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In the crosshairs: private equity firms help techcompanies reinvent themselves
Top of MindIssues facing technology companies
Top of Mind discussion series: Four themes to navigateunprecedented disruption
Theme #4: In the crosshairs
In the crosshairs: private equity (PE) firms helptech companies reinvent themselves is part of anEY Top of Mind series addressing four key themesthat can help guide technology executives’ actionsduring this time �of unprecedented disruption.Here we explore� the challenges facing incumbenttechnology companies finding themselves “in the crosshairs” of disruptive start-ups andactivist investors, and the potential opportunitiesthese challenges offer for savvy investors andtech executives.
The four-theme series includes:
1. Stack to solution — technology stacks beingdisplaced by cloud-integrated solutions
2. Hunting for hidden gems — pockets ofinnovation and troves of data lying untappedwithin the company
3. Multifaceted security — vulnerabilities andthreats multiplying amid technology transitions
4. In the crosshairs — challenges proliferatingfrom upstarts and activist shareholders
To access our collective overview of the fourthemes, go to ey.com/technology.
2 | Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
$197mMedian last-twelve-month (LTM) revenueof tech companies taken private in 2015
All dollar references are in US dollars unless otherwise noted.
But being overshadowed doesn’t equate to being out of business. And the decline in enterprise value of “in the crosshairs” companiesis not always in proportion to any actual decline in their ongoingbusiness prospects.
In the delta between such companies’ market and actual declines,there is opportunity for savvy investors and tech executives. “Everysuccessful tech company will find themselves ‘in the crosshairs’eventually because the speed of technology innovation means eventoday’s disruptors will face their own disruption tomorrow,” saysJeff Liu, Global Technology Industry Leader, Transaction AdvisoryServices at EY. “The trend this phenomenon is driving right nowinvolves PE firms taking private large incumbent enterprisetechnology vendors. And we expect to see many more of thesedeals in the coming year.”
Mutual value and opportunityWhile the promise of potentially outsized returns drives PE firmsinto in the crosshairs deals, tech executives also have growninterested in PE investment. In addition to the obvious financialmanagement expertise and deep pockets they bring, PE firms haveaccumulated strategic and operational expertise as a result of thelonger and deeper commitments required following the 2008financial crisis. PE firms’ objective analysis can help tech executivesmake the tough decisions necessary to transform their companiesand position for future success.
A company in the crosshairs has to calculate multiple challengescoming in fast from new directions — and pivot. Some will be able to change course and still come through the transformation intact,while others are likely to experience transformational transactions —whether as buyer, seller or “spinner” of one or more business units.And activist investors looking to maximize shareholder value arehelping to accelerate that process. “These companies have grownand matured for decades, so in aggregate there is a tremendousamount of enterprise value at stake,” says Liu.
Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves | 3
“Every successful tech company will find themselves ‘in the crosshairs’ eventually because the speed of technology innovation means even today’s disruptors face their own disruption tomorrow.”
Jeff LiuGlobal Technology Industry LeaderTransaction Advisory Services EY
Incumbent technology company executives may feel great frustration in the current market environment. Their companies increasingly find themselves in the crosshairs of activist investors and disruptive technology start-ups, as their core businesses are overshadowed by hot new digital technologies(cloud, mobile, social and big data analytics)and the new business models they enable (such as the sharing economy).
There is a broad range of potential crosshairs targets for PE firmsto evaluate. A good example is the payment processing companythat is being overshadowed as excitement over mobile paymentssoars. But the business of incumbent payment processing providersis unlikely to diminish in proportion to the rise of mobile payments.Similarly, so-called “old” technologies for enterprise security,document management, middleware, storage and many others mayrepresent valuable opportunities. “For lack of a better word, ‘old’technology is the new way for PE firms to get big tech deals done,”says Chris Le Roy, Transaction Advisory Services, Ernst & Young LLP.
