Private equity (PE) houses have not always had the best reputation in the IT channel – why do you think this is?
I think it probably stems from a general misunderstanding of what PE can offer (not wholly restricted to this sector), compounded by a number of high-profile investments going bad – such as Azzurri and 2e2, as well as the more recent Trustmarque deal. 2e2 collapsed particularly quickly and created significant turmoil for employees, customers and creditors – people always remember the failures rather than the successes.
But 2e2 was originally supported by Gresham Private Equity in 2003, and after a successful buy-and-build strategy it was sold on to Duke Street in 2006. The reasons were different for each of these failures, but they all had in common high levels of bank debt, which is typical of PE-backed companies. Unfortunately, when operational challenges created financial pressure, none of these companies had enough headroom in their debt facilities to manage through without breaching their bank covenants.
How do you get over the suspicion that many channel firms will have towards PE funding – the feeling that there is always a catch?
PE houses need to highlight what they have to offer beyond financial investment. They need to demonstrate how they can support management to grow their businesses with expertise as well as capital, and how a win-win scenario for all stakeholders can be achieved. Management will only ever get comfortable with a financial partner that they have spent plenty of time with and therefore this room has to be built into the fundraising process.
At a grassroots level, PE houses need to get out in the market with advisers such as Livingstone to educate management teams on the possible opportunities that this offers. If there is a catch, it may be that PE can be expensive when compared with other forms of investment capital, and management teams can come under pressure if the company underperforms as the PE house needs to protect its investment. Essentially, management teams need to have a carefully evaluated business plan that stands up to scrutiny. They also need to understand that there are risks to these deals.
Why are PE houses suddenly so interested in the IT sector, and in particular the channel?
Companies operating in the IT sector offer a highly attractive mix of characteristics: high growth supported by strong underlying market dynamics and recurring revenue models which reduce risk. PE investors have always been interested in the IT sector, and now the market is taking advantage of significant seismic changes in technology such as cloud, mobile, analytics and social media, which has heightened interest.
There is potential for companies with PE support in these markets to grow very quickly, organically and by acquisition, to increase in value significantly. As channel firms have been broadening their services offering, generating recurring, contracted revenue, they have increased their earnings visibility – reducing risk and allowing them to support higher levels of bank debt (although not in the cases of 2e2 and Trustmarque).
Would you agree that most owner/managers always have an exit strategy in mind?
I think this is directly linked to age and the number of recessions that the owner has been through. In my experience, the majority of young tech entrepreneurs have a ‘take on the world’ attitude and are all about expansion. Exit is furthest from their minds and efforts are focused on growth.
As a business develops and the owner-manager experiences good times as well as bad, they become more risk aware, certainly when most of their personal wealth is tied up in the business, and will evaluate exit options more closely. This isn’t always the case and we’re aware of plenty of entrepreneurs who don’t need the money, enjoy the job, and have no intention of stopping.
How is the IT channel performing in comparison with other markets you operate in?
The IT channel, post-recession, is having to adapt to different delivery and purchasing models. This creates opportunities as well as challenges and I think the channel is still on this journey. Customers are starting to invest again but they are more cost conscious and are keen to take advantage of AAS models. Margins are still very much under pressure and growth in the economy is not yet being fully reflected across the IT channel.
How does the relationship with a PE investor actually work?
PE investors back managers and their business plans. They will work closely with management teams and each firm will have a particular style and approach; some are more hands-on than others. Therefore it’s all about finding a PE team that suits management’s needs and is a good cultural fit. As part of an investment, PE will take a board seat and will want to appoint an independent chairman. They will attend board meetings and are always available as a sounding board.
If management are on track and hitting their business plan targets, the PE investor will leave them to get on with it unless they particularly need strategic support, say an acquisition or when an exit is being considered. If the plan is not being achieved, the PE house will always look first to managers for a solution and it would be an Armaggedon-type situation before they would consider replacing management, although this does happen.
What are the benefits to channel firms of working with PE backers? Why should they consider it as an option?
First and foremost, PE offers a clear alternative to selling to a trade buyer when shareholders are considering their exit options. Benefits include the confidentiality arising from an ‘internal’ deal and the ability for founders to realise some of their proceeds by selling a share in the business to their management team while still maintaining a residual shareholding.
PE can provide additional capital to support growth and acquisitions for the business. They can also professionalise and implement reporting structures for less sophisticated businesses. In all instances, PE backers will work to raise the profile of a company.
How can they get PE houses interested in them? What steps do they need to take?
The PE market has moved on considerably from a few years ago when investors would sit tight waiting for transactions and interesting opportunities to come to them. They are much more proactive today, working with deal origination teams to target the most attractive companies in the sector. When assessing an opportunity, PE will focus on the strength of a management team, the company’s market position and competitive advantage and naturally financial criteria and growth rates.
PE transactions are complicated and I would recommend that if a group of shareholders or a management team are contemplating a transaction, they should work closely with an experienced adviser. Transactions don’t happen overnight and relationships can take months or even years to develop before both parties are ready to consummate a transaction; however, a transaction stands a far greater chance of success if there is an adviser who has been through it all before.
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