Fragmentation and market structure

The opportunity for vertical software companies to buy and transform operating via GBOs (growth buyouts) is massive. To pull off a GBO founders need transformational software (duh) but also to be in the right markets where market structure supports the M&A strategy.

There’s a common pattern we see in what will and won’t work:

1. Right-skewed distribution: only small companies (HVAC, single family property management, etc). The acquirer will be stuck doing small acquisitions and ~growing the number rather than size of transactions which means tons of tnx costs and a cap on the ultimate outcome~. This is a great place to franchise OR to bring down the cost of acquisition/integration as a tech enabled rollup like Teamshares.

2. Left skewed distribution: only huge companies to buy (network effects-driven companies). Too expensive to get started and not clear you even CAN buy anyone/that they’d sell.

3. Bimodal distribution: everyone is either too small or too big with nothing in the middle (accounting firms). It’s too hard to cross the chasm so you either get stuck doing tons of small deals or chasing whales (combination of #1 and #2).

4. Normal distribution - the one that works: This is ideal because there’s a business to buy at every deal size and company stage. You can get started easily, grow gradually, and know that the market will ultimately support a big company in the end.

Build and validate a software value prop in your market and if the market structure supports, start buying to transform and own the P&L.

Sometimes fragmentation is optimal

The premise of a lot of (venture-backed) rollups is “the industry is fragmented, and therefore inefficient. We’ll build great tech and create a consolidator with no scaled competition.” Ie it’s premised on the status quo necessarily being stupid and the obvious alternative being better.

But markets are generally and increasingly efficient (or at the very least it’s incumbent on you to prove otherwise if you think otherwise). So if fragmentation has persisted, it might be the logical/efficient path.

Here’s why fragmentation might make sense:

1. No network effects- most businesses don’t just naturally get better as they get bigger without specific intervention or synergy.

2. High transaction costs - really small companies are more expensive. Businesses without professionalized management (owner-operators) are painful to integrate.

3. No economies of scale - businesses with simple supply chains and distribution models have few opportunities to improve unit costs through increased size alone.

4. No shared customer acquisition - inherently “local” (either geographical or cultural) businesses might not be able to create shared brands and marketing. Local newspapers and long tail beauty brands come to mind.

5. Diseconomies of scale - the service might get worse or harder to manage as it gets bigger (boutiques and artistic endeavors don’t scale well).

6. Regulatory- being small might be a revealed preference of regulators

In markets resistant to consolidation, trying to consolidate and create a scaled platform operator might be pissing into the wind and fighting gravity. In contrast, when we look at targets for Growth Buyouts we want markets with a normal distribution of target company sizes which not only means there’s a raft of companies to buy at every stage/size but also that the market naturally supports big companies at all.

Read more about GBOs