When to Buy: The Add-On Question
Private equity is well-known for buying additional earnings through “add-ons,” or companies added to an existing operation. Buying something is usually faster than building it, which is part of the reason it’s popular in private equity. But is it worth it?
The belief is that 2+1=3. Or 4. Or 7+.
And yet. Industry research puts the M&A failure rate somewhere between 70% and 90%, depending on how you count (and that's before you account for the opportunity cost of the operator attention the failed deals consumed).
If you are going to buy instead of build, it’s critical that you set things up for the best possible path towards the math above.
But it does mean that you start with an internal question, not a question about any given prospect. That question is: are we in a position to buy anything at all right now?
The Qualification Gate
When our portfolio companies start contemplating add-ons and acquisitions, we start with a baseline: six conditions before we can even begin shopping. These are pre-recs, not a wishlist or a we’re-close-enough list:
A stable, predictable core business. Integrating a new entity is an uphill battle in the best of circumstances. Trying to roll it into an unstable platform is a fool’s errand. Acquisitions only amplify instability.
Leadership staying multi-year. Integration takes years. If a CEO is contemplating an exit, or two ops leaders have turned over in eighteen months, this is the wrong moment.
A clear source of funds. Not "we'll figure it out." Which dollars, from where, with what cost, on what terms.
Capacity for additional exposure. Cash, attention, risk capacity…they’re all finite. If any of them is already stretched, an acquisition may cause things to fray.
Timely, accurate financials. You can't underwrite an acquisition off financials you don't trust. Worse: you can't integrate into a company whose own numbers are unreliable.
Manageable integration capacity. Not "possible in theory." Manageable, by the people in place, in the time that’s actually available.
If the answer to any of these is “no,” the company has work to do before spending capital for an add-on. It’s worth asking whether the company doing the buying is built to absorb what's being bought instead of racing to evaluate the deal in front of them. The deal can be excellent on paper and still be the wrong deal for this company this year.
If all six are yes, the deal-specific work begins.
A note on what we're talking about
An add-on is a company or asset acquired in service of an existing one. It’s a common method in private equity-owned companies to grow quickly, commonly referred to as inorganic growth. The categories matter less than the question they're answering, but the vocabulary is useful:
Vertical: pulling another rung of the supply chain in-house. A supplier you depend on, or a downstream channel that's currently a middleman.
Horizontal: a competitor with similar offerings, usually to expand footprint or take share.
Extension: a company with unrelated operations that shares something complementary (a customer base, a distribution channel, a region).
Acqui-hire: a purchase made primarily to bring on the team rather than the business itself.
Asset purchase: buying specific assets (IP, equipment, inventory, a license) rather than a whole company, usually from a wind-down or strategic shift by the seller.
Each comes with different upsides, different integration nuances and different failure modes.
Shopping Is Different from Buying
Regular review of the deal flow in your market is a healthy operating habit, and we ask our portfolio companies to do it, even as we also keep an eye out. It sharpens your market awareness, surfaces competitive market dynamics, and forces a steady internal capabilities check ("Could we do that? Do we need to?").
But shopping is different from buying. Reviewing a deal isn’t a downpayment on saying yes.
We run the seven questions below on every opportunity that crosses our desks at Permanent Equity or those of our management teams. Candidly, most opportunities do and should end in no.
The Seven Questions
1. What are we buying, and why?
It sounds simple, but simple is what’s often skipped. Just because something is for sale doesn't mean it's worth buying, or that it’s worth you buying. So, first you’ve got to specify what you actually want (the customers, the geography, the team, the IP, the license, the elimination of a competitor) and why getting it via this transaction is more compelling than getting it any other way.
“Because it's available" or "because we have the money” isn’t a credible answer.
In practice, this translates into an Investment Memo.
2. What are the tradeoffs of buying vs. building?
This is the central strategic question for any add-on, with four real answers:
Some things can't be built. Certain licenses are rarely issued. Some long-standing customer relationships exist on terms that can't be replicated. In these cases, acquisition can be the clear answer.
Some things take too long to build. Entering a new market or forging customer trust may take years to do organically, with no guarantee of success. Buying gives you a starting point that you'd otherwise need a decade to reach. (Caveat: most customer contracts have change-of-control provisions. Don't assume relationships travel with the deal.)
