Blue sky rethinking

Corporate Financier, April 2007

For years after the dramatic deflation of the dotcom bubble, technology companies were left in the doldrums. Investor and acquirer interest gradually picked up, but it's only in the past couple of years that technology M&A has really taken off again. Now, activity is reaching the numbers of levels of 2000 – only this time, it's all a bit more considered.

In 2006, global tech M&A edged over Euro100 billion (£67 billion) for the first time since the millennial boom, according to analysis by PricewaterhouseCoopers. The number of deals, at 582, was slightly down on 2005's total. That included 18 "mega-deals" worth over  Euro1bn, lead by French telecom supplier Alcatel's Euro11.1 billion (£7.4 billion) acquisition of Lucent Technologies. The bulk of deals by number is very much in the mid-market, with 94 per cent of deals in the Euro10m-500m range.

The numbers are even more impressive if you take a broader definition of technology. Specialist advisor Regent Associates, which includes digital content and media, applied technologies and other areas, counted 3295 European deals worth a total $337 billion (£172 billion). In number terms, if not by total value, that's again matching the 2000 peak.

M&A activity is increasingly crossing national borders as tech groups seek to build global presence and move into new geographic markets. Globally, over a fifth of deals were cross-border by PwC's figures. In the UK, the proportion was significantly higher at 52 per cent, according to analysis by Icon Corporate Finance.

In part, the re-emergence of tech M&A reflects the wider boom in global M&A activity, fuelled by low interest rates, surging profits and deep-pocketed financial buyers.

But there are also factors unique to the technology sector. "Mentally and culturally, this is an industry used to double digit organic growth, but the market is only delivering growth of between five and six per cent," says Peter Rowell, executive chairman of Regent Associates. "They're saying we're used to growing at 10-12 per cent, the market's only delivering half of that, we're generating cash so we'll use these resources to acquire."

Industry drivers
Deals are being driven by the mature generation of tech businesses which blossomed in the late 1990s. The prime examples are in software and IT services, which accounted for two thirds of the deals logged in PwC's study.

"A lot of consolidation plays in software have been about reducing the number of different applications within certain segments of the market, and driving profitability by taking costs out," says Andy Morgan, technology sector leader at PwC. "The big push is coming from the top with people like Oracle and IBM really driving the agenda."

Despite the headlines won by the new generation of internet giants and deals such as Google's $1.65 billion (£840 million) all-stock acquisition of video hosting site YouTube, the old guard remain the prime acquirers. Oracle and IBM together made eight disclosed acquisitions totalling £5.8 billion last year.

The most active trade acquirers have the balance sheets to pay for acquisitions in real money rather than stock, something that many vendors appreciate. Listed tech groups tend to pay relatively low dividends, so have plenty of cash to invest in maintaining growth.

"Technology is a fast moving area," notes Brian Parker, head of M&A at tech specialist Icon Corporate Finance. "You can either invest in R&D or you can acquire other businesses that have developed new lines of business and new areas of growth."

Innovative UK software companies have been much favoured by overseas buyers - mostly from the US, but also from continental Europe and, increasingly, India and the Far East. Hardware groups are also seeking out software and services businesses to improve their margins and profitability.

With a highly fragmented industry in areas such as specialist business software, there's pressure for straightforward consolidation plays. A host of smaller IT groups have looked to acquisitions to reach critical mass or to fill out their product lines with niche applications, or sought the sanctuary of a new corporate owner.

"There's definitely a trend for consolidation," says Paul Harrison, finance director of accounting software group Sage, one of Europe's most active acquirers (see box).  "There are more independent businesses looking around thinking, for various reasons, is it sensible going forwards to be part of something bigger?"

Private interest
The other big driver is private equity. With record funds which need to find a home, the buyout houses are targeting mature IT companies. According to PwC's figures, four of the ten largest UK tech acquisitions were leveraged deals by private equity buyers.

The bulk of private equity involvement in tech deals has shifted from the sell to the buy side, Morgan notes. "We've now got an environment where the technology portfolio of the private equity portfolio population has been refreshed somewhat," he says.

One potential source of deals is AIM, which has become rather less attractive as a fundraising route for technology companies. Expect to see more deals such as August Equity's £41 million take-private of niche design software house Planit Solutions in late 2006.

