Technology: Europe's magnetic north

Technology mega-deals grab headlines, but according to unquote" data they have become neither more frequent nor more valuable since the financial crisis. In the first three quarters of 2017, there were only two buyouts valued at more than €500m: the €4.76bn buyout of Norwegian enterprise software company Visma by an HgCapital-led consortium in June 2017, and Partners Group's £1.055bn acquisition of UK-based software company Civica in July 2017.

At the peak of the financial crisis a few mega-deals were constituting the majority of the value for technology buyouts. And while the number of large-cap deals has not decreased, the value has been trending downwards in the years since, barring 2014, which saw a flurry of software deals. In 2015, the mid-cap surpassed the large-cap space in this sector for the first time. It remained ahead in 2016 and looks on course to stay ahead again this year.

Jan Helle of global CMT-focused corporate finance adviser Arma Partners offers one possible explanation: "There are not many large companies that are actionable. A lot of companies in the technology space are generally younger companies that fit firmly into the mid-market," he says.

EQT Partners is among the best-placed GPs to comment on this: according to unquote" data the GP has completed the most buyouts (12), with an EV higher than €50m in the technology sector since 2012, with an average value of €280m. Dominik Stein, partner at the firm's Munich office, agrees that not many large deals are being completed, but does not think it is because of a lack of opportunities. He says: "Part of the reason for the lack of large-cap deals is high pricing. We carefully evaluate where we spend our time, based on where EQT can add significant value to the company, while still achieving target IRRs."

We took part in four situations for large technology companies this year and only one was completed. The others either did not happen at all, or they happened as partial monetisations because that was the only way to meet the high price the sponsor wanted" – pan-European mid-market GP

As a result of this, partial monetisations have become more prevalent. A partner from a pan-European mid-market GP, speaking to unquote" on condition of anonymity, says: "We took part in four situations for large technology companies this year and only one was completed. The others either did not happen at all, or they happened as partial monetisations because that was the only way to meet the high price the sponsor wanted."

One example of this is US private equity firm Warburg Pincus's acquisition of a 35% stake in Switzerland-based financial technology company Avaloq at a CHF 1bn valuation. Another, in a technology-related business, was BC Partners' sale of 30% of unquote" parent company Acuris, to Singaporean sovereign wealth fund GIC at a valuation thought to be around £1bn.

As technology becomes increasingly embedded in businesses from all sectors, it becomes more challenging to evaluate which deals to classify as technology transactions. Technological due diligence provider Intuitus Advisory has found a system that works for its business, as COO Iain Mackay explains: "At Intuitus, we differentiate between technology and IT. IT is where technology is a support function, whereas technology is where the technology itself is the product – such as software – or is so intertwined with the product that there is little differentiation."

While a company such as Acuris is not a purely software business, it is not out of the question that a prospective buyer would employ the services of a specialist due diligence provider to audit the databases and examine the coding of the management software.

Given the number of businesses that have a software or data element to them, you might expect that due diligence providers would see more of what Mackay calls IT deals. However, this is not the case. Mackay says: "Seven years ago, our engagements were 30% technology and 70% IT. That has flipped and we have seen a fourfold increase in the number of transactions." He adds that the firm is "mostly focused in the mid-market" although it is "increasingly extending into the larger technology deals".

A technology, media and telecoms (TMT) sector analysis report by unquote" sister publication Mergermarket looked at all M&A activity in the sector for the first three quarters of 2017 compared with the previous year. It reports a global decrease in value from $391.1bn last year to $299.5bn. In Europe, Mergermarket data recorded 813 TMT deals worth $47.4bn this year, compared with 780 deals worth $81.6bn in 2016. This is a 4.2% increase in deal count and a 41.9% decrease in deal value across the two periods.

However, the report notes that certain parts of the technology industry are very attractive to private equity sponsors. This is confirmed by unquote" data, which still shows a lull in value – €6.1bn for the first three quarters of 2017, down from €6.9bn for 2016 – but an uptick in volume from 66 to 99 buyout transactions. Filtered for deals of less than €500m, these figures show a stronger performance in the low-cap and mid-market spaces for the first three quarters of 2017 than in 2016, increasing in value from €3.9bn to €4.9bn and volume from 62 to 94 deals.

