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2013:Year inReview

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Information Technology: McGladrey Quarterly Private Equity Deal

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McGladrey 2013 Year in Review Private Equity Profile

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McGladrey announces the 2013 Year in Review Private Equity Deal Flow ProfilePrivate equity (PE) investors reined in their investing in 2013, breaking a streak of three consecutive years of increased deal-making. But investment in the information technology (IT) industry continued to soar in 2013, with capital invested soaring up 55 percent to $86.5 billion, and deal flow holding near the decade high set in 2012. “IT companies are performing well,” says David Van Wert, director of transaction advisory services at McGladrey. “I think 2014 will be a better year than 2013 in terms of deal count and the median deal size will be a little higher, as well.”

Technology continues to permeate every aspect of modern life, with opportunities in sectors ranging from education to health care. “There are a variety of trends that are either touching IT or that are IT-centric, and I think this will only continue,” says Kartik Sundar Raj, partner of transactions advisory services at McGladrey. Deal-making has been particularly strong for makers of enterprise products, including productivity and automation software. “Software and IT are industries where you are seeing strong returns from the companies, but the dynamic aspect of others industries like education, health care and even logistics—things that have typically been done by humans—are all being automated and tracked using big data,” Van Wert says.

The number of exits in 2013 slid to the lowest point since 2009. Lofty prices likely have a lot to do with this trend, as valuations remain high in both public and private markets, and PE firms are hesitant to pay high multiples, as it invariably lowers returns on the investment. Secondary buyouts drove down the overall exit number, as deals between PE firms fell by 60 percent from 2012 to 2013.

Focusing on the middle market, McGladrey provides PE firms and their portfolio companies with integrated transaction advisory, tax, assurance and consulting services. Our work with 1,000 technology companies and 1,100 PE firms gives us a deep understanding of the key trends impacting deal flow in the technology industry. In the past six years, we have performed due diligence on more than 1,500 deals, more than 150 of which were IT transactions. Check out our top 10 list of accounting due diligence observations for the IT industry on page 6.

Donald A. LipariNational Executive Director, Private Equity ServicesMcGladrey [email protected]

David Van WertDirector, Transaction Advisory ServicesMcGladrey [email protected]

Kartik Sundar RajPartner, Transaction Advisory ServicesMcGladrey [email protected]

Stacy DowTechnology Industry Practice LeaderMcGladrey [email protected]



While overall PE deal-making in 2013 declined for the first time in five years, IT bucked the wider trend, as deal flow was essentially flat, and capital invested surged to $86.5 billion thanks to the buyout of Dell in Q4. Even without the Dell deal, capital invested was particularly strong in the second half of the year. “If you look at the quarterly trends, you can see improvement throughout the year, and I think that will continue in 2014,” Van Wert says.

It is no secret why investors have been flocking to the IT industry, as technology has begun to proliferate in virtually every aspect of society. “There are a lot of mega-trends that are driving activity in the industry, such as big data, social media, wearable devices and the push towards the cloud,” Sundar Raj says. “Other industries like education and health care are also pushing for new technologies. It seems like 2013 was the ice-breaker year, and that it will continue into 2014, 2015 and maybe even beyond.”

Purchase price multiples have been rising across PE deals in all industries, but high prices have become routine in IT deals, and have not deterred investors

IT private equity deal flow

IT private equity deal flow by year

IT private equity deal flow by quarter

due to the high amount of potential presented by technology companies. Many of the largest transactions of the year had valuation-to-EBITDA multiples in the double digits, including an 18.4x multiple in the $1 billion private-to-public deal for Websense. “Without question, multiples are high right now, and if anything, it is only going to increase,” Sundar Raj says.

Regardless of their investment focus, almost every PE firm is involved in the IT space in one way or another. The fact that fundraising has increased for four consecutive years, with investors closing 212 funds totaling $179 billion in 2013, should bode well for continued strength in IT deal-making over the coming years.

Source: PitchBook

$6 $4 $5$3 $3 $3

$4 $10 $7 $6 $10 $9 $15 $16 $12 $17 $15 $8 $15 $17 $8 $14 $19 $45

84

55

68

38

52 51 51

69 64

42

7080

64

80

6672

93

73 73

97

63

9197

83

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Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2008 2009 2010 2011 2012 2013

Capital invested ($B) # of deals closed

Source: PitchBook

$22 $47 $81 $113 $18 $20 $31 $60 $56 $87

217231

319

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245223

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336 334

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Capital invested ($B) # of deals



IT private equity deal flow Deal flow details

Capital invested details

Software continued to be the backbone of PE investment in 2013, but investors proved willing to explore opportunities in other sectors, as well. Hardware deals remained popular, and the 69 investments in communications and networking companies were the most since 2007. There continues to be a healthy mix of deals for both enterprise and consumer companies, as investors look to capitalize on a broad range of industry trends.

Add-on and minority transactions held steady from 2012 to 2013, but the number of platform buyouts dropped by 11 percent. Adaptability is critical in the IT space, which can pose a challenge for PE investors, who must take a long-term outlook, while having a fairly rigid hold period for investments. To that end, add-ons can be used as a means to augment an existing platform company, while minority deals offer a high degree of flexibility.

PE firms pumped $37.3 billion into software companies in 2013—the most since 2007—thanks in large part to the six deals of $1 billion or more. The Dell deal drove capital invested in hardware to an all-time high of $28.3 billion, as the sector accounted for one-third of total IT investment. IT services, which saw a 14 percent decline in deal flow, also experienced a 28 percent drop in capital invested, with only one deal of $500 million or more.

The median buyout size hit a decade high of $142 million in 2013. Much of the increase can be attributed to heightened activity for deals in the $100 million to $500 million size range, particularly in the communications and networking sector. Capital invested declined in communications and networking though, despite the sector’s uptick in deals, with only two deals of $1 billion or more, compared to six in 2012.

PE transactions (count) by deal type

Median deal size ($M)

PE transactions (count) by sector

PE transactions ($ amount) by sector

0%

20%

40%

60%

80%

100% Other

Software

Services

Semiconductors

Hardware

Communicationsand networking

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012 2013

Buyout Add-on Growth/ExpansionPlatform Creation Other

Source: PitchBook

Source: PitchBook

$0

$20

$40

$60

$80

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$120

$140

$160

Buyout Growth

0%

20%

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100% Other

Software

Services

Semiconductors

Hardware


Source: PitchBook

Source: PitchBook



Add-on deals in the IT industry

Select IT Q4 2013 transactions

Add-on deals as a percentage of buyouts

Add-ons accounted for more than half of overall buyout activity for the first time ever in 2013, but were particularly popular in IT. The percentage of add-on deals in the IT space has increased each year since 2008, and reached an all-time high of 61 percent in 2013. “Due to the dynamic aspect of the IT industry, if you buy a business in 2014, it is not going to be the same business five years down the road—demands and tastes are constantly changing,” Van Wert says. “As companies evolve, the platform often can adapt through add-ons. So, if a piece of technology is not core to their business today, they

can do an add-on and pivot the direction of the company years down the road.”

The buy and build strategy was especially popular in the communications and networking sector, where add-ons represented 69 percent of all buyouts. And add-ons have always been popular in the software sector, where more than 60 percent of the buyouts have been add-ons in each of the last three years.

Company name Investor Sector Amount ($M)

Dell

Mitchell International

The Active Network

Tellabs

Securus Technologies

GlobalLogic

Silver Lake Partners, MSD Capital,Michael Dell

Kohlberg Kravis Roberts

Vista Equity Partners

Marlin Equity Partners

ABRY Partners

ODSA Topco (platform),