The criteria for financial buyers can differ from those of corporates. While the first concern for trade buyers is often the quality or scope of the customer base, for private equity it's all about the cashflow. Highly recurrent and secure revenue streams with strong leverage potential, and the potential for further growth by acquisition, remain at the top of the private equity wishlist.

"Private equity has taken a deep breath and gone back into the technology market," says Wendy Hart, head of the technology industry group at Grant Thornton. "There was an almost across-the-board antipathy to tech investment up to two or three years ago, but now they seem to be more comfortable with the parameters. Software and web companies are now a known quantity, and they know what they're looking for."

Software services businesses, with revenues based on recurrent licensing fees rather than one-off sales, are drawing strong interest from private equity buyers. Telecoms businesses which are now reaping the cash generative rewards of heavy capital investment are also a favourite.

With many such service areas heading towards commodity status, some private equity players see richer opportunities elsewhere. "We tend to bias more towards businesses with real technology products - higher and deeper technology, with lots of R&D investment and lots of IP," says Nic Humphries, head of the tech team at HgCapital. "We like those kinds of businesses because we can grow them on an international scale, because there's a reason for them to exist on the international scale."

Inevitably, trade and financial buyers find themselves chasing the same targets, nudging valuations upwards. "There have been cases of PE firms arguably overpaying for technology assets," Hart notes.

Multiple concerns
Average valuations for software and IT services have risen by 12 per cent over the past three years, by PwC's metric. Valuations are increasingly based on the fundamentals of current performance, rather than more speculative measures of future potential.

Data on UK deals compiled by Icon Corporate Finance show average price to sales ratios of around 1.7 for IT companies, and 16 times price to earnings. "Those two numbers, compared to the peak valuations of the bubble years, are something under half," Parker notes.

Regent's analysis of European deals meanwhile show average price to earnings (including estimated earn-outs) rising to 19.5. Sales multiples have been more volatile, reflecting increasing profitability in the industry which is now being factored into the metrics.

"Improvement in operative performance has been a big driver," agrees Morgan. "As metrics have become a lot more focused on fundamentals, the work that's been done in developing the bottom line has fed through into valuations."

But although the general trend is upwards, the spread of valuations is widening. Software and services, content providers and outsourcing companies have seen the highest multiples, with resellers, service integrators and some telecom services well below average.

A handful of high-profile deals have raised concerns about a return to bubble valuations in the content and so-called "Web 2.0" areas. "The real sexy end of the market at the moment is the crossover between technology and the media world, which is really driven by the emerging business models of Google, Yahoo, eBay and so on," Morgan says. "That's certainly an area where we're seeing some racy valuations."

Most of the raciest deals have been all-stock, as many were in the dotcom bubble. But there seems low chance of any potential bubble spreading from content to the wider tech arena.

"There is a lot of focus on mobile platforms and social networking, and if there's a bubble space, it's there," says Hart. "But in mainstream IT services and life sciences, the imperatives are the normal ones of profitability and growth. I don't think a sudden reversal is likely."

Decision time
Mainstream tech M&A may have already reached a plateau in terms of activity. "There's not a lot of tension in the market - there's nothing out there that's seriously going to drive it up or down," says Rowell. "Sellers have a value expectation that's close to the levels that buyers are considering. It's quite different to what we've seen over the last 10 years."

Even with an active and stable market, it's hard to forecast how long those favourable conditions will persist. "For the next 18 months, you can be fairly certain of getting a good deal, but beyond that it's open to vagaries," Rowell notes.

Mid-market companies in many technology sub-sectors need to decide whether they want to take advantage of the current market to either buy or be bought out. "Mid-cap companies are acquisitive, and they need to retain that otherwise growth will slow and they'll end up being acquired," says Parker. "The trick is not doing too much."

The broader message for mid-cap firms is to decide whether they want to get big or remain in a niche. While there will always be a place for businesses with IP and expertise in a particular market, they will remain attractive to financial or trade buyers.

Even if the current conditions persist, bulking up by acquisition will continue to be challenging. Very few European players have made the step from being a leading provider in their domestic market to global leadership, Morgan notes. "That's where the question arises for a lot of mid market companies, particularly in software and IT services where the synergy potential is significant," he says. "A status quo type situation is hard to see as a sustainable strategy over anything more than the short term."