Germanic origins
Arma's Helle believes a number of factors are driving this growth in aggregate value across the small-cap and mid-market spaces. "There are a few macro themes: a general increase in private equity activity globally, based on a lot of dry powder, and the sheer size of funds is unprecedented," he says. "Add very cheap and available debt to this and you can see why dealflow is increasing across the board."

Private equity activity in the tech sector is not following the same trend everywhere though, and even within Europe there are regional differences. The upward trend in the mid-market is most evident in northern European markets – in particular the DACH and Nordic regions and to a slightly lesser extent France, with the UK and Ireland being the one region that bucks the trend.

Off the back of this, Arma has expanded its operations into Germany, opting for Munich as its base, partly for its transport links to other major German-speaking financial centres. "We have been very focused on the DACH region for a long time and we recognise an increasing level of activity," he says. "Therefore, we decided that having a physical presence in Munich was the right thing to do. DACH is a region where a local presence is important. The companies are spread across the region, so having someone there to travel around and cover the market is important."

Today, increased volume of dealflow in Scandinavia, DACH and France is coming, to some extent, at the cost of dealflow in the UK, but the overall trend is positive" – Jan Helle, Arma Partners

This is nothing new, but Helle thinks part of the growth is from established companies expanding, which naturally pushes up ticket sizes. "For a long time, the DACH region has had a vibrant mid-market tech sector, but it tended to be more on the smaller side," he says. "A lot of companies have grown in size, attracting attention from larger private equity funds that are finding a number of very attractive companies at the larger end of the mid-market."

The UK still accounts for a large proportion of tech buyout activity, but it has not been experiencing quite the same surge as other northern European countries.

Helle suggests this is motivated to some extent by concerns about stability, and it is hard to ignore the fact that the UK has recently decided to leave Europe's political and possibly economic union: "Today, increased volume of dealflow in Scandinavia, DACH and France is coming, to some extent, at the cost of dealflow in the UK, but the overall trend is positive. It is somewhat of a flight to safety; generally these are investments in stable economies that have done well through the cycle and there are lots of very interesting companies."

Software-as-a-sanctuary
Software has consistently been the largest advanced sector within technology across all deal types and geographies in the past five years. Stein highlights this as a reason for strong mid-market activity. "The software market in Europe is relatively small. It is quite rich in the mid-market and you can focus on a niche, such as supply chain and logistics software, and have plenty to choose from. But if you want to place €800m equity in a single deal in that same sector you are limited to a few companies."

Within software, which is itself an extremely broad sector, two areas jump out as being particularly active this year. The first is financial technology generally and within that the insurtech space and payment-related technology. The second is enterprise software, many providers of which now sell subscriptions to their products including access to the software, cloud hosting for users' data and files, and IT support and troubleshooting as part of the package.

This presents a major consolidation opportunity for private equity firms. Stein explains how EQT approaches this, making add-on acquisitions dubbed "technology tuck-ins" that can expand the company in different ways. "For software-as-a-service (SaaS) companies, sometimes you can do synergistic deals where you complete a merger and remove some costs, but it is rarer than in other sectors," says Stein. "Many of EQT's software companies buy peers in what we call technology tuck-ins. To broaden the product offering we can sell into the existing customer base or alternatively pursue add-ons to ‘buy' customers to sell into. But this is harder to execute if several competing software platforms need to be maintained."

Arma has recently advised on two high-profile enterprise software SBOs. The firm acted for HgCapital on its sale of Personal & Informatik to Permira in September 2016, and Bregal Unternehmerkapital on its sale of ProAlpha to Intermediate Capital Group in August 2017. "ProAlpha and Personal & Informatik are both examples of enterprise software companies that have grown very nicely," Helle says. "They are deemed to be safe investments with a lot of downside protection." He refers to how deeply embedded clients are in their existing software systems and the recurring revenues that these long-term contracts guarantee.

The software market in Europe is relatively small. It is quite rich in the mid-market and you can focus on a niche, such as supply chain and logistics software, and have plenty to choose from" – Dominik Stein, EQT

Valuing a fast-growing SaaS company presents a challenge to prospective investors, and GPs need to have a certain amount of in-house expertise. "We have a large number of professionals (35) within EQT focusing mostly on TMT, plus 25 venture colleagues who are heavily focused on that sector," EQT's Stein says.

