Top of Mind Issues facing technology companies In the crosshairs: private equity firms help tech companies reinvent themselves
Top of Mind discussion series: Four themes to navigate unprecedented disruption Theme #4: In the crosshairs In the crosshairs: private equity (PE) firms help tech companies reinvent themselves is part of an EY Top of Mind series addressing four key themes that can help guide technology executives actions during this time of unprecedented disruption. Here we explore the challenges facing incumbent technology companies finding themselves in the crosshairs of disruptive start-ups and activist investors, and the potential opportunities these challenges offer for savvy investors and tech executives. The four-theme series includes: 1. Stack to solution technology stacks being displaced by cloud-integrated solutions $197m Median last-twelve-month (LTM) revenue of tech companies taken private in 2015 2. Hunting for hidden gems pockets of innovation and troves of data lying untapped within the company 3. Multifaceted security vulnerabilities and threats multiplying amid technology transitions 4. In the crosshairs challenges proliferating from upstarts and activist shareholders To access our collective overview of the four themes, go to ey.com/technology. All dollar references are in US dollars unless otherwise noted. 2 Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
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). But being overshadowed doesn t equate to being out of business. And the decline in enterprise value of in the crosshairs companies is not always in proportion to any actual decline in their ongoing business prospects. In the delta between such companies market and actual declines, there is opportunity for savvy investors and tech executives. Every successful tech company will find themselves in the crosshairs eventually because the speed of technology innovation means even today s disruptors will face their own disruption tomorrow, says Jeff Liu, Global Technology Industry Leader, Transaction Advisory Services at EY. The trend this phenomenon is driving right now involves PE firms taking private large incumbent enterprise technology vendors. And we expect to see many more of these deals in the coming year. Mutual value and opportunity While the promise of potentially outsized returns drives PE firms into in the crosshairs deals, tech executives also have grown interested in PE investment. In addition to the obvious financial management expertise and deep pockets they bring, PE firms have accumulated strategic and operational expertise as a result of the longer and deeper commitments required following the 2008 financial crisis. PE firms objective analysis can help tech executives make the tough decisions necessary to transform their companies and position for future success. A company in the crosshairs has to calculate multiple challenges coming 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 are helping to accelerate that process. These companies have grown and matured for decades, so in aggregate there is a tremendous amount of enterprise value at stake, says Liu. 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 Liu Global Technology Industry Leader Transaction Advisory Services EY Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves 3
$69m Median LTM revenue of tech IPO companies in 2015 There is a broad range of potential crosshairs targets for PE firms to evaluate. A good example is the payment processing company that is being overshadowed as excitement over mobile payments soars. But the business of incumbent payment processing providers is 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 may represent 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 crosshairs companies The risk for PE firms taking crosshairs companies private is that the future for such companies is not guaranteed or easy. Some will not survive. Tech companies challenged by disruption from cloud computing, smart mobility, social networking and big data analytics typically must transform for continued success. They face several critical choices in doing so. Topping the list is whether or not to pursue a stack-to-solution transition, in which a company transforms into a seller of comprehensive solution services instead of selling within one or more points of the technology stack (see our report Stack to solution: go big or go home). Often, companies face business model choices, as well as the conundrum of how to increase operational and capital efficiencies when they have fallen out of favor in capital markets. The already daunting challenge of navigating those choices and making a successful transformation is exacerbated by public market pressure for consistent quarterly financial performance. 4 Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
PE and in the crosshairs companies: a well-suited match Under 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 critically important elements of customers enterprise IT infrastructure. In many cases, none of the new digital technologies is a candidate to displace older enterprise solutions. If a tech company caught in the crosshairs falls in market value more than its relative importance to CIOs, it might be a good candidate to be taken private to transform away from the glare of public-market scrutiny. At present, crosshairs companies may well represent PE firms best opportunities among potential technology deals. Le Roy explains, With tech company valuations as high as they have been lately, it s very difficult for PE firms to find good full enterprise or carve-out deals where they can make competitive offers. We re seeing them focus on crosshairs opportunities that include key infrastructure