You can increase the valuation of small VFX studios simply by merging them into a larger group -- without needing to make any operational improvements.
World class visual effects are often created by operations that are, to put it bluntly, a mess. Large VFX studios struggle to work consistently across projects. Small studios scramble to deliver the next project. Management practices that are commonplace in other industries have yet to find a foothold in VFX, large scale change management being one notable example.
Despite this, the VFX industry attracts quite a bit of interest from outside investors. VFX studios receiving an injection of capital tend to pursue a roll-up strategy, in which several smaller firms in the same industry are merged to form a larger firm. Cinesite and FuseFX are two such examples. (You can read more about Cinesite’s M&A activities here.)
Gains from M&A
Gathering several smaller firms under the same umbrella should allow them to share resources, achieve new economies of scale, and cross-sell services within the group. Are VFX roll-ups able to realize these types of gains from M&A in practice, though?
VFX studios operate within deeply entrenched and heavily customized technology pipelines. Sharing technology and operating practices between smaller studios is certainly possible, but it’s all too easy to undermine the qualities that made them successful as independents. Individual studios also work hard to build trust with their small roster of key clients, and these clients don’t regard the work of different studios as interchangeable simply because they’re part of the same group.
If, like Cinesite, you adopt a “house of brands” approach and allow your studios to preserve a good amount of autonomy, there may still be gains for the group in the form of shared services. A larger business can better afford comprehensive business support services and high-powered leadership. Individual studios will continue to fight for their own hiring practices, technology priorities, and client relationships. When their portion of group overhead is loaded onto their financials, they suddenly look a whole lot less profitable than they did before.
Bigger is Better When It Comes to Multiples
Does this mean VFX roll-ups simply leverage assets to acquire more assets, with poor prospects of realizing any other gains? Not if we look at roll-ups through the lens of corporate finance – specially, an M&A strategy called multiple arbitrage.
The private equity market is notoriously opaque when it comes to company valuations. As a rule, though, the larger of two otherwise identical companies typically sells at a higher multiple, because it is perceived as a less risky investment. Larger companies also tend to enjoy a lower cost of capital, which gives them a greater potential for investment returns in the long run. All things being equal, smaller VFX studios will each increase in value when rolled up into a group.
The key point here is that the roll-up strategy increases the value of smaller companies without any need for operational improvements or synergies. VFX studios may confound efforts to achieve those gains across the group, but they are unnecessary for skilled finance people to increase the value of an investment through M&A. Companies in the lower middle market offer significant potential for high returns in a roll-up thanks to multiple arbitrage.
