But P/Es are as much about investors' perceptions as about earnings. If investors come to doubt that earnings can be sustained, the multiple will come down, throwing sand into the gears. And it's virtually a foregone conclusion that every industry will ultimately run out of suitable acquisition candidates. Yet consolidators almost always cite the arbitrage as the key to their strategy. "It is the concept," says Ledecky. "It's a gerbil wheel." At that point, investors in roll-ups will have to worry whether their company can effectively manage what it owns.
Trouble is, roll-ups often lack experienced management teams. "Roll-ups tend to be headed by executives who have experience in roll-ups, but not in the industry," says Samuel Hayes, a finance professor at Harvard Business School. That, he says, can be a recipe for disaster. Indeed, some observers contend that once traditional measures of performance are applied, like comparison of same-store sales or other measures of operational growth, lofty P/E ratios will fall back to earth even before a roll-up runs out of potential targets.
"Fueling growth by buying companies with lower P/E ratios has long been discredited as a strategy that has no rationale," says Geoffrey Brooks, an assistant professor at the University of Pennsylvania's Wharton School. He cites the failure of diversification in the 1960s as a prime example. Jeffrey Evans, vice president of research at Credit Lyonnais Securities (U.S.A.) Inc., agrees. "It's the greater-fool theory. At some point it has to stop, and someone is left holding the bag." Often that includes the CFO.
Consider Fine Host Corp. The Greenwich, Connecticut-based food-service firm set out to consolidate small players that run concessions and cafeterias at universities, corporations, and sports arenas. It went public in the summer of 1996 at $12 a share and shot up to $43 by the fall, buoyed by a flurry of acquisitions. But in April 1997, the CFO, Nelson A. Barber, was suddenly demoted to treasurer, and by October analysts were complaining about a lack of information. In December, the stock fell 64 percent when the company removed Barber and its CEO, Richard E. Kerley. The company later admitted it had recognized some income before it was earned and incorrectly capitalized certain expenses, and restated earnings back to 1994, incurring losses instead of profits. The Securities and Exchange Commission is conducting an informal investigation.
In many cases, though, the promoters and underwriters make a killing whether the roll-ups bear fruit or not. "The people who financially engineer these deals make an enormous amount of money," says Patrick Hurley, partner and M&A director at Howard, Lawson & Co., a Philadelphia investment bank. He says that the promoters get a large equity stake for a very small up-front investment. "If they have been able to sell stock, they've made money whether the roll-up succeeded or not." (Often they are locked into agreements that prevent them from selling for 12 to 18 months.) Up-front fees for underwriting, accounting, and legal services are also high due to the complexity of the deals. Hurley estimates that total managers' fees related to completed roll-ups, including the management fee, underwriting fee, and selling concession, are about 50 percent higher than for normal IPOs.
When roll-ups do go wrong, the underlying problem is most often a focus on the financial engineering at the expense of improving operating efficiencies. "The biggest risk in this whole phenomenon is that acquirers lose sight of the nuts and bolts," says Evans. "They just buy things to buy them." Perhaps this point is best illustrated by the title of the keynote presentation, "It's Easier to Buy 'Em Than to Run 'Em," at the upcoming second annual Industry Roll-Ups Conference, a how-to course on the strategy.
CONFLICT-RIDDEN?
Some roll-up cowboys seem to have problems handling the conflicts of interest that can arise. Consider Ledecky. One of the companies he merged into USOP as it went public was Sharp Pencil, of which he himself was majority owner. Although he used $17.6 million of the February 1995 IPO proceeds to, in effect, buy himself out, Ledecky did not think it necessary to get an independent appraisal of Sharp's value, according to USOP's prospectus. Ledecky, who denies any conflict of interest, says he got the same multiple for Sharp Pencil as the other founding companies. "They were all valued in the same way. Everyone negotiated the deal together." Still, investors had little way of knowing whether the price was fair, because none of the financial information about Sharp in USOP's prospectus was audited, according to the filing.
Ledecky's conflicts of interest didn't end once he paid himself for Sharp. He took Consolidation Capital public even while serving as chairman of USOP and USA Floral. That raised the risk that he would make acquisitions for Consoli-dation Capital that might have as easily served USOP's and USA Floral's interests. "[Management] may have conflicts of interest in determining to which entity a particular business opportunity should be presented," says Consolidation Capi-tal's prospectus. And even if USOP, USA Floral, and Consolidation Capital weren't competing for the same businesses, Ledecky's time and attention could not be fully devoted to the interests of either or any of the companies, a factor that was also noted in the prospectus. Ledecky announced his resignation as chairman of USOP in January, effective this month.
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