Incremental private equity: Meaning, Criticisms & Real-World Uses

What Is Incremental Private Equity?

Incremental private equity refers to a core strategy within private equity where a firm acquires a "platform" company and then systematically adds smaller, complementary businesses to it. This approach, often termed a "buy-and-build" strategy, falls under the broader umbrella of private equity strategies. The goal of incremental private equity is to generate significant value by creating a larger, more diversified, and more efficient entity than the sum of its individual parts. By consolidating smaller players, private equity firms aim to achieve economies of scale, expand market reach, and enhance operational efficiencies within the portfolio company.

This strategy contrasts with traditional standalone acquisitions, where a private equity firm might acquire a single company with the intent of optimizing its existing operations before an exit strategy. Incremental private equity, on the other hand, is characterized by a series of smaller mergers and acquisitions that occur post-platform acquisition, creating a growth trajectory through consolidation.

History and Origin

The concept of consolidating smaller businesses into larger, more valuable entities predates formal private equity. However, the systematic application of a buy-and-build approach as a core value creation lever for private equity firms gained significant traction from the 1980s onwards, evolving alongside the rise of leveraged buyout transactions. Initially, private equity focused heavily on financial engineering—optimizing capital structure and reducing costs. Over time, as markets matured and competition for attractive targets increased, firms increasingly turned to operational improvements and strategic inorganic growth to drive returns.

Academic research has since explored the effectiveness of these strategies. A 2017 paper, "Buy and Build Strategies in Private Equity: Boost or Transformation?", highlights how private equity fund managers actively develop their portfolio companies through these add-on acquisitions, emphasizing the trade-off between the quantity and complexity of such deals. T⁵his shift reflects a recognition that substantial value can be created not just through financial leverage, but also through the integration and optimization of multiple businesses, leveraging shared resources, and achieving greater market power.

Key Takeaways

Consolidation Strategy: Incremental private equity involves acquiring a core "platform" company and then adding numerous smaller, complementary businesses (add-ons).
Value Creation: The primary goal is to enhance the platform company's valuation through economies of scale, market expansion, operational synergies, and multiple arbitrage.
Growing Trend: Add-on acquisitions have become a dominant strategy in private equity, often representing a significant majority of all private equity-backed buyouts in recent years.
*⁴ Operational Focus: Beyond financial engineering, this strategy emphasizes operational integration and strategic management to drive growth and efficiency.
Strategic vs. Financial Buyer: Incremental private equity allows financial buyers to act more like strategic buyers by building scale and scope, aiming for long-term operational improvements.

Formula and Calculation

While there isn't a single universal formula for "incremental private equity" itself, the value creation often hinges on the concept of multiple arbitrage. This typically involves acquiring smaller add-on companies at lower enterprise value (EV) to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiples than the larger platform company's multiple. When these smaller companies are integrated into the larger platform, their EBITDA is then valued at the platform's higher multiple, leading to an increase in overall firm value.

The theoretical value uplift from multiple arbitrage can be conceptualized as:

\text{Value Uplift} = (\text{EBITDA}_{\text{Add-on}} \times \text{Platform Multiplier}) - (\text{EBITDA}_{\text{Add-on}} \times \text{Add-on Multiplier})

Where:

(\text{EBITDA}_{\text{Add-on}}) = The EBITDA of the acquired add-on company.
(\text{Platform Multiplier}) = The enterprise value to EBITDA multiple of the platform company.
(\text{Add-on Multiplier}) = The enterprise value to EBITDA multiple at which the add-on company was acquired.

This simplified calculation illustrates the core financial mechanism. In practice, the actual gain depends on successful integration, realization of synergies, and market conditions at the time of exit.

Interpreting the Incremental Private Equity Strategy

The effectiveness of an incremental private equity strategy is interpreted through its ability to enhance the fundamental value and operational performance of the combined entity. When a private equity firm pursues this approach, it's a strong indication that they believe in the potential for significant synergies and operational improvements that transcend simple financial restructuring. The success is measured not just by the initial acquisition price and eventual sale price, but by improvements in revenue growth, profitability, market share, and competitive positioning.

For instance, if a platform company in a fragmented industry acquires several smaller competitors, the interpretation is that the private equity sponsor aims to consolidate the market, increase pricing power, streamline operations, and leverage a larger customer base. This strategy allows the firm to scale rapidly without relying solely on organic growth, which can be slower. The ability of the general partner to identify suitable add-on targets, execute effective due diligence, and integrate diverse operations is crucial to the interpretation of success.

Hypothetical Example

Consider "TechSolutions Inc.," a mid-sized software company providing industry-specific management tools, acquired by a private equity firm, "Growth Capital Partners." TechSolutions Inc. becomes the platform company.

Platform Acquisition: Growth Capital Partners acquires TechSolutions Inc. for $100 million, valuing it at 10x its current EBITDA of $10 million.
Add-on Acquisition 1: Growth Capital Partners identifies "SmallSoft LLC," a smaller competitor with a niche product that complements TechSolutions' offerings. SmallSoft LLC has an EBITDA of $2 million. Due to its smaller size and niche market, Growth Capital Partners acquires SmallSoft for $12 million, reflecting a 6x EBITDA multiple.
Integration and Synergies: TechSolutions integrates SmallSoft's product into its suite, cross-sells to both customer bases, and consolidates administrative functions. This leads to cost savings and increased sales, boosting SmallSoft's contribution to the combined EBITDA.
Add-on Acquisition 2: Next, Growth Capital Partners acquires "DataAnalytics Co.," a data analytics provider with $1.5 million EBITDA, for $7.5 million (5x EBITDA). DataAnalytics Co. enhances TechSolutions' product with advanced reporting features.
Combined Entity: After integrating both add-ons, the combined entity (TechSolutions Inc. + SmallSoft LLC + DataAnalytics Co.) now has a total EBITDA of $13.5 million ($10M + $2M + $1.5M).
Value Uplift: When Growth Capital Partners prepares to exit its investment, the market may value the larger, more diversified TechSolutions Inc. at a higher multiple, perhaps still 10x EBITDA, or even higher due to its enhanced scale and market position. If the exit occurs at 10x EBITDA, the combined entity would be valued at $135 million.

