Friday, March 09, 2007

Why PE should leave technology alone

Again, I can't make any claim to being an expert on the subject, but I've made the argument before that PE and technology companies do not mix. As I was showering the other night in preparation for my J.O.B., the primary reason for this state of affairs came to me. I would also like to thank Equity Private for the insight shared with me by e-mail a few nights ago, for this helped crystallize the logic in my mind.

Private equity should be about operations. Squeezing operational efficiencies out of mature businesses (or business models). Expanding into new markets. New leadership. Adjusting the capital structure. Acquiring customers (and competitors). Reducing costs. Involving stakeholders. That's what it *should* be about. Taking a poorly performing enterprise and making it...well...perform.

At least, that's my (somewhat high minded) theory.

It would appear that in the last few years, the performance piece of the puzzle has been lost (intentionally?). Yes, there is plenty of levering and capital structure machinations, but not much else.

I don't think selling off assets (EOP) or the traditional "corporate raider" model can be applied in technology. The technology space never rests. There is always some innovation occurring; tis the nature of the beast. Even the lowly hard drive, courtesy of tech PE darling Seagate Technologies, is evolving constantly. Higher densities are the primary way, but interface technology is also changing. Witness the growth in Serial ATA (SATA) and SAS interconnects. In networking, we have the same thing. Never mind all the dark fiber that was buried and has subsequently been written off by network providers. We've got 10 Gb Ethernet here, and even faster modes on the way. You can peel off tons of lambdas over a given strand of fiber. The race is unending.

This is why technology companies do not (now) make good PE targets. When the basis of your business is innovation, research and development, and your window to get to market and make back the investment grows increasingly shorter, there is no way for even large tech companies to rest on their laurels and collect rivers of cash. Levering is largely, if not exclusively, about being able to service debt. (Commercial real estate shares this property, and it is an equally simple business at the most basic levels.) However, the interest payments on the leverage employed in taking out a technology company cannot be guaranteed to be serviceable based on the standard market fluctuations in technology. Things change too fast to count on that constant cash flow.

Recently, Investment Dealer's Digest had a bit about the new-ish emphasis on bringing operators into PE shops - rockstar CEOs, as the saying goes - with lots of connections, hands-on experience and wisdom. THIS, to my mind, is the essence of the proposition. Financial engineering can only take a business so far. That isn't to fault the VPs and rainmakers, but seriously at some point, the enterprise has to be able to consistently MAKE money.

Last week I was sitting in on a conversation between my business partner and my second cousin's wife who works for IBM. My cousin's wife was making the point that the bean counters have taken over the company and their solution to every problem is to cut - something, anything, just make costs go away. This is not a long term solution to the problem. If you've got a business pipeline that will fund operations profitably, but your staff is already overworked, you can't just leave the staffing where it is. You have to be able to add people and resources to do the work faster and better. Under such circumstances, refusing to add headcount, or even worse, to try to remove it, is absurd. Quality of service delivery will suffer, which will impact the brand and eventually the commitment of those customers to continue to pay for the services. At least, they will probably seek to spend that money elsewhere. The same point applies to IBM as it does to PE shops looking to take out a technology company. Innovation is the name of the tech game.

Now, I can see some exceptions, and as I may have previously mentioned, there are some operators that seem to know where the intersection of technology and private equity lies. Or at least they are closer to finding it than others. Seagate and Flextronics would seem to be too good examples, and both were Silver Lake deals. Silver Lake is much more of the exception however, because technology is all they do. Both of these were manufacturing heavy companies which probably had outdated processes and facilities, and are operating in fields with razor thin margins. There was probably a lot of upside to these deals because they are operating at the intersection of the "real", tangible world and the technology world. That will be less the norm in the future, as fewer companies will be engaged in creating hardware products and even more development is channeled into software. I don't know that the same kind of benefits can be engineered in a software company that have been engineered with Seagate. You can always reduce headcount and spin off divisions, bring in new managers, recapitalize and reorganize, but at some point, you'll need new product which means new ideas, new research, new development, new engineering, plus all the other stuff (QA, documentation, support, distribution, security, sales, etc.).

