Wednesday, April 29, 2009

Q.E.D. quod erat demonstrandum (which was to be proved)

It may be a coincidence, but in the past week, post Oracle/Sun I have found myself brought into a few conversations regarding roll-up opportunities, where a Fund executes on a strategy of bringing a number of related companies together under common ownership. It is a distinct class from traditional venture capital.

Implicit in the execution of such as strategy is a substantial reduction of the combined Companies operating economics. Moreover, sufficient capital is necessary to achieve a critical mass, where the resulting entity is a serious market share player in its market segment and has a multitude of going forward building/liquidity options for shareholders.

Since leaving the M&A advisory world nearly than 10 years ago, I have not spent many cycles thinking about the opportunity, and don't really have an opinion on the segment, but thought a compendium of these conversations would be of interest.

Arbitrarily, if we look at one market, say security, it's now (over)populated with nearly 1,000 vendors. Unfortunately, 950 don't have (and never will) a meaningful EBITDA. This overpopulation will need to adjust (shrink) as customers just don't need choice of this magnitude; that's the opportunity.

For illustrative purposes, let's make some assumptions for a target anchor company:

Revenue $50mm (growing 20%/year)

EBITDA $ 5mm (for simplicity assume this is also pre-tax income)

The company has been sitting in 2-4 venture portfolios for 6-8 years and such Funds are now approaching their LP's with a series of one-year life extensions. The GP's are no longer receiving fees for managing investments from these vintage funds, and the LP's are suffering illiquidity angst. While the Funds were not previously excited about a 'sub-par' exit that nearly returns $25mm in assumed invested capital (management will also participate (happily) in the exit pool), I suspect the dynamics have changed. Returning capital, when the classes you are measured against are down 40%, is not such a relatively bad thing anymore.

The target company is too small for an IPO (even if there was a window), too large to receive more venture funding, too insignificant to move the needle by a large acquirer, and after a long IPO drought, the 'best' buyers, those in the middle-market, are all but extinct. These are dynamics not limited to security but are endemic across the entire software/internet world today.

I suspect the M&A market will value such a company somewhere in a 4-5x EBITDA range. This loosely equates with 50% of total revenues (note, Sun is being acquired at 1.5x MAINTENANCE revenues).

With a near-term objective of maximizing cash-flow, I would expect the $45mm of operating expenses can be slashed to $25mm, while revenue declines to $40mm. Leaving $15mm of free cash-flow.

While speaking with my operational friend, Dennis, and expressing concern about what the cost reductions would mean for future growth, he highlighted that you should put all your focus on one objective. If it's cash flow, when you achieve the sought metric, it will give you great balance sheet flexibility to either execute subsequent add-on's (with greater cost reductions and enhanced deal structuring alternatives) to fuel incremental growth, upstreaming cash to shareholders, or replacing debt with equity.

Of course, these thoughts are not unique. CA built a multi-billion company with precisely this modus operandi. A concern though, in looking at the market today, vs ten years ago, is that customers are much better built to 'plug n play' vendors. The effect of open source, common API's and a move to a cloud based infrastructure, is that lagging vendors, or one's whose relevancy has declined, are subject to more rapid replacement than previously contemplated.

I am sure many 'buy low and sell high' professionals are looking at similar dynamics. No doubt we will see a number of busy players soon. Hopefully, rebuilding the 'middle market'.

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