Sage advice

Sage Group is a global leader in the competitive market for accounting and business management software and, since 2003, the only IT group on the FTSE 100. The Newcastle-based business has also, in recent years, been one of the most active acquirers in its sector. In its last financial year, Sage scooped up seven acquisitions, ranging from small purchases in China to the £297 million takeover of US healthcare specialist Emdeon - its largest deal to date.

The strategy is all about enhancing Sage's portfolio, says group finance director Paul Harrison. "In existing geographic markets, we're always on the lookout for more relevant products and services which we can sell to our SME customer base," he says. That can mean new capabilities such as the credit card settlement services developed by US-based Verus, which Sage has now integrated into its core accounting packages. It can also mean businesses with a dominant presence in niche vertical markets, such as Emdeon in doctor's practices.

Potential acquisition targets are mostly identified by local management teams. "We find that the business rules that underpin the usage of our software vary a lot by geography, so it makes sense for us to be very decentralised," Harrison says.

Acquisitions also provide a way into new territories, as with recent deals in Shanghai and Malaysia. "Our experience, as we move into new geographic markets, is that SMEs like to buy from leading brands and existing channels. It's much better to acquire them than to build new ones," Harrison says.

The group has what Harrison calls a very disciplined approach to valuation, based on discounted cashflow modelling with rigorous analysis of strategic opportunity and cultural fit. "It's very much geared around the knowledge that every pound we spend on acquisition could be returned to shareholders, so we've got to be sure through modelling that we can earn a better rate of return by investing in acquisitions," he says. The programme is backed by revolving credit facilities totalling £850 million.

Analysis can reveal significant upside at potential targets, increasing the earnings multiples Sage is willing to pay. "The sort of businesses that financially are attractive are those where the company has a strong customer base, with good brand and channels to market, but which isn't run particularly efficiently," he says.

Private equity competition can push prices too high, however - last year, Sage abandoned an agreed £334 million deal for Norwegian group Visma after private equity house HgCapital tabled a rival £382 million bid.  "We've walked away from several transactions because private equity has outbid us and taken valuations to a level that we wouldn't feel represented good value to our shareholders," Harrison notes. "But there have been other cases where we haven't been the highest bidder, but we have been successful because of our relationship with management."

Building strong relationships can take time, however - Sage was talking to Spanish software house Grupo SP for six years before closing a £49 million acquisition in 2003.

Harrison sees strong opportunities for further deals, with a continuing trend towards industry consolidation. "There are lots of opportunities out there," he says. "The skill is to select the right opportunities."

The next big clean thing

IT might dominate deals, but other areas of the broad technology arena are quietly thriving. Applied technology, including instrumentation, medical systems and avionics, remains the unsung hero of M&A, says Peter Rowell of Regent Associates. "These all have unique hardware allied with software and services. That's an important part of the market, and a consistently strong area," he notes.

Life sciences and biotech are also tipped to see revived deal activity. Many of the pharma giants have weak product pipelines which could be filled out by strategic acquisitions. As with the IT sector, AIM-listed life science companies could prove attractive targets for the majors.

Current VC activity can offer a good indication of future M&A trends. Many of the software and IT companies now in consolidation were backed in their early growth phase by VCs. And with investors currently piling into so-called clean technologies, it's a safe bet that consolidation plays will follow.

Cleantech, as the sector is often know, covers a broad range of applied technologies which aim to address some of the most pressing problems threatening long-term economic growth. It includes cleaner energy generation and storage (which accounts for roughly half of cleantech investment in the US and three-quarters in Europe); water and air treatment; and technologies for improving production efficiency and reducing waste.

2006 saw cleantech become the third largest venture investment category after software and biotech, attracting a total $3.6 billion (£1.8 billion) investment. Although some early stage cleantech ventures have won investment, most of the businesses attracting funding are already established with solid customer bases and revenue streams. The public markets are also showing a strong appetite for cleantech, particularly in renewable energy.

Cleantech will become an increasingly important area for M&A, PwC's Andy Morgan believes. "The level of transaction activity so far has been pretty small, but it's certainly growing," he says. "There are a whole host of areas that are going to attract a lot more investment over the next couple of years because it's definitely a big issue for the technology industry and the broader economy."