The incremental private equity strategy in this example allowed Growth Capital Partners to acquire $3.5 million of EBITDA for $19.5 million (an average multiple of 5.57x) and then have that EBITDA valued at the higher platform multiple of 10x, contributing significantly to the overall gain beyond just the initial platform investment.

Practical Applications

Incremental private equity, through buy-and-build strategies, finds widespread application across various sectors within the financial landscape. Its primary use is in fragmented industries where consolidation can unlock substantial value.

Industry Consolidation: Private equity firms frequently employ incremental private equity to roll up smaller, regional businesses into a larger, national or international player. This is common in sectors like healthcare services, IT services, waste management, and business services.
Geographic Expansion: A platform company can acquire smaller businesses in new geographic markets to quickly expand its footprint without lengthy organic market entry.
Product/Service Line Expansion: Acquiring companies with complementary products or services allows the platform to offer a broader solution, increasing market share and customer value.
Supply Chain Integration: Private equity firms might acquire suppliers or distributors to create a more integrated and efficient supply chain, reducing costs and improving control.
Regulatory Framework: Firms implementing incremental private equity strategies must navigate complex regulatory compliance. The Securities and Exchange Commission (SEC) regulates investment advisers, including private equity firms, particularly under the Investment Advisers Act of 1940. This regulation ensures proper disclosure and adherence to fiduciary duties, especially as these firms manage significant capital for limited partner investors.

The use of add-on acquisitions has become a defining characteristic of modern private equity. By the end of 2022, add-on acquisitions accounted for over 76% of all private equity-backed buyouts in North America, a significant increase over the past decade, demonstrating their continued importance as a value driver. B³ain & Company's Global Private Equity Report consistently highlights the prevalence and impact of buy-and-build strategies in the industry.

²## Limitations and Criticisms

While incremental private equity offers compelling opportunities for value creation, it is not without limitations and criticisms.

Integration Risk: One of the most significant challenges is the successful integration of newly acquired businesses into the platform company. This involves merging different corporate cultures, IT systems, operational processes, and management teams. Failure to integrate effectively can erode potential synergies and even lead to value destruction.
Due Diligence Burden: Repeated add-on acquisitions require extensive due diligence on each target. This can strain the resources of both the private equity firm and the platform company, particularly if deals are executed rapidly. Missed risks or undisclosed liabilities in smaller targets can have disproportionate impacts.
Overpaying for Add-ons: The desire to build scale quickly can sometimes lead private equity firms to overpay for add-on targets, especially in competitive markets. This can diminish the overall returns of the strategy, as the initial multiple arbitrage benefit is reduced or negated.
Increased Regulatory Scrutiny: As add-on acquisitions become more prevalent and contribute to market consolidation, they may attract increased attention from antitrust regulators. Concerns about reduced competition in specific markets can lead to heightened scrutiny of proposed deals, potentially delaying or blocking acquisitions.
*¹ Debt Burden: While typically smaller, add-on acquisitions may still involve additional debt financing, potentially increasing the overall leverage of the portfolio company and making it more susceptible to economic downturns or rising interest rates.

Incremental Private Equity vs. Buy-and-Build Strategy

Incremental private equity and a buy-and-build strategy are often used interchangeably because they describe the same core approach within private equity.

Incremental Private Equity emphasizes the process of adding value in increments through serial acquisitions post-platform investment. It highlights the step-by-step nature of building a larger entity from a base.
Buy-and-Build Strategy directly refers to the tactic or methodology of acquiring a foundational "platform" company and then "building" it up through subsequent smaller "add-on" acquisitions.

The primary difference, if any, is purely one of emphasis in terminology. Both terms describe the same strategic approach where a private equity firm leverages a initial investment in a platform company to consolidate a fragmented market or expand capabilities through a series of follow-on acquisitions, aiming to create a larger, more valuable business. Confusion might arise if "incremental" is taken to mean minor, rather than a systematic process of growth. However, in private equity context, both terms convey the intentional, structured growth through acquisition.

FAQs

What is the main objective of incremental private equity?

The main objective is to create a larger, more valuable company by combining a core "platform" business with several smaller, complementary "add-on" acquisitions. This aims to achieve economies of scale, market expansion, and operational synergies.

Why do private equity firms use this strategy?

Private equity firms use this strategy to drive significant returns beyond what might be achieved through standalone investments. It allows them to capitalize on fragmented markets, leverage operational expertise, and benefit from multiple arbitrage opportunities.

How does incremental private equity create value?

Value is created through several avenues: consolidating operations to reduce costs, expanding market reach, cross-selling products or services, improving management and processes, and selling the combined entity at a higher valuation multiple than the average multiple paid for the individual components.

Is incremental private equity suitable for all industries?

No, it is most effective in fragmented industries characterized by many small to medium-sized businesses, where there is significant potential for consolidation and the realization of synergies. Industries like healthcare services, software, and business services are common targets.

What are the risks associated with incremental private equity?

Key risks include challenges in integrating different company cultures and operations, the potential for overpaying for add-ons, increased regulatory compliance scrutiny (especially antitrust), and the burden of executing numerous transactions.