The UK technology sector is in good health at present, showing a high level of transactional activity over the last six months. In particular, the most noticeable themes have involved software, private equity and high valuations.
Notable recent software transactions have included Advanced Computer Software, Allocate, Incadea, Access Software and Kerridge. The first three transactions involved quoted companies being taken off the market, and the last two were private equity deals. In fact, both of these involved private equity firms on each side of the deal, buying and selling. In all of these deals, the valuations were between 13 and 16 times EBITDA, a range which represents one of the periodic high points for the sector.
The other noticeable trend is one away from the public markets, with the two IPOs (telecoms businesses Gamma and The People’s Operator) being outnumbered by a plethora of public-to-privates, mostly backed by private equity firms. In addition to the likes of Allocate, Daisy completed its own public to private, in order to continue its buy-and-build program in the business comms space.
Private equity funds are currently huge
These high valuations, along with the increasing tendency for M&A activity to be dominated by private equity, are related to another long-term trend, namely the substantial increase in private equity funds. In 2005, according to the Financial Times, the private equity industry had $1.2 trillion of funds under management, held by 3,355 firms. By last year, this figure had swelled to $3.8 trillion in the hands of 5,868 firms, of which a remarkable 2,252 are currently in fundraising mode, according to data from Carlyle co-founder David Rubenstein. In addition, it is noticeable that the average fund size has doubled over the period.
Although difficult to prove, it is hard to resist the conclusion that the current high prices being paid for good tech assets result primarily from the sheer volume of private equity money needing to be deployed. Due to the longer-term nature of the funds, private equity firms have some flexibility as to when they put their money to work, and they are supposed to be good at buying low and selling high. However, they can’t sit on their hands for too long, as the internal rate of return clock begins ticking the moment they raise the fund and draw it down. Therefore, the sheer weight of available funds needing to be deployed is causing prices to rise.
It is also hard to resist the conclusion that returns from private equity are coming down. To some extent this is not surprising, nor is it ominous. When base rates and inflation are so low, and rates of return from all asset classes are also low, it is quite acceptable to deliver lower risk-adjusted returns from private equity too. Ostensibly, targeted returns for mid-market private equity funds are still 20 to 25 per cent, with between 15 and 20 per cent targeted returns viewed as acceptable for larger buyouts.
However, we can’t help thinking that the returns modelling, in some of the buyouts we are seeing, reflects some element of wishful thinking. Private equity firms seem to assume that they can continue to grow the top line at 10 per cent a year and improve margins, enabling them to double EBITDA over the next five years. In addition, they continue to assume that exit multiples will remain stable when they come to exit in three to five years’ time. On that basis, even if they were to give management their allocation of 25 per cent, they would still show an internal rate of return of 25 per cent, which is obviously attractive to private equity.
However, with a different set of assumptions, the picture for returns changes dramatically. Should revenues only grow at five per cent per year, or interest costs go up and exit multiples revert to their long-term mean of between 10 and 13 times EBITDA, in fact they’ll be lucky to get all of their money back. These are perfectly reasonable assumptions, which casts further doubt on the way that returns are modelled by private equity firms.
The better, or luckier, private equity funds regularly meet, or exceed, the targeted rates of return mentioned above. It is not uncommon for a fund to report that they have achieved a return of three to six times their money on a recent exit, and some cases the returns have been even higher. However, it should be remembered that these sorts of returns have been achieved during a period when most of the factors that create equity value have been positive. Leverage is more available to companies and its cost has fallen, while exit multiples have also risen. With the UK economy also improving in recent months, increased revenue and profit growth have been achieved, further strengthening the position that many tech companies find themselves in.
Even if these factors just stay as they are, these kinds of return will be much harder to achieve over the next five years. If they go into reverse, the returns may become non-existent or even negative.