About a year ago, we published an article titled “Why Tech Companies are Favoring Private Equity Over IPOs” in which we described the shift from public to private markets as a source of liquidity for shareholders. What we didn’t discuss then is the third and most common route to liquidity, M&A. It may surprise you that Private Equity is quickly becoming the preferred path to M&A, with strategic buyers increasingly struggling to compete with the arsenal of weapons PE firms bring to bear in a transaction.
Most strategic buyers are bringing a knife to what has quickly become a gun fight. To explain, we’ll contrast how financial (PE) and strategic buyers operate, from strategy to diligence and decision-making, hopefully delivering some insights on these different species while making a few predictions for near-term deal making.
Dry Powder is at Record Levels
Foundational to this story is the fact that there is currently $500 billion of committed, undeployed Private Equity capital earmarked for investment in software companies. That’s equity capital – apply a conservative leverage ratio and there’s now over $1 trillion looking for investment opportunities in this sector. If you take into account the five year investment window for a standard fund, PE needs to deploy $100 billion of equity per year. Since 2014, an average of $52.7 billion of publicly disclosed PE deal value (equity and debt) has been invested annually in software companies. This is record investment pace, but not nearly enough to keep pace with fundraising, as PE has clearly become the most attractive asset class for pensions, endowments, and other LPs.
On June 7 at Bloomberg Invest New York, the CEO of Stanford Management Company, Robert Wallace, suggested that the $25 billion endowment is allocating more and more capital to Private Equity because of the “alpha” they can’t find in other asset classes. Not surprisingly, all of this has led to an environment in which PE firms have become incredibly aggressive in competing for quality businesses. This is not just reflected in values – 30 PE deals valued over $1 billion since 2016 at an average EBITDA multiple of 16x – but also in what we’ll call a martial discipline around people and processes.
Figure 1: Private Equity Dry Powder
PE Firms are capable of investing $1T in the Software Economy
PE Firms are Deal Machines
The first difference between financial and strategic buyers is simply focus. Private equity firms are designed to buy companies, grow them or otherwise improve their operating metrics, and then sell them (or float them in a public equity offering). The objective is to deliver strong returns for Limited Partners (and fees/carried interest for General Partners), attract more capital, and raise another, larger fund. PE firms are built to do deals. On the other hand, strategic buyers are first and foremost operating companies, designed to profitably build, sell, and deliver products or services. They consist of engineers, marketers, sales people, customer support agents, etc., all organized to attract and retain customers.
Yes, most larger businesses also have a Corporate Development department that leads M&A pursuits. In some businesses, such as Google or Oracle, this is a highly sophisticated department with deep deal-making expertise and a proven, repeatable process. However, it doesn’t change the fact that an operating company needs to organize a deal team for every process, which means recruiting senior people from all of their departments to validate strategic fit and conduct diligence on the opportunity. The deal also needs a corporate sponsor, a senior executive who will “own” the business going forward. For some managers, the responsibility for integration and future business performance, and the resulting paranoia about job security, is enough to jeopardize the deal and create an immediate disadvantage for a strategic buyer.
By contrast, the financial buyer assembles a small deal team (typically 3-5 professionals) and surgically attacks the process. Consultants and experts will be hired at various stages of the process to advise on technology, products, market, and financial matters at a pace strategic buyers simply cannot match. PE firms also benefit from streamlined decision making. They’ll inform and update their Investment Committees as the process moves forward, clearing objections along the way and essentially pre-wiring deal approval. Strategic buyers often require formal approval from their Boards of Directors (and sometimes shareholders), which always lacks certainty no matter how compelling the strategic fit.
Post-Deal Complexity Creates Uncertainty for Strategics
Another key consideration and difference between the two buyers is how the acquired business will be operated. With financial buyers, not much changes; it’s simply new ownership. Strategic priorities may shift, investments may increase for some initiatives and decline for others, and key positions may be filled with new hires. Otherwise, it’s typically the same business with the same team and minimal distraction overall. With strategic buyers, the acquired business will most likely be folded into another. This means that teams, technologies, and systems will need to be integrated. The target business will likely need to adopt the policies and philosophies of the acquirer. Different cultures will need to learn how to work together. Customers on both sides will need to understand how this impacts their relationships with the respective businesses. Uncertainty may lead some customers to terminate their contracts. In summary, strategic buyers have many more variables and significant complexity to consider when executing a deal. And none of this can wait until after the deal closes. Integration planning is a critical part of the decision process and yet another factor that consumes precious time and contributes additional hurdles during the deal process.
The Impact Horizon
The final consideration we’ll explore here is what we call the impact horizon. In our July 2016 article, we discussed the benefits of being private versus public, specifically the luxury to focus on long-term growth versus short-term expectations. This also applies to these two classes of acquirers. While PE firms don’t hold investments indefinitely, even within a 3-5 year liquidity window they have flexibility to make decisions that enable longer-term value creation. The investment thesis can play out over multiple years, which allows near-term investments in sales, marketing, global expansion, acquisitions, etc., all of which can drive substantially stronger growth within the liquidity window. In other words, acquisitions by financial buyers aren’t measured in the first quarter or even first year of ownership. With strategic buyers, you guessed it, they are.
Figure 2: Software M&A – PE vs. Strategic Deal Volume
Strategic acquisitions appear to have peaked while PE acquisitions have steadily grown
In fact, most strategic buyers need to demonstrate that a deal is accretive within a quarter or two, if not immediately. This is increasingly difficult because most strategic buyers justify transactions with revenue and expense synergies, of which the former can take years to materialize. If the strategic buyer is publicly held, many of the details of the transaction will be publicly disclosed, which means industry and financial analysts will debate the deal in public forums like CNBC. All of this creates pressure and simply raises the stakes of a strategic acquisition, which ultimately leads to doubt, delay, and missed opportunities to acquire high quality businesses.
PE Dominance is the New Normal
Is this the new normal? We believe so. Private Equity driven M&A has been increasing steadily since 2013, and appears to be on pace to eclipse strategic M&A for the first time during 2017. With PE capital at record highs, and fundraising continuing to outpace investment, financial buyers will continue to challenge strategic buyers for deals. They have proven they can deliver competitive valuations while simultaneously delivering greater deal speed and certainty to sellers.
Going forward, we predict that strategic buyers will be largely relegated to the opportunities that PE cannot pursue – deals with an earlier stage, unprofitable business that have overwhelming strategic value to the buyer, mega-deals that PE simply cannot finance, or deals that require significant operating synergy. The more professional and nimble strategic buyers (e.g., Amazon, Google, Salesforce) will continue to win their highest priority deals, but the rest of the herd is being left behind