What IT Customers Need To Know About Private Equity In Tech

NEW BEGINNING
For executives watching their companies' stock price flounder, a private equity buyout can look like a new lease on life. Kronos had been trading around $30 to $40 a share, and then "four organizations offered us about $50 a share," says CEO Aron Ain, who's been at Kronos since 1979, two years after it was founded by his brother, Mark. Hellman & Friedman is paying $55 a share for the company.

Ain is convinced that, as a private company, Kronos can pursue growth-oriented investments, such as global expansion, without worrying as much about the short-term reaction from Wall Street and other investors. Ain says customers he talked with were more worried about Kronos being bought by another software company, which might be more likely to drop products or limit support for products that overlapped.

But how do customers do in such deals? There isn't a long track record of private equity tech investments to answer the question. One of the earliest was Silver Lake's purchase of hard-disk manufacturer Seagate Technology in 2000. Before the buyout, Seagate spent $500 million a year on R&D; the year after, $600 million, says Silver Lake's Roux. He says employment, capital spending, and R&D spending are up across the firm's portfolio of companies.

Piggly Wiggly Carolina, a grocery store chain, became a customer of GXS--for EDI transactions, data synchronization services, and product information management--in 2003, after it was purchased by Francisco Partners. Rachel Alvarado, the company's director of IS, has no complaints about GXS's responsiveness, especially its customer service. It's more difficult to assess the financial health of GXS, since it's not traded publicly, but she thinks management's been "up front and straightforward" in responding to her financial inquiries. Another GXS customer, Royal Bank of Canada, was "apprehensive" after the buyout, says Brenton Trites, RBC's senior product manager, but the vendor has since provided a broader product portfolio.

A vendor's financial health is particularly important when betting on critical infrastructure, like the IP systems Avaya sells. But Roux contends that people making IT buying decisions worry about what will happen in three to five years, not the next quarter. "They want to know that their vendor is going to be there with them in the long term," he says.

Garfinkel at Francisco Partners says private equity firms have no incentive to slow product development or slash R&D spending. "Eventually, we have to sell the business, and nobody is interested in buying companies with incomplete product road maps," he says. When Francisco Partners buys a company, it reviews the product portfolio and, with the management team, charts where the opportunities will be three to five years down the road.

But private equity owners will cut costs, often forcing harsh decisions longtime managers had avoided. Pet projects aren't likely to survive. "Some dream architecture that will never pay off for the customer or the company" won't get R&D funding, says Garfinkel. Same with a product line at the end of its life.

If tech companies haven't been aggressive with offshore development, new owners likely will push that option to cut costs, says Credit Suisse's Maynard. Francisco Partners has done that with some of its portfolio companies to keep R&D going at the same level or higher for a lower cost. One of the areas cut the most is sales and marketing, where some tech companies tend to overspend, he says.

In 2006, private equity accounted for only 6% of total merger and acquisition activity in technology. "There's still a lot of growth left," Roux says--providing many more examples to help us evaluate the benefits and pitfalls of private equity's growing influence in technology.