FSN: Could private equity damage the software industry?

Could private equity damage the software industry?

7th august 2006
It seems that not a week passes without the announcement of an ever larger and more audacious private equity deal. Underpinned by massive pension funds, and other institutional investors, private equity is re-shaping businesses across the globe. But what may be an appropriate way of financing consumer businesses such as Hertz, Toys R Us, Warner Music and Burger King may present challenges in the medium term for suppliers and consumers of ERP and business software who rely on stable long term relationships, rather than one-off transactions. Gary Simon, FSN's managing editor looks at the threat to the software industry and its customers.

Who could blame modern management for wanting to take a quoted company out of public gaze and back into private ownership? The constant stream of accounting regulation, compliance and stakeholder demands is enough to shake the resolve of many battle-hardened board rooms. Added to which, the treadmill of quarterly reporting and constantly having to meet or exceed analysts' expectations is often seen as a brake on management innovation. Boards can find themselves tempted to make decisions with an eye to short term share price movements rather than the long term interests of the business.

Hence the last few months has seen a steady stream of software houses, being swept off their feet by suitors such as Golden Gate Capital, a private equity house with more than $2.5 billion of capital under management. Together with famous firms such as Kohlberg Kravis Roberts (KKR), and Bain Capital, private equity firms as a whole are thought to be able to draw on more than $2 trillion of buying power.

Sunguard Data Systems, was acquired by a group of private equity firms last year for $11.3 billion and in a feeding frenzy, this year, FSN has reported on transactions by Infor, a Golden Gate Capital company, with SSA Global, GEAC (Extensity) and Systems Union Group. Quoted in the US , Cristobal I Conde, CEO of SunGard Data Systems said, “I get calls all the time from CEOs. They think they need to consider going private. They can't ignore the possibility anymore.”

Whilst escaping the scrutiny of investors and regulators provides a powerful incentive for some transactions, the promise of relatively inexpensive funding and the opportunity to rapidly ramp up the business is also very persuasive. As reported by FSN in May, scale was a central issue to Systems Union Group's decision to sell to Golden Gate Capital.

At the time, Paul Coleman, System Union Group's CEO told FSN, “Put quite simply, as a $200m business in the current global environment we are too small to compete effectively. We do not have the financial wherewithal to expand into the US . The balance sheet wouldn't take it and I do not want to make the wrong move. In my view you have to be a $500m company to play on the global stage.” Similar arguments applied to GEAC (later Extensity and now folded into Infor), which, for example, found that it had to pass on attractive acquisition opportunities because it did not have the financial muscle to compete successfully.

In the past, private equity firms have had the reputation in some circles of being corporate raiders, which would make savage cuts in overheads, announce significant redundancies and ‘flip' the company for a huge profit a few years later (usually less than 5) by selling the repackaged business or floating it again.

But the risk to the software industry and its customers does not necessarily come from these quarters, nor as some have suggested, from the discontinuance of certain software products or massive disruption. For example, SunGuard says that it has added 3,000 jobs since it agreed to be acquired and Infor which has made acquisitions at breathtaking speed to become the world's third largest ERP vendor appears to have taken care so far to build and sustain its product portfolio and keep its customer base on side.

“We are broadening our offering to include solutions that will enable our customers to improve performance throughout the organisation,” said Jim Schaper, chairman and CEO of Infor. “Companies can now choose fully integrated solutions for specific industries as well as best-in-class standalone solutions from one provider.”

The real concern is the macro-economic environment surrounding the state of the global private equity market and the possibility that it is yet another bubble waiting to burst. The market has been awash with cheap money for a very long time. This means that private equity firms have been able to use the money they have raised from institutions and borrow more against the value of the businesses they are acquiring. Typically only a small amount of the deals are represented by equity stakes. Debt levels can be sizeable and for example, Infor's takeover of SSA Global, Extensity and Systems Union, consummated last week, appears to include a $150 million revolving credit facility, $2.25 billion term loan facility, and a $1.425 billion senior subordinated bridge facility. Schaper told FSN that not all of this is required on day one and there is plenty of “buffer”.

Only time will tell if we are at the top of the market, but if we are witnessing a bubble, then private equity firms will find it difficult to extricate themselves. Should global interest rates continue to rise this could, despite good management, hamper the operations of the software houses they own.

Infor's Schaper told FSN he is “comfortable with the level of debt relative to EBITDA” and plans to be paying it down. His level of confidence derives, amongst other matters, from the quality of the maintenance revenue streams based on mature products and the Infor's historically high levels of customer retention. Nevertheless Schaper told FSN that while he is in no hurry to take the group through an IPO this is on the cards.

If the IPO market turns sour again, the US economy cools down (as many expect) or the interest rate position looks less favourable, heavily indebted companies in all business sectors, not just software could find themselves under pressure. But software provision brings additional levels of responsibility for suppliers and special concern for customers.

Whilst an unfavourable economic scenario would represent an inconvenience for consumer based industries that have succumbed to the private equity spell, its owners could weather the storm and its customers would be largely unaffected. But for ERP vendors, suppliers of business software and their global customers the consequences could be far more damaging. The software industry has spent years telling us, with some justification, that ERP software is strategic and fundamental to efficient business operations. Unlike one-off consumer transactions, for example, the rental of a car from Hertz or the purchase of a football from Toys R Us, business software is a product that is deeply embedded in an organisation and all of its processes.

Businesses are totally at the mercy of their software suppliers. Anything that threatens the development, support and maintenance of the software could be severely damaging to its customers. The changes sweeping the global software industry may please, shareholders, companies, Wall Street and the City of London in the short term but it is the customers who may end up paying in the future for what might turn out to be yet another example of market exuberance.

Related FSN articles

Infor to become 3rd largest ERP vendor
Systems Union “too small” to compete globally
Systems Union to be acquired by Extensity
GEAC to throw off shackles of public company status post acquisition

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