PE risk lies in the transformation challenges of in the crosshairscompanies The risk for PE firms taking crosshairs companies private is that thefuture for such companies is not guaranteed — or easy. Some willnot survive. Tech companies challenged by disruption from cloudcomputing, smart mobility, social networking and big data analyticstypically must transform for continued success. They face severalcritical choices in doing so. Topping the list is whether or not topursue a stack-to-solution transition, in which a company transformsinto a seller of comprehensive solution services instead of sellingwithin one or more points of the technology stack (see our reportStack to solution: go big or go home).
Often, companies face business model choices, as well as theconundrum of how to increase operational and capital efficiencieswhen they have fallen out of favor in capital markets. The alreadydaunting challenge of navigating those choices and making asuccessful transformation is exacerbated by public market pressurefor consistent quarterly financial performance.
4 | Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
$69mMedian LTM revenue of tech IPOcompanies in 2015
PE and “in the crosshairs” companies: a well-suited matchUnder the right set of circumstances, however, companies in the crosshairs can present excellent opportunities for PE firms.Many such tech companies continue to run solid, if low-growth,businesses delivering products and services that remain criticallyimportant elements of customers’ enterprise IT infrastructure. Inmany cases, none of the new digital technologies is a candidate todisplace older enterprise solutions. If a tech company caught in thecrosshairs falls in market value more than its relative importance toCIOs, it might be a good candidate to be taken private to transformaway from the glare of public-market scrutiny.
At present, crosshairs companies may well represent PE firms’ bestopportunities among potential technology deals. Le Roy explains,“With tech company valuations as high as they have been lately, it’svery difficult for PE firms to find good full enterprise or carve-outdeals where they can make competitive offers. We’re seeing themfocus on crosshairs opportunities that include key infrastructuretechnologies — as long as there is sufficient value in the brand toprovide a competitive advantage and a path through transformationinto something new.”
PE’s crosshairs criteriaPE firms considering crosshairs investments must take care to tellthe difference between those that possess the potential to transformfor future success and those that do not. In addition to an objectiveassessment of brand value, PE firms should evaluate: • The degree to which the company’s technology is core among customers’ “run the enterprise” level technologies
• The strength of the company’s relationships with CIOs• The size, stability and growth rate of top-line revenue • Free cash flow• Earnings before interest, tax, depreciation and amortization (EBITDA)
Ideal candidates for privatization will have lost market value but still have strong brands, technology that is core to enterprise ITinfrastructure and demonstrably excellent relationships with CIOs.They should also have large, stable (if low-growth) top-line revenue,and sufficient cash flow and EBITDA to enable post-deal de-levering.
Enterprise tech incumbents often meet financial metricsOf the criteria above, the three financial metrics — top-line revenue,cash flow and EBITDA — can be objectively evaluated throughearnings report data. To get a sense of what kind of metrics qualifyan incumbent tech company to join a PE firm’s portfolio, we analyzed36 tech privatizations that occurred in 2015. Then, we comparedthe results to those of 2015’s 192 tech IPOs — the opposite side ofthe tech-company investment opportunity spectrum.
Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves | 5
$13.4mMedian LTM cash flow of techcompanies taken private in 2015,almost four times higher than that of tech IPO companies ($3.6 million)
The differences are stark and show why large incumbent techcompanies make good deal candidates for PE. Based on Capital IQdata for tech companies taken private or going public duringcalendar year 2015, median LTM revenue for the privatizations was $197 million — nearly three times higher than the IPO set ($69 million). Year-on-year (YOY) revenue growth was lower for incumbents; however, not as low as you might think. The IPO companies had a median YOY growth rate of 20% while the incumbents’ median was 14%.
As the accompanying figure shows, however, it is in EBITDA and,especially, cash flow that incumbents make the PE opportunityclear. Their median LTM EBITDA is double that of the IPO set andmedian LTM cash flow is nearly four times higher ($13.4 millionversus $3.6 million). Cash flow is the most critical factor for PE, as it makes de-levering possible and thus supports an eventualsuccessful exit.
“The privatizations we saw in 2015 may be only the beginning.There remain quite a few targets who are good candidates from the point of view of this financial profile,” says Le Roy.
