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The evolution Of Tech LBOs –

A lot can change in the course of five years, especially in an asset class as young as private equity. This is particularly true when one considers the technology side of the market, which took many buyout shops for an unforgettable rollercoaster ride (sans the soft landing) between 1998 and 2001.

In the years immediately following the bubble burst, tech-devoted private equity firms saw many would-be targets-particularly the public ones-taking defensive stances when they were approached, while generalist buyout shops acted as if they got a bad taste in their mouth when they even thought about anything more advanced than a factory floor. Now, however, that shyness and posturing has all but disappeared, and technology deals of every shape and size are being executed in what some private equity players say is a pivotal time in the marketplace.

“The technology industry has definitely matured,” says Terry Garnett, a managing director at Garnett & Helfrich Capital. “On a global basis, there are now about 175 technology companies that have over $5 billion in annual sales. That’s almost $1 trillion of sales originating from the technology segment alone.”

The stable cash flow that often accompanies multi-billion-dollar businesses has buyout shops-tech-focused or not-buzzing around the sector. What’s more, the fact that most of these companies are comprised of five to 10 divisions valued anywhere from $500 million to $1 billion-plus means that there are plenty of corporate spin-offs just waiting to be snagged by the circling private equity players, Garnett says.

Indeed, a number of notable carve-outs are already in the market, including Bain Capital’s $3 billion deal to buy the sensors and controls unit from Texas Instruments Inc.; the $2.7 billion majority-stake acquisition of Auna Telecommunications by a group including Providence Equity Partners, Thomas H. Lee Partners, JPMorgan Partners and Quadrangle Group; and the agreement for Kohlberg Kravis Roberts & Co. and Silver Lake Partners to acquire Agilent Technologies Inc.’s (NYSE: A) semiconductor products group for $2.66 billion.

Some market participants point to a single event-last summer’s $11.4 billion taking-private of SunGard Data Systems by a Silver Lake Partners-led consortium of private equity firms-as being the bellwether of the new face of the technology market. With six other firms participating in that transaction, SunGard is the largest PE-backed technology LBO in history.

“Before SunGard, CEOs and board members of public companies were reluctant to receive [sales] calls,” says Accel-KKR Managing Director Tom Barnds. “After SunGard, our phones were ringing off the hook.”

Prior to the SunGard deal, it was widely felt among CEOs and board members of publicly-traded technology companies that going private was a sign of failure-that they couldn’t survive in the public marketplace. But once the 11-fiqure deal closed, many company heads had a change of heart.

“They figured that if a company as big and profitable as SunGard went private, it couldn’t connote failure. Instead, it came to be viewed as a way to streamline a business, reduce Sarbanes-Oxley costs and otherwise transform the company,” Barnds noted.

But SunGard did not come out of the blue. Generally speaking, says Garnett, the technology market has evolved over time to the point that it is now amenable to the traditional buyout model. Predictable cash flow, entrenched customers and stable revenues make companies in the telecom, Internet, software, hardware and semiconductor industries suitable toward private equity capital structures.

A Re-Inflation?

As private equity firms once again flock to the technology sector-including recently formed tech specialists and older generalist players-it’s easy for long-term tech investors to compare today’s expanding tech market to the bubble years.

“When we first started doing this people thought it was a lousy market. They’d say there were no deals, no leverage, no prospect of good returns. People thought it was worse than it really was,” says David Roux, co-founder and managing director of Silver Lake Partners. “Today we are on the verge of the opposite. People think that it’s easier and lots of things look more attractive than they really are.”

Investors are being blinded by the good times, Roux says. They see that the technology space is large and relatively untapped compared to other sectors; it’s growing two to three times faster than the overall economy; leverage is available; and larger companies are seeing the benefits of going private, which creates deal flow opportunities.

What investors are missing is the fact that there are extremely challenging dynamics, such as frequently-changing business models and technologies, ferocious competition and a winner-takes-all mentality (think Microsoft) that do not disappear just because a company has some years of stability behind it.

That the market is ripe for investment because a number of companies are seeing stable cash flow is “what people say when they’ve never been in a downturn,” one tech-focused PE pro says. “It’s like asking people in 1998 what it’s like to invest in the Internet. Of course they all said it was great. But if you’d have asked them again in 2001, what do you think they would have said?”

Alex Slusky, founder and managing partner of Vector Capital, is another tech-dedicated investor who feels that the recent rush to tech is something that should not be glossed over. “I am worried about the lack of discipline that other private equity players have shown,” he says. “Valuations in the technology sector are at historical highs.”

Slusky says he’s seen tech companies bought by private equity firms for as much as 4x revenue and 10x EBITDA, “which I don’t believe are prudent bets,” he notes. If those prices don’t lead to an all-out collapse of the company, they will almost certainly lead to sub-par returns.

“A lot of firms are modeling their deals for equity returns in the teens, and not in the 30s, which I believe should be expected from our industry,” Slusky says, noting that this is a result of private equity firms placing more emphasis on raising ever-larger investment vehicles. “It’s more about managing capital and collecting fees on large capital pools rather than collecting superior returns,” he says.

For good measure, Slusky holds that good tech deals in the mid-market, when you know what you’re doing, can come for under 2x revenue and 6x or less EBITDA.

Technology Of The Future

Generally speaking, those dedicated to the tech sector are bullish when discussing the coming year. This is partly because as industry leaders like Microsoft Corp. and Oracle Corp. continue to grow year over year, their second-tier counterparts are having an increasingly more difficult time competing for market share.

“Because the price of admission is to [generate] $5 billion to $10 billion in revenue, you’re going to see more consolidation activity,” says Garnett & Helfrich’s Garnett. “The $1 billion or $2 billion in revenue companies are going to start scrambling to find a new home. So you’re going to see a very active M&A market this year and the private equity firms are going to be in the middle of all of that.”