly have gone public, including 50 in 1997. Roll-up formations in 1998 exceeded those in 1997, primarily because of the continuation of a strong bull market during most of the year. The IPO of U.S. Delivery Systems, Inc. in 1994 is considered by many as the start of the roll-up process. Others attribute its beginning to the 1970s, when entrepreneur Wayne Huizenga (one time owner of the prior World Champion Florida Marlins baseball team and Blockbuster Video) combined several small companies in the highly fragmented waste management business to form Waste Management Inc.

Bank Debt Associated with an IPO

The strategy of nearly all roll-ups is to grow aggressively through acquisitions. Most of the growth is financed through the issuance of an IPO and then from secondary equity offerings. However, the new firm may also be able to grow by using financial leverage. A successful IPO often allows a company to obtain debt financing. Bank credit facilities and debt offerings are favorites when market conditions are favorable.

Bank credit facilities are customarily seen as either short-term lines of credit, usually for one year and used for working capital, or term loans, greater than one year and used to finance capital equipment. If deal size warrants, bank lines may be underwritten by a syndicated group of financial institutions. Syndication of the debt allows the pooling of risks, assures better distribution, and generally allows for large financing amounts. It is not uncommon to have a syndicate group both underwrite the new equity and issue debt. The risk comes to those firms that hold their portion of the debt or equity in their pipeline in anticipation of higher prices later. For several of these underwriters it is possible to allocate a portion of their final holdings to their secondary trading portfolios in order to enhance returns derived from these transactions. Market conditions for these new issues can turn negative very quickly and the window of opportunity for favorable prices frequently is short.

Frequently, proceeds from debt offerings then are used to reduce bank borrowings. Management of these roll-up firms must decide the amount of financial leverage to undertake to optimize shareholder returns. Most roll-up companies are so new they have never had a public market for their debt. As such, financial leverage begins with what is known as SEC Rule 144 borrowing. This borrowing allows the holder to make a public sale of unregistered securities without filing a formal registration statement. The registration statement details the purpose of the proposed public offering and a detailed description of the company's operations, management, and financial condition. Rule 144 securities generally can't be sold for some period of time, usually a minimum of two years from the purchase date. Most of these investments made without SEC registration are private placements made to institutional investors. However, it is entirely possible that individuals may hold these shares as participant venture capitalists.

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Bank Involvement

Banks desire to enter this market because of the high reward-to-risk-ratio. Banks earn fees for their services. The largest fees generally accrue to the lead manager or underwriter of the roll-up. It is also possible for banks to earn additional fees if they also actively manage these equities. Several of these equities could be in a proprietary mutual fund portfolio or among the bank's trust client accounts. …