technologies as long as there is sufficient value in the brand to provide a competitive advantage and a path through transformation into something new. PE s crosshairs criteria PE firms considering crosshairs investments must take care to tell the difference between those that possess the potential to transform for future success and those that do not. In addition to an objective assessment 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 IT infrastructure 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 metrics Of the criteria above, the three financial metrics top-line revenue, cash flow and EBITDA can be objectively evaluated through earnings report data. To get a sense of what kind of metrics qualify an incumbent tech company to join a PE firm s portfolio, we analyzed 36 tech privatizations that occurred in 2015. Then, we compared the results to those of 2015 s 192 tech IPOs the opposite side of the tech-company investment opportunity spectrum. $13.4m Median LTM cash flow of tech companies taken private in 2015, almost four times higher than that of tech IPO companies ($3.6 million) Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves 5
The differences are stark and show why large incumbent tech companies make good deal candidates for PE. Based on Capital IQ data for tech companies taken private or going public during calendar 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 opportunity clear. Their median LTM EBITDA is double that of the IPO set and median LTM cash flow is nearly four times higher ($13.4 million versus $3.6 million). Cash flow is the most critical factor for PE, as it makes de-levering possible and thus supports an eventual successful exit. Median LTM EBITDA and cash flow of tech company IPOs and privatizations, 2015 ($m) EBITDA 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 core technology assessments Assessing a crosshairs company s brand value, customer relationships and how core its technology is to enterprise customers IT infrastructure is more challenging. Mitigating the risk inherent in crosshairs deals requires deep, insightful diligence into questions 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 execs Whether you re an executive of a large incumbent technology company assessing how to get your organization out of the crosshairs, or a PE firm evaluating prospective investments, a crosshairs deal could well create a win-win scenario. PE firms must take care, however, to thoroughly assess the risks presented by a company in the crosshairs of disruptive technology start-ups and activist investors. Cash flow $0 $2 $4 $6 $8 Privatizations $10 $12 $14 $16 $18 IPOs Source: EY analysis of Capital IQ data for calendar year 2015, includes 192 tech IPOs and 36 tech privatizations. 6 Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves
Questions for tech executives to consider: 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 PE firms 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? The privatizations we ve seen in 2015 may be only the beginning. Chris Le Roy Transaction Advisory Services Ernst & Young LLP Top of Mind In the crosshairs: private equity firms help tech companies reinvent themselves 7
Find out more In the crosshairs: PE firms help tech companies reinvent themselves is part of a series of top-of-mind executive briefs providing separate deep-dive analyses of four disruptive technology transformation themes: stack to solution, hunting for 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 or jeffrey.liu@ey.com; or Chris Le Roy at +1 212 773 5496 or chris.leroy@ey.com. Name Telephone number Email Technology sector contacts Pat Hyek Global Technology Industry Leader +1 408 947 5608 pat.hyek@ey.com Jeff Liu Global Technology Industry Leader +1 415 894 8817 jeffrey.liu@ey.com Transaction Advisory Services Winston Chung Global Technology Sector Team +1 415 984 7075 winston.chung@ey.com Channing Flynn Global Technology Industry Leader +1 408 947 5435 channing.flynn@ey.com Tax Services Dave Padmos Global Technology Industry Leader +1 206 654 6314 dave.padmos@ey.com Advisory Services Guy Wanger Global Technology Industry Leader +1 650 802 4687 guy.wanger@ey.com Assurance Services Transaction Advisory Services (TAS) technology contacts Ranjan Biswas India Tim Dutterer Co-Leader of Technology, Parthenon-EY Staffan Ekström Global Telecoms Leader Transactions and TMT Leader, Nordics David Hedley US Technology M&A Leader Neil Hutt United Kingdom Ben Kwan TAS and TMT Market Segment Leader Greater China Simon Pearson United Kingdom Barak Ravid Co-Leader of Technology, Parthenon-EY Dr. Carsten F. Risch Germany +91 806 727 5131 ranjan.biswas@in.ey.com +1 415 264 8442 tim.dutterer@parthenon.ey.com +46 8 520 593 90 staffan.ekstrom@se.ey.com +1 415 984 7128 david.hedley@ey.com +44 1189 281535 nhutt@uk.ey.com +852 2849 9223 ben.kwan@hk.ey.com +44 20 7951 0418 spearson@uk.ey.com +1 415 894 8070 barak.ravid@ey.com +49 30 25471 21426 carsten.risch@de.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY s Global Technology Sector EY s Global Technology Sector is a global network of more than 21,000 technology practice professionals from across our member firms, all sharing deep technical and industry knowledge. Our high-performing teams are diverse, inclusive and borderless. Our experience helps clients grow, manage, protect and, when necessary, transform their businesses. We provide assurance, advisory, transaction and tax guidance through a network of experienced and innovative advisors to help clients manage business risk, transform performance and improve operationally. Visit us at ey.com/technology. 2016 EYGM Limited. All Rights Reserved. EYG no. 00057-164GBL EY-GTC ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.