Hard times over for hardware investments?

Hardware has always been held at arm's length by private equity. While certain elements of the industry such as semiconductors are appealing, the majority of companies operating in the heart of this space tend to be avoided due to the challenges and costs that accompany building a successful hardware manufacturing business.

The sector has managed to house a few mega-deals over the years – particularly in the aforementioned semiconductor market. Most notably, in November 2006, Philips' semiconductors division, NXP Semiconductors, was snapped up by a consortium of private equity giants led by KKR and supported by Apax Partners, Bain Capital, Silver Lake, Axa Private Equity and AlpInvest Partners.

The semiconductor market, sitting comfortably on the fringe of hardware, is a safe way for private equity to dip its toe into the industry. As semiconductors are used in all modern solid-state electronics, a business operating in this space is unlikely to experience a spectacular fall from grace.

However, a company building a specific piece of hardware with only one use – such as former Barclays Private Equity investment PC-PoS, a digital point of sale (DigiPoS) manufacturer – is vulnerable to the constantly improving technology market and its fickle consumers.

In August 2003, Barclays Private Equity bought a 32.5% stake in UK-based PC-PoS for £35m. PC-PoS was described by unquote" data as being "one of the largest global suppliers of electronic point of sale (EPoS) solutions and peripheral equipment for retail" at the time. However, in 2011 Barclays wrote off its stake in PC-PoS after the company went into administration, despite generating revenues of £57m in 2010, as well as an EBITDA of £2m. Over the past few years, EPoS has fallen out of favour for the more convenient mobile point of sale system, which is quickly being adopted by retailers on a large scale and is expected to hit the $2bn mark in the US by the end of this year.

Telling figures from unquote" data uncover the general attitudes of managers towards Europe's hardware market. Since 1990, there have been just 500 investments in hardware and semiconductors, while the software industry on its own has been subject to more than 4,100. Half of the investments in hardware and semiconductors have been expansion deals, with early-stage capital coming in second and buyouts sitting in third place, with a mere 60 having taken place in the last 23 years.

More than deep pockets
"To invest in hardware you need to have deep pockets," says DFJ Esprit partner Richard Marsh, "because you have to be able to finance companies through multiple rounds of funding and that needs experience and cash. That means there are fewer people investing in the space, which means you'll see fewer deals done.

"When investing in hardware you need to recognise that the most successful companies can grow really fast. This creates a larger requirement for working capital, because you have a physical product with manufacturing and stock and it sucks up money. There is a real gap here that banks should be filling but aren't, so as an investor you need to help your portfolio and have great access to non-bank debt lenders."

DFJ Esprit is one of the few European firms that actively invests in the hardware and semiconductor space. According to Marsh, earlier this year the firm found that the semiconductor and hardware market accounted for approximately 8% of European venture capital investments by value, as well as 12% of the exit market, over the last three years. DFJ Esprit's portfolio made up more than 50% of that exit market in the sector, says Marsh. "We have generated returns in the sector and have the experience and funds to invest in it, but there are fewer funds to co-invest with and so it's harder to build syndicates."

DFJ's portfolio showcases the relationship that is forming between the sparse number of venture capital firms operating in the hardware space and the companies leading the industry. The latter has noticed the lack of venture funding in the sector, says Marsh, and has started to co-invest with venture capital firms to fill the funding gap.

One example of this is DFJ Esprit-backed ZBD Solutions, a UK-based manufacturer of electric shelf labels, or "e-paper for retail". ZBD recently secured a further $25m in funding from a consortium including DFJ Esprit and TTP Ventures, as well as listed trade player Zebra Technologies Corporation.

ZBD claims to have experienced growth of 17,910% during the five-year period ending in 2012. Because of its substantial growth, the company was named the fastest growing company in Deloitte's 2012 UK Technology Fast 50 awards, as well as the second fastest in Deloitte's 2012 Technology Fast 500 EMEA awards. "It's absolutely unheard of that a hardware company is up there at the top," says Marsh. "It's normally software or e-commerce because traditionally they are businesses that scale faster, but the market opportunity for ZBD is extremely large and proves what can be achieved."

Likewise, DFJ Esprit and Gimv are backers of Greenpeak, a Dutch manufacturer of wireless data communication controller chips. Greenpeak's chips are supplied to original design or equipment manufacturers for wireless connected home applications that control energy efficiency, lighting, heating, access control and security for the home.

Founding fathers
In the case of DFJ Esprit, one of the key criteria for investing in a hardware start-up is its founding team, says Marsh: "This is an industry where you need to have substantial experience behind you before you create a start-up. It's not a sector where you want to be learning as you go along.

"Our portfolio company Greenpeak's founding team is also the founding team who created wifi. ZBD's core technical team pioneered the very first liquid crystal display (LCD) screen technology. Another of our portfolio companies, Neul, was created by the co-founders of Cambridge Silicon Radio, who are the people who basically launched Bluetooth.

"That quality of team and founder is always going to be attractive. In a market where there's less money going into the sector, you will see fewer deals done but you will expect to see a concentration of quality."

On the surface, it's easy to understand why the asset class is reluctant to invest in such a seemingly risky space. However, as the pace of technological advancements continues to race on without bounds, recent hardware deals show it is unwise to ignore the space. Instead, a deeper inspection of new hardware devices in whatever shape or form is required to achieve outsized returns and to be at the forefront of tomorrow's world.

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