After the M&A Frenzy: What’s Next?

We have no crystal ball, but Software Equity Group has a decent track record forecasting the software industry’s economic expansion, consolidation and contraction over the past fifteen years. We believe the U.S. economy, despite the Fed’s best efforts, will finally fall victim to the housing bust, tight credit and skyrocketing oil prices. Economists expect the GDP will slow to 1.6% in Q4 and may well contract further in 2008 until there is a modest negative decline for two consecutive quarters, the economic definition of a recession. The current expectation is any recession will be moderate and will last some 12 to 24 months. Nevertheless, such a contraction will likely create a new M&A environment for software industry entrepreneurs and investors.

What will be the likely impact of a mild recession on the software industry? Enterprise customers will markedly reduce their IT capital spending, as they have in prior downturns. Consequently, software company growth will slow, and investors will increasingly turn their attention to profitability and net income. It’s almost a law of nature. Larger software companies, in response, will turn their attention to cost-cutting, re-examining spending priorities, paring headcount, and enhancing the productivity of those who remain. We anticipate many of these larger companies will take a product line approach to cost-cutting, scrutinizing each product line, and assessing product line-specific revenue, expense, market leverage and, most importantly, return on investment. Particular attention will be paid to products acquired during the M&A frenzy of the past few years.

After conducting these product line, operational and financial reviews, we fully expect a good number of public software companies will shed non-performing and incongruent product lines and business units in an effort to cut development, support and marketing costs. In fact, SEG has established a new division to assist in the profitable disposition of these assets.

Private equity firms will be even more diligent and disciplined in assessing their portfolios of software companies acquired and taken private in the past three years. Overall, private equity accounted for 25% of all North American M&A activity in 2006, and within the tech sector $44B was spent on buyouts last year. By June 2007, private equity had already exceeded the 2006 total, with transaction valuations averaging approximately 10x TTM EBITDA. Many of these companies – with revenues in the hundreds of millions – or billions – of dollars – were acquired to serve as platforms for add-on acquisitions and accelerated revenue growth in hopes of an IPO three to five years out.

To pay for these platform acquisitions, private equity turned to lending institutions that initially hesitated, but soon embraced, software company debt financing. Banks found comfort in strong recurring revenue from annual maintenance and support contracts and deemed it satisfactory collateral. Lending amounts as a multiple of EBITDA increased from 3.9x in 2002 to 5.1x in 2006, and there were many instances of debt leverage exceeding 6x EBITDA in 1H07 prior to the Collateralized Debt Obligation (CDO) debacle, and the dampening effect it had on LBOs.

Following these platform acquisitions, private equity firms in 2006 and 2007 have engaged in a frenzy of “tuck-in” or “bolt-on” acquisitions on behalf of their platform companies to bolster product lines, expand turf, and aggressively grow revenue. In August 2005, Silver Lake, Bain, Blackstone, et.al. took SunGard private in an $11.3 B leveraged buyout. In 2006 SunGard, now private, acquired six tuck-ins and four more thus far in 2007. Battery Ventures acquired Made 2 Manage in the Spring of 2003 and has aggressively acquired add-ons ever since, adding five companies in 2006.

The net result is private equity-owned platform companies now own a host of acquired assets they’re attempting to understand, manage, integrate and leverage. In good times, when IT budgets are healthy and growing, there’s little impetus to cut costs, especially after the first year following an acquisition. But when growth slows, private equity firms will be very disciplined in assessing their acquired assets. They’ll really have little choice. The debt leverage on these acquired companies assumes continued economic expansion and continued growth of recurring revenue and operating income – not very likely in times of recession.

After taking a very hard look at their portfolio companies, and after scrutinizing each business unit and product line, many PE investors will opt to shed non-core business units that are not providing the strategic leverage, accelerated growth or incremental revenue anticipated at the time of acquisition. First to go: non-performers and acquired companies no longer deemed core to the platform company’s business.

These expendable assets will find a home. Second and third tier private equity firms and other financial investors, as well as savvy smaller public and private software companies, will provide a ready market for these assets, but at valuations that will likely be below the seller’s basis. The net result will be a software M&A market that continues to be quite active, but for reasons quite different than those of the past two years. Valuations are almost certain to decline, but not precipitously. Financially sophisticated, IRR-conscious private equity firms are unlikely to engage in fire sales. Buyers of these disposed assets will operate the companies conservatively, ensuring they are financially self-sufficient but still poised to take advantage of the next economic expansion. Sensing opportunity, entrepreneurs and investors will be drawn back into the fray, excited about building a divested asset into a world-class software company. It’s simply the biorhythm of our industry.
Ken Bender is Managing Director of Software Equity Group, an investment bank and M&A advisory serving the software and technology sectors. Founded in 1992, the firm has represented and guided private companies throughout the United States, Canada, Europe, Asia Pacific, Africa and Israel, and public companies listed on the NASDAQ, NYSE, Toronto, London and Euronext exchanges. Software Equity Group also represents several of the world’s leading private equity firms.

Software Equity Group’s Quarterly Reports are now read and relied upon by more than fifteen thousand software industry senior executives, entrepreneurs, venture capitalists and private equity investors in 28 countries around the globe. The Q3 Report carefully analyzes software industry mergers and acquisitions, assesses public software company financial and stock market performance during the quarter, and identifies key trends that impacted the software equity markets year-to-date. A complimentary copy of the Q3 2007 Quarterly Report can be downloaded from our web site, http://softwareequity.com/research_quarterly_reports.aspx