Tech Appeal Grows Amid Credit Storm

By Ari Nathanson and Jeremy Harrell

A funny thing’s happened to the technology buyout: It’s making the transition from fad deal to wise investment, a transformation that could be pushed further along by the faltering credit markets.

Returns in the tech sector come primarily from organic growth and strategic acquisitions, as these deals use far less leverage than your garden-variety buyout. Now that the credit markets have slowed to a crawl, and lenders are less willing to fuel deals at 7x EBITDA, buyout firms that have been doing tech deals at debt-to-EBITDA ratios at 5x EBITDA feel like they’re still in business.

Which is lucky, since they have plenty of money to put to work. So far this year, buyout firms that specialize in technology have raised some $12 billion, and the number balloons higher when you add in money raised by generalists that dabble in the sector. Some of the biggest names in tech buyouts have amassed significant war chests. Silver Lake, one of the pioneers, is in the midst of raising a $10 billion third fund. Insight Venture Partners, a mid-market tech-focused firm based in New York, closed in June on a $1.25 billion sixth fund. Meanwhile, Hellman & Friedman, an occasional tech player, closed an $8.4 billion fund earlier this year, while Bain Capital, another generalist with an appetite for tech, is gearing up to raise a $15 billion tenth fund.

Subdued Leverage

Don’t get us wrong: Technology buyout firms have clearly discovered the joys of financial engineering.

The shell shock of the dot-com explosion has worn off, and software companies, semiconductor manufacturers and other cutting-edge companies have successfully transformed themselves from cash-hungry targets for venture capital to stable, EBITDA-producing companies capable of shouldering debt. “There’s been a lot of new capital coming into tech buyout funds, and the leverage multiples available to those deals was ratcheting up on a monthly basis,” said Chris McCabe, head of the technology team at mid-market investment bank Piper Jaffray.

Indeed, new lenders have flooded the tech market, among them mid-market lender CapitalSource Financial, which recently hired away a JPMorganChase banker to launch a tech-focused debt group. The resulting explosion of debt structures, including payment-in-kind toggle notes, helped push tech deals well into the bulge bracket, giving rise to multi-billion deals for chip-maker Freescale Semiconductor (acquired by The Blackstone Group, The Carlyle Group, Permira Advisers and TPG in 2006) and the parents of online travel-booking services Travelocity and Orbitz (acquired by TPG and Silver Lake, and Blackstone Group, respectively, both in 2006).

The growing availabilty of debt to finance tech buyouts is no doubt one reason that generalist firms such as Blackstone Group, Carlyle Group, Hellman & Friedman and Kohlberg Kravis Roberts & Co. have made such aggressive pushes into the sector over the last several years. As with other areas of the buyout business, the competition and liquidity have combined to drive prices higher. TPG and Silver Lake, for instance, had to fend off a rival bid from Apollo Management in the auction for Travelocity’s parent.

All that said, leverage ratios for tech deals have remained subdued compared with more run-of-the-mill buyouts. Tech companies are still defined primarily by their growth, and the sector grows at almost double the rate of the rest of the economy. To generate returns, tech-focused LBO firms can let the company’s top-line growth—and not its leverage—do the talking.

Silver Lake, which is based in New York and Silicon Valley, provides a case in point. Glenn Hutchins, a Silver Lake co-founder and co-chief executive, wouldn’t provide details about Silver Lake’s equity-to-debt ratios. But he did say that his firm structures deals with more equity and less debt than is found in typical buyouts, preferring to let a company’s growth drive returns. “Since we pursue good companies with good growth prospects, we use debt judiciously and invest equity aggressively in building the business,” Hutchins told Buyouts. “So Silver Lake is less reliant for its success on the debt markets than the average player in the private equity industry is.”

Silver Lake’s first fund, closed in 1999, delivered a 2.2x cash-on-cash return through December 2006, according to the Washington State Investment Board, a Silver Lake limited partner. The firm’s second fund, closed in 2004, had returned 1.3x as of the same time. The firm’s signature deal is the 2000 buyout of disk-drive company Seagate Technology, a $2.2 billion transaction funded by $1.1 billion in equity. Silver Lake and its partners earned roughly 8.6x invested capital. “Technology deals have never been as levered as general LBOs,” said Alex Slusky, a founder and managing partner of mid-market shop Vector Capital Partners, which closed a $1.2 billion fund in July. A typical Vector Capital deal relies on a 3x to 5x debt-to-EBITDA ratio—although the firm has occasionally gone as high as 6x to 8x during during the easy credit climate of the last cycle. Still, even 6x to 8x debt-to-EBITDA ratios can seem like a mark of sobriety when LBOs in other industries have been topping out at 9x and 10x debt-to-EBITDA ratios in the last 18 months, Slusky said. In 2003, Vector Capital took control of struggling Canadian software firm Corel Corp. for $13 million. Today the company, of which Slusky is chairman, is worth $321 million, and that’s despite a 20 percent drop in market cap since the company returned to public trading 18 months ago.

Impact Of Credit Crunch

Now is obviously a good time to be doing deals in a sector that doesn’t rely as heavily on leverage for returns. But tech buyout firms haven’t been completely insulated from the credit troubles blossoming around them. For those that need a reminder of what’s been happening: The seemingly endless supply of cheap, easy leverage has evaporated. Investment professionals across the buyout industry have reported financing arrangements that have driven down leverage levels by a turn or more and that provide less flexibility to struggling portfolio companies.

“I can’t imagine that we’d be able to push forward with better terms, even though we were getting modest leverage compared to what you were seeing in the bigger deals,” said Jeff Horing, managing director and co-founder of Insight Venture Partners. “I’m expecting that the next time we go back to the markets for a deal that the spreads are going to be meaningfully wider than they were.”

Nonetheless, Horing said he likes the tech buyout market better now than he did even one year ago. Lenders are generally more comfortable with the notion of a tech deal, and even in a constrained market they’re showing appetite for tech company-backed debt, he said. “We’ve actually approached some of our lenders [in the last month] to see if we could buy down the debt on a discount basis in some of our over-performing deals, and they had no interest in selling at a discount,” Horing said. “So it gives you a pretty good sense that they like the credit that they backed and really have no interest in walking away from those deals.”

Meantime, the fundamental opportunity behind tech buyouts continues to look strong. Mark Bettencourt, a partner in the technology and private equity groups of Boston law firm Goodwin Procter, points to home runs like Hellman & Friedman’s 8x exit from Doubleclick earlier this year as partial evidence. “Disruptive” companies such as these can alter the tech landscape and deliver handsome profits to a few lucky investors, Bettencourt said. But beyond that, plenty of mid-sized public companies, often in the software business, need a veil of privacy behind which to develop their next-generation products, Bettencourt said.

“The way to reposition a company is to take it private to develop the next evolution of the technology,” Bettencourt said. “It’s not about making a slightly different widget; it’s about making a new widget.” Often, he added, shareholders don’t have the same patience as a buyout firm, and an LBO shop is more willing to cough up the necessary capital expenditures to make the project a success.

In the best of all worlds for tech buyout shops, the pullback in the credit markets, and the early shakiness of Freescale and other recent deals, will be just enough to scare some of the johnny-come-latelys from the market, leaving them a less competitive field to operate in. Hutchins, for one, said he wouldn’t be surprised to see some generalists, who arguably rely more than the tech specialists on leverage for their returns, to pull out of technology if the debt market continues to recede. “I assume some people who have dipped their toe in technology and had it scalded will retreat,” he said.

Added Vector Capital’s Slusky: The “technology industry does have a lot of unique factors, and simply applying a financial engineering approach to tech companies is likely to end in some pretty questionable investments.”