Some things are more expensive to build. If a target has spent years at breakeven or net loss developing something that now works, the math may favor buying the proven thing over building the unproven version.
Some things are obstacles. Sometimes buying a competitor improves market dynamics in your favor enough to justify the cost on those grounds alone.
If none of these four answers applies cleanly, build is usually the better path.
3. Are there conflicts of interest in play?
Real or perceived, public perception issues create accusations of collusion, even if the actual transaction is clean. If your buyers, your regulators, or your industry peers might look at the deal a little sideways, decide now whether you're willing to defend the choice (and what defending it actually requires).
4. How would integration practically work?
Integration is where most M&A fails and where planning is weakest. Integration plans typically involve multiple steps and substantial change management on both sides of the deal. And someone has to do the work.
If you can't name who, on what timeline, with what authority, the integration isn't planned, it's wishful thinking.
5. What could go wrong?
No business is perfect. Baggage tends to accompany any purchased earnings. Industry research puts the M&A failure rate at 70% to 90%. Acquirers aren’t necessarily bad at math, but the unknowns dominate the knowns once the deal closes.
Name what you know you need to watch out for. Then assume there are unknowns you haven't named, and stress-test the deal against the possibility that the worst of them is true. (Our piece on How to Conduct a Pre-Mortem is a useful method for surfacing them.)
6. What are the evaluation metrics, and over what time period?
Only buy something if you're confident the company has the capacity and capability to use it to its advantage. That confidence has to be measurable. So set the milestones and metrics in advance. 18 months later, you want to know whether the acquisition is doing what you bought it to do.
Financial performance expectations on an add-on should usually clear a specific performance threshold against the capital used to acquire it. Each capital base may have a different approach.
7. How does this opportunity compare to our other strategic priorities?
Every initiative you pursue impedes another. When you evaluate an add-on, you're not evaluating it against zero. Instead, that opportunity has to hold up against everything else that operator attention, that capital, and that integration capacity could be doing. If there’s an organic initiative you already have on the roadmap, an add-on, even a good one, may throw you off course.
Why We Hold Changes the Math
Most private equity buyers know they'll sell the company within three to seven years. That means most M&A in private equity is structured around the next exit: make the company look bigger, do the deal, integrate later (or never), let the next owner deal with whatever didn't work.
A 30-year hold means integration isn't a problem we pass to the next owner. At Permanent Equity, we are accountable for what happens next. The lights we leave on stay on. The cultures we mash together stay mashed. So while the hurdles to be cleared have to stay high, it also gives a different shape to those bars. If a deal isn't right this year, it may be right in three years, or never, and either of those outcomes is fine. We never want to be forced actors, add-ons included.
Capital for Add-Ons
The right source of capital depends on the deal and the company. Generally, an add-on can be funded by:
Cash on the balance sheet
Cash contributed by shareholders
Bank debt
A seller's note
Company stock
Each carries different cost, risks, and messages about how confident the parties are in what's being bought. A seller who takes a substantial note is signaling that they believe the business will perform. A buyer who funds entirely with debt is taking concentrated risk on a single thesis. None is right or wrong in the abstract, but the choice is part and parcel of the strategic question.
A Note on Valuations
Add-on valuations depend on both historical performance and how the buyer intends to use the acquisition. Quality, size, execution risk, and source of funds all move the number.
Using numbers, even ballpark ranges, in advance of underwriting can unintentionally kill a deal. Or worse, it can lock you into a price you committed to before you knew what you were actually buying.
Building the M&A Muscle
The operators we've seen build well through add-ons (over years, not quarters) tend to treat M&A as a discipline rather than a reaction. They review constantly. They qualify the company before they qualify the deal. They ask the seven questions in order. And they pass on most of what crosses their desk, even when the individual deal looks good in isolation. The patience is process, and they’re building muscle ongoingly so that when the right opportunity reveals itself, they’re ready.
When they do buy, the deal is rarely the most exciting one they've seen. It's the one that survived all the filters, opportunity costs, and for which the team has built high conviction.
Interested in a conversation?
For investments, contact Danny Gray at Danny@permanentequity.com
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Permanent Equity is a private equity firm investing 30-year committed funds in companies that care what happens next.