At the end of the day, the company has to be able to perform. Private equity should be a vehicle, and I have no problems with it being a well compensated vehicle, for increasing corporate performance. Create. Innovate. Execute. Wash, rinse, repeat. All of that takes of precious cash that most of the current generation of PE firms would rather have flow to them, as management/consulting fees or dividends. Technology companies have to be able to move fast, and debt is a burden preventing that kind of dynamism. If you're not moving, you're dead, and a tech company weighed down by debt is well...figure it out.

4 comments:

JamesVU2000 said...

Great post. Ultimately capital investment in every industry is the only way to grow over the long term. It doesn't matter whether its equipment or people. Right now it seems like we are long one and short the other.

Anonymous said...

interesting theory but not backed by facts. it would be more interesting if you could get the returns on a few buy out tech deals.
what your post does not mention is that PE brings an incredible focus to tech firms with a longer term horizon than public markets can stand.

Khyron said...

Anon,

I'll take the bait.

Where are your facts, if I may ask?

So while we're both making factless claims...

As for PE bringing "incredible focus to tech firms with a longer term horizon than public markets can stand", I'd say "isn't that the bloody point of PE anyway, no matter the industry or type of enterprise?"

You just gave the definition of PE, at least as it makes sense to me.

(I'd be hard pressed to call Hertz, KB Toys or Burger King anything more than private dividend plays, LBOs in the orignal sense, bearing only minimal likeness to value creating PE other than the fact that PE funds did the deals. That's a topic for another time.)

Anyway, we all know that is what is supposed to happen. That comment didn't add much.

As for returns, not many tech deals have been done, or at least their numbers made public, so its kind of hard to say. I just did a quick bit of looking for returns on some of Silver Lake's investments but I need more time to dig deeper. However, off the top my head, the other big tech PE shops are Gores Technology Group and Platinum Equity, both of L.A. (And run by brothers, Alec and Tom Gores, respectively.) Few of the PE "Masters of the Universe" are in the space now, mercifully. SunGuard, Flextronics, NASDAQ and Gartner remain in Silver Lake's portfolio.

The Gores brothers are operators. They tend to have a longer term horizon from what I have observed. They also seem to be deep value players. There appear to be few household names in their portfolios. Both firms appear to be about the restructuring and management of the enterprise as opposed to squeezing them for fees and dividends. I would attribute that to the smaller companies they seem to pursue and their overall styles.

Interestingly enough, I ran across this post by Paul Kedrosky about why I am wrong. I tried to view the McBusiness article but the problem Paul notes still seems to exist 2 years later. However, since the interviewee is a principal in Silver Lake, I think the exceptions I've previously made for them still apply.

While Silver Lake seems to have a good eye for tech deals, most other firms should probably avoid the space. They don't have the experience in the industry, the operational depth, and he general wherewithal, to successfully pull of these types of deals. There hasn't been a lot of tech activity by the rockstar PE guys, and I hope there isn't too much. I think it will end badly, resulting in value destruction on a grand scale.

However, Anon, you have piqued my curiosity and I will spend some time tonight researching these exits. However, you haven't said anything that hasn't been said before. (Or isn't fairly obvious.)

Cheers!

Khyron said...

Continuing the conversation, there was an interview with Carol Levenson (sub req'd) in the latest Barron's. On page 2 of the article, she mentions how tech *used* to be a safe haven from PE types but even that reality is now shattered.

While the deals have been consummated, yes, the exits on Freescale and SunGuard still have to take place. Although she makes a good point about PE now, the same kind of PE I have railed about, where the people who get hurt are the employees and bondholders in the firm. The PE guys run off with their dividends and management/consulting fees, maybe doing some good or maybe not, plus they have whatever equity that they will eventually dump back on the market. Some, if not many, employees can look forward to getting axed. Now, I'm all for creative destruction, but that can't be a good feeling if you've been told by your management that the PE guys are going to save the company.

What a crock.

While Freescale may be free to innovate now that Motorola has yielded control, the fact remains that it is a small player in a tough market. Yes, they are a big embedded player. That's good. However, there are a lot of people producing chips in that space, and fabs cost lots of money to run and upgrade, never mind building new ones. They could always go the TSMC route on the side, as has IBM, I guess. But this is a capital intensive business, and the silicon industry is known for big market swings. We'll see how the PE guys make this work. However, Anon, if we see a levered dividend, I rest my case.