Buy or Build? 5 Ways Add-Ons Boost ROI

There comes a time in the life cycle of every company when a path for growth must be set forth. While there are many broad ways to achieve growth — hiring top talent, opening new locations, differentiating product to capture more market share — there are two main frameworks for doing so. While many companies opt to achieve these efforts organically, or “build” growth, others find it less costly, and more efficient to “buy” growth, acquiring smaller or complementary companies that can accelerate their strategy.

For investors sourcing such targets, the question of return on investment often arises. Typically, there is a defined motive for a strategic buyer in seeking out these acquisitions. If you distilled these motives, you would find there are five common reasons that drive a decision to pursue the “buy” strategy and execute add-on acquisitions to boost ROI.

Multiple Arbitrage

As we’ve covered in a primer on multiple arbitrage, growing the size of a company can automatically lead to multiple expansion, leading to higher valuations and exit multiples. Since these benefits are market-driven and not operational, the company cannot realize them until it raises capital or sells itself. Multiple expansion precipitates higher valuation which affects cheaper costs of debt and equity capital. Reducing the cost of capital, the price of investing, naturally boosts ROI, and so too does selling a company for a greater price than otherwise warranted before taking advantage of multiple arbitrage.

Cost cutting

Cost synergies add to the bottom line by eliminating redundant tasks or resources. A large freight company with excess warehouse capacity and truck space can buy a smaller competitor, discard of its assets, and assume its inventory and trade routes for minimal incremental cost. The same applies to a manufacturer with excess capacity in a factory in which there are minimal marginal costs of producing materials and no marginal cost concerning employees, the latter meaning that it takes it only takes one person to produce one or one thousand aluminum cans. Streamlining human resources is a common practice in industries like airlines that rely on customer support call centers, in which an acquirer can consolidate the two centers into one. Generic admin functions like accounting or tax departments also present clear opportunities for consolidation and generating the same output for significantly less input.

Cross-merchandising

Penetrating deeper and wider customer channels inevitably leads to revenue gains. Revenue synergies occur when the merged entity consolidates the customer bases of the prior standalone companies and either sells complementary products to the same customer, or the same product to new customers. For instance, a baker buys a dairy farm and sells butter to his customers who had only previously bought bread from him. Conversely, if he buys a competitor across town, he continues selling bread but now to completely new customers while maintaining his old ones.

Purchasing power

Companies build buyer power over suppliers through purchasing ever larger quantities, which results in negotiating leverage translating into cheaper input prices and progress toward economies of scale. Depending on the supply and price elasticity of the good in question, a buyer can dramatically reduce its per-unit cost by scaling up order volumes and turn greater profits in doing so given that there exists sufficient end demand for the new supply. For example, a fertilizer manufacturer reliant primarily on phosphate and potash can acquire competitors until the aggregate sales, and thus raw materials purchases, become large enough to negotiate price breaks for each incremental ton perhaps. WalMart is constantly cited for squeezing its suppliers, and from a purely economic standpoint is the preeminent example of a company with high purchasing power.

Financial leverage

As a company acquires smaller ones, it accumulates assets and grows its total enterprise value, which in turn qualifies the company for higher debt levels than were available when it was smaller. We discuss the power and benefits of leverage to enhance equity returns in our LBO primer, and it’s important to stress that an optimal level of debt with which to operate that boosts returns on equity capital and garners favorable treatment under the US tax code (interest payments come out of the gross profit and reduce taxable income). Lenders consider physical assets, free cash flow, growth potential, and business risk before issuing credit. Larger companies are inherently less risky, higher valued, and more asset-rich than small ones, so accordingly qualify for more and cheaper debt that can be used for more inorganic acquisitions and new organic investments to boost ROI.

For all these reasons the “buy” strategy is often as or more attractive than an organic “build” strategy. Particularly in a market where many corporations have the cash available to pursue such an acquisition, seeking out add-ons may prove one way for investors to amplify return on their initial investment.