Published August 2020
Over the years, many private equity (PE) firms in the industry have come to embrace buy-and-build strategies as part of their playbook to create value through M&A synergies. Through this approach, PE firms seek out relevant companies that could enhance business operations of another larger company already in their existing portfolio. Company founders of tech companies looking for ways to cash out may do well by taking advantage of this trend and consider selling their company to PE firms as an alternative to the more traditional IPO approach.
Private Equity Firms Are Awash in Cash
PE firms have large piles of cash at their disposal, their stockpile growing vastly over the years. This uninvested capital, known as “dry powder,” currently amounts to $2.5 trillion and about a third of this sum goes toward buyouts. PE fundraising has also trended upwards since the financial crisis, hitting a record $537 billion in 2019. As such, PE firms have no need to buy companies at low prices and might be more willing to buy a highly-valued startup that has a lot of potential for high growth.
Although high amounts of uninvested capital may suggest weak PE activity, PE buyout volume has been on the rise. According to Bloomberg, this volume has exceeded $100 billion in 2020, based on announced or completed deals as of May. This was a 15% increase compared to the same period last year. As for deal count, MergerMarket reports indicate about 800 announced deals in North America in 1H 2020, compared to under 700 in the same period last year.  Pitchbook revealed that sales to PE firms or PE-backed companies accounted for 20% of successful exits (went public or got acquired) in 2019, up from 5% in 2003.
Some of the largest acquisitions in recent years include Thoma Bravo’s massive deal with mortgage finance software provider Ellie Mae ($3.7 billion, 2019), Vista Equity Partner’s acquisition of project management platform Wrike ($800 million, 2018) and healthcare billing platform ZirMed’s sale to Bain Capital-backed Navicure ($750 million, 2017). Data center company Cologix’s PE owner Stonepeak Infrastructure Partners engineered a partnership with Abu Dhabi-based Abudala Investment Company for the latter to invest up to $500 million into the company. With access to ample funding in the private markets, companies no longer need to pursue the IPO route to raise funds for continued growth.
IPO Challenges and Restrictions
In fact, some companies do not even have business models that are suitable for IPOs. To raise public funds successfully, these firms should ideally be operating in a substantially sizeable market, growing quickly towards a clear path of profitability, or are already profitable. In 2019, ride-sharing companies Uber and Lyft went public at high valuations despite a lack of profitability, leading to a dismal showing in the stock markets. These companies are part of a small number of venture-backed companies to go public — 3% according to Pitchbook. This shows that many companies simply do not pursue the IPO route for various reasons.
Companies may also have other concerns such as dilution of shares and other public company regulations. For example, the SEC requires public companies to disclose information such as cybersecurity risks and incidents. Under private control, major reputation-damaging incidents may not become public, which could be more preferable for the management team.
In current times of social distancing, the scaling down of IPO investor roadshows could also have a negative impact on the pricing. Post-IPO companies will face stronger scrutiny of their earnings and growth rates amid the challenging economic situation. Founders that are planning public offerings in the short to medium term will need to consider these factors.
Despite the challenges, there were many tech IPOs that were quite successful this year. ZoomInfo was one of the largest, raising $935 million back in April. In recent weeks, it has commanded a very high revenue multiple (based on last twelve months) of over 80 times. The day after bank technology provider nCino got listed, its shares almost tripled to hit a high of $92. To be sure, many business-facing technology providers will still do well with IPOs, especially those that offer mission-critical services and generate recurring revenue.
Taking Advantage of “Multiple Arbitrage”
Although tech IPOs have done well, companies need a lot of preparation and the resilience to overcome market uncertainty. Company founders should not ignore the PE buyout option, especially if the company complements a PE firm’s existing portfolio. Through the buy-and-build strategy, PE firms will engage in “multiple arbitrage,” which refers to the ability for acquired companies to command a higher price multiple associated with the parent company.
Multiple arbitrage works because markets have a bias towards companies with larger market value. That is why PE firms are willing to pay a premium for these companies. Intense competition within the PE sector for promising deals also help to increase the valuations, allowing founders to pocket some extra cash.
Recent Buy-and-Build Cases
Thoma Bravo, a PE pioneer of the buy-and-build strategy, has acquired over 200 software and tech companies over the past two decades. One recent example is their 2018 acquisition of Apttus, a software provider that made its mark on the Salesforce platform. Its growth rates foreshadowed an IPO exit, but after Salesforce acquired its rival SteelBrick in 2015, Apttus have had to face a larger competitor in their field. To prepare for another possible IPO attempt in the future, Thoma Bravo led new investment in Apttus’s recent $715 million majority stake of its rival Congo.
In another case, Thoma Bravo acquired technology solutions provider ConnectWise for $1.5 billion in 2019. Later that year, ConnectWise merged with Continuum, purchased by the PE firm in 2017. The combined entity is now one of the largest and most dominant players in the Managed Services Provider (MSP) space. Datto, another significant player in the MSP space, is currently preparing for an IPO three years after its sale to PE firm Vista Equity Partners and its simultaneous merger with portfolio company Autotask. The public offering could value the company at over $1 billion.
To wrap things up, an IPO may not be optimal for certain companies. For companies that face profitability or growth challenges, or have offerings that complement a PE firm’s portfolio company (e.g. a merger or add-on), the PE exit path may be a more efficient one. PE firms can leverage their dry powder to help these companies to achieve scale and deliver long-term growth so that the larger, integrated entity would become more attractive to public investors. In any case, even if the company gets sold to a strategic buyer, aggressive bids from PE firms can drive up the final price.
There is an icing to the cake: although founders may not have intended a PE sale, the extra resources could go a long way towards fulfilling their original mission — whether to make banking/mortgage/insurance more accessible, or to drive greater efficiencies in the corporate sector. Founders would then be able to cash out a tidy sum and focus their energies on their next pursuit, while PE firms can continue to leverage their resources to build more valuable and efficient companies.