But even then there is often a need to bring in a third-party due diligence provider such as Intuitus, which has itself been fast to adapt its service offering to cope with the influx of software projects. "We've added two modules to our due diligence in recent years," says Mackay. "First, a software code quality review in which we assess the quality of the underpinning code. Second, cybersecurity reviews. Many people think cybersecurity is about penetration testing, but actually it is a lot more to do with culture, oversight and responsiveness if you do get a breach."

This information will help potential sponsors better understand a company's quality, but putting a value to that is still a difficult task, especially when traditional measures like an EBITDA multiple seem inaccurate. "We spend a lot of time thinking about valuing software companies," says Stein. "Depending on the sector, in Europe EBITDA multiples are more prevalent, whereas in the US mostly revenue multiples are applied."

The 40% rule
American VCs and some forward-looking banks now talk about software deals in terms of the 40% rule. The idea is that if a company's revenue growth percentage combined with its profit margin is greater than 40% it has a good chance of succeeding. This means a company such as Rocket Internet-backed Delivery Hero is assessed as a good prospect despite being pre-profit. The business recorded revenue growth of 66% in the first half of 2017, while making a loss of €45.3m from €246.5m sales (-18%) giving it a score of 48%, which is above the threshold.

This might be a step too far for European banks at the moment, but Stein says EQT agreed the financing for its acquisition of Danish CMS software company Sitecore utilising a cash-EBITDA concept where available cash from upfront subscriptions is recognised. "Sitecore is one of the first deals in Europe to be financed on a cash-EBITDA multiple, as the banks understood and supported the transition from a perpetual licence to a subscription model," Stein says. This allows terms and leverage to be more flexible and makes sense for SaaS companies where 50-60% of contracts are often paid upfront in full.

Valuations of this type are speculative by their very nature, and despite what has been said about downside protection and technology as a safety haven, there will be many unpredictable challenges ahead.

What is becoming more predictable, however, is an increase in political uncertainty and the possibility of a rise in protectionist legislation. Germany tightened its foreign takeover laws in July and the UK is currently debating changes to the Enterprise Act, which would broaden its scope for intervening in technology M&A deals. The aforementioned partner at a mid-market GP acknowledges the potential for problems: "I'm worried about that," he says. "Chinese buyers were very hot 12 months ago, but the amount of deals has slowed down. Of course, this is partly because within China there were interventions but it will still have an impact. On the plus side, it will be relatively transparent which companies are affected."

Software is eating the world and there is still a lot of growth to be found in e-commerce" – Dominik Stein, EQT

However, as companies collect more data on their customers, this information itself could be considered pertinent to national security. If that were to happen it could have a big impact on the market. At the moment data normally sits either with the company or in the cloud, and even if it is in the cloud it is usually a local cloud, as stipulated by many local legislations. For this reason, the source described that particular concern as "a couple of years out".

Helle, however, is bullish on the strength of the sector and support for free trade: "We are not worried about that. We live in a global world where capital moves freely across borders. Certain sectors have particular sensitivities, but we are strong believers in cross-border M&A. US buyers in Europe, Asian buyers in Europe and pan-European cross-border activity is a strong theme that will continue," he says.

Nobody who focuses on this sector is afraid of uncertainty, and part of being successful as a technology investor is embracing exponential change and being adaptable, Stein says. "I am really excited about underlying trends. Software is eating the world and there is still a lot of growth to be found in e-commerce. Fibre is also very attractive, as the need for high-speed internet connections is ever increasing and data analytics becomes more relevant in all sectors. Thus the sectors EQT are investing in are very exciting."

Despite the geopolitical uncertainty that lies ahead, this optimism is supported by the data, particularly in north-western European markets. The strength in these markets may have come slightly at the expense of the UK in the short term, but the macroeconomic environment points to sustained growth across the board in the medium to long term, barring any serious political or economic catastrophes. In fact, with numerous European cities setting out their stalls as the de facto startup hub post-Brexit, that political uncertainty might even prove to be a catalyst for further growth.

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