So far in 2004, there has been more than $6.5 billion raised by funds dedicated to the tech sector, representing roughly a fifth of all the disclosed buyout capital raised. With all this dry powder lying in wait, it won’t be long until that translates into deal activity. However, this time around, when that money is put to work, there will likely be some notable differences from the last technology craze.
During the tech crazy five years ago, investors were looking for growth stories-sexy companies with shiny new products that seemingly did the impossible. During that timeframe, the approach of the buyout shops largely changed. In a 1999 Buyouts article, American Securities Capital Partners Managing Director Paul Rosetti said that when it came to deals in the tech sector, “More and more buyout guys are using a non-leveraged approach, [since] they realize that they can get their return from growth.”
This was evident in the type of transactions sponsors were completing. Deals for Fairchild Semiconductor and Zilog in the 1997-1998 window pointed to the cyclical play sponsors were aiming for, and between 2000 and 2001, growth was clearly the objective with Internet deals such as Datek Online or Homeruns.com dotting the Buyouts Deals List.
After the bubble burst, the search for growth investments turned into a hunt for turnaround plays, and investors took to weeding out the good businesses to wait out the slump and perhaps goose the company’s performance with some operational enhancements.
But now, as the surviving tech businesses have emerged and investors have a better idea of what technologies are commercially sound, sponsors are, in a lot of cases, taking a back-to-basics approach. GPs are tackling technology investments as they would a manufacturing deal or a buyout in healthcare, where consistency of cash flows and visibility become the most important attributes to an investment, and the guesswork involved with predicting growth is considered upside rather than serving as the premise behind a deal.
Because of this, sectors with steady rather than unbridled growth have been catching investors’ eyes, and sponsors are buying software companies with regular maintenance contracts or service businesses with recurring revenues. UGS PLM Solutions, acquired by a consortium in a $2.05 billion deal earlier this year, is a technology services business focused on product-lifecycle management and could serve as an example of this. While the investors certainly expect the company to grow, it’s the consistent performance of UGS and its blue chip customer base that attracted the buyers.
“We’re finding that private equity firms are clearly focusing on the more mature technology businesses,” Barrington Associates’ Adam Roseman says. “Strong, free-cash flows, a recurring revenue component or subscription contracts; these are all important characteristics for buyout investors nowadays.”
Another factor that could be pushing the focus away from solely investing in growth is the availability of leverage. In the past, LBOs in technology had been difficult to maneuver. The research and development costs needed to fund the growth prohibited the amount of leverage investors could use, and lenders were also wary to back an unproven business with growth projections based as much on hope as any historical evidence. Today, when investing in companies with more stability and visibility, technology players are better positioned to maximize the debt and benefit from the leveraging the business.
In the UGS deal, for example, Silver Lake Partners, Warburg Pincus and Bain Capital financed the transaction with roughly $1.2 billion of debt, which made up nearly 60% of the purchase price. While that level of leverage still seems low for an LBO, for a tech company, it represents a significant amount of debt, and some deals will even push higher than that. “A software company with maintenance contracts can be levered 30%/70% equity to debt as long as there is visibility,” TA Associates Managing Director Kurt Jaggers says.
What’s Driving This?
The driver behind this shift in focus could be open to debate, but it is likely a combination of sponsors aiming to use more discretion and also, more simply, a response what the industry is dishing up.
In the late 1990s, as Rosetti alluded to, the trend was for buyout firms to pursue VC type investments, but now, it’s not such a bad thing to take a more conservative approach. “We’re not a venture capital fund,” Silver Lake Managing Director and COO Alan Austin says. “We’re interested in market leading businesses, not chasing down the next great thing in tech.”
Demonstrating just how far the tables have turned, VC firms have now started borrowing from the LBO blueprint, and some are regularly chasing down control acquisitions. Firms such as Kennet Venture Partners, Battery Ventures and Primus Venture Partners have all completed buyouts this year, and Barrington’s Roseman says, “We’ve had a number of later stage venture capital firms call us up looking for buyout opportunities.”
Meanwhile, even as investors are generally showing more caution today, the tech space has clearly matured and the opportunity to back momentum deals isn’t as discernible as it was in the past, making the growth play even harder. Tech spending among corporations has leveled off and clear-cut growth stories are no longer as obvious as past eras.
“Over the past 20 to 25 years, there’s always been a major theme,” TA’s Jaggers says. “Whether it was personal computers, client networking or the Internet, there has always been one main driver in technology. Now that driver is a little less clear, so as a consequence investors are spreading themselves out more and looking to different subsectors where there are some trends that are positive.”
Despite all of this, there is still no question that some sponsors who target tech are doing so with growth in mind. Garnett & Helfrich Capital, for example, is made up of ex venture capitalists with a clear leaning towards growth. Earlier this year, David Helfrich told Buyouts, “In order to generate extraordinary returns, you should be doing something that others aren’t… We’ve identified what we believe draws on both the best of venture and of buyouts, with the high growth of venture and then the acquisition base upon which you can layer that growth.”
Even Jaggers admits, “Our main focus is on finding the underlying growth.” However, he adds, “It’s important to know what has the makings for a long-term company and what’s a short-term fad.”