Private Equity & Enterprise Software Companies

It is a common thing to see private-equity-financed rollups in established industries, but till recently, we have not seen much of its impact in the enterprise software industry. Bill Burnham finds that of the 32 acquisitions of listed software companies that he has tracked last year, private Equity firms accounted for 25% of them, up strongly from 11% of deals in 2005. He goes on to predict that private equity may account for over 50% of deals in a couple years.Rather than targeting fast growing software firms, PE shops typically target "mature" software companies as they not only tend to have lots of cash but they also derive a large percent of their revenues from maintenance revenues. These revenues are seen by private equity investors and, more importantly their lenders, as a stable source of cash flow that can be used to finance lots of debt.

Seven Steps To Carry
The basic private equity software play book goes something like this:
1. Buy software company
2. Do dividend recap in which you simultaneously lever up the balance sheet and dividend out all the cash you just borrowed plus most of the existing cash on the balance sheet.
3. Raise new fund off of massive IRR created by dividend recap.
4. Do lots of acquisitions to make organic growth impossible to discern
5. Raise prices, slash R&D, increase sales and marketing.
6. Take company public/sell it at same PE you bought it for to investor/large company apparently unfamiliar with the concept of enterprise value.
7. Repeat.

While admitting that this is a bit of snarky characterization of PE software deals because software offers some unique scale effects in SG&A, Bill thinks that this characterization is probably closer to the truth than a lot of mumbo jumbo about "value add" "synergies", etc. While the attempted Hummingbird deal did not materialize, the Intergraph acquisition seems to be progressing satisfactorily. Infor’s acquisition spree spurred by private equity financing has made it a noticeable integrated solution provider. In a way the number of rollups that Infor has pulled off is amazing – such attempts on a scale and range is perhaps unparalleled. The early results look encouraging.

The burning question is would customers see this as a safe and attractive model for a software company? Looks like we may see some attempts by others to emulate infor rollup (this is frankly quite similar to oracle’s acquisition strategy – though on a smaller scale ). Would it spur on the startup ecosystem again? As I wrote recently, anything that questions status quo and takes shot at inertia is welcome and more so in this dynamic fast changing world - private equities contribution in changing the nature of business are quite telling. I would like to see the private equity players coming up with a disruptive model on annual maintenance and support charges - they can try out new models - this may spur more action in the enterprise software market affecting the financial planning of the dominant players. I would also like to see private equity players getting more active with deals(not just activities, while I am fully aware of the various regulatory challenges that they face therein) in more promising parts of the world- emerging economies.