Diligence key to brand, customer relationship and coretechnology assessmentsAssessing a crosshairs company’s brand value, customerrelationships and how core its technology is to enterprisecustomers’ IT infrastructure is more challenging. Mitigating the riskinherent in crosshairs deals requires deep, insightful diligence intoquestions that assess a prospect’s key strengths, including: • What is the market perception and reputation of the company?• How do corporate CIOs really feel about them?• How critical to enterprise IT infrastructure is their offering? • How hard or easy to replace is it? • How effective is the management team?
Conclusion: crosshairs deals can be win-win for PE and tech execsWhether you’re an executive of a large incumbent technologycompany assessing how to get your organization out of thecrosshairs, or a PE firm evaluating prospective investments, acrosshairs deal could well create a win-win scenario. PE firms musttake care, however, to thoroughly assess the risks presented by acompany in the crosshairs of disruptive technology start-ups andactivist investors.
6 | Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
$0
Cash flow
EBITDA
$2 $4 $6 $8
Privatizations IPOs
$10 $12 $14 $16 $18
Median LTM EBITDA and cash flow of tech company IPOs and privatizations, 2015 ($m)
Source: EY analysis of Capital IQ data for calendar year 2015, includes 192 tech IPOsand 36 tech privatizations.
Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves | 7
• How confident are we that our technology remains core to enterprise IT infrastructure?
• Should we pursue a stack-to-solution transformation? If so, what is the right solution opportunity to pursue?
• In what ways must our operations — from sales and marketing to R&D and product/service delivery — transform?
• What is the best capital agenda to help us manage through our transformation?
• In what ways will privatization accelerate our transformation?
Questions for tech executives to consider:
• Are we certain our crosshairs-deal candidate’s technology remains core to enterprise IT infrastructure?
• How valuable is the candidate’s brand? Have we done the most objective brand assessment possible?
• How strong are the candidate’s customer relationships, particularly with CIOs?
• In what ways will privatization accelerate the company’s transformation?
• Will key talent stick with the company through the challenges of going private and subsequent transformation?
Questions for PE firms to consider:
“The privatizations we’ve seen in 2015 may be only the beginning.” Chris Le Roy Transaction Advisory ServicesErnst & Young LLP
Find out moreIn the crosshairs: PE firms help tech companies reinventthemselves is part of a series of top-of-mind executive briefsproviding separate deep-dive analyses of four disruptivetechnology transformation themes: stack to solution, huntingfor hidden gems, in the crosshairs and multifaceted security.
For more information, or to discuss the diagnostic tools EY has developed to show how these themes might affect your own organization, contact Jeff Liu at +1 415 894 8817 [email protected]; or Chris Le Roy at +1 212 773 5496 or [email protected].
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This material has been prepared for general informationalpurposes only and is not intended to be relied upon asaccounting, tax or other professional advice. Please refer to your advisors for specific advice.
Name Telephone number Email
Technology sector contacts
Pat HyekGlobal Technology Industry Leader +1 408 947 5608 [email protected]
Jeff LiuGlobal Technology Industry Leader +1 415 894 8817 [email protected] Advisory Services
Winston ChungGlobal Technology Sector Team +1 415 984 7075 [email protected]
Channing FlynnGlobal Technology Industry Leader +1 408 947 5435 [email protected] Services
Dave PadmosGlobal Technology Industry Leader +1 206 654 6314 [email protected] Services
Guy WangerGlobal Technology Industry Leader +1 650 802 4687 [email protected] Services
Transaction Advisory Services (TAS) technology contacts
Ranjan BiswasIndia
Tim DuttererCo-Leader of Technology, Parthenon-EY
Staffan EkströmGlobal Telecoms Leader —Transactions andTMT Leader, Nordics
David HedleyUS Technology M&A Leader
Neil HuttUnited Kingdom
Ben KwanTAS and TMT Market Segment LeaderGreater China
Simon PearsonUnited Kingdom
Barak RavidCo-Leader of Technology, Parthenon-EY
Dr. Carsten F. RischGermany
+44 1189 281535 [email protected]
+1 415 984 7128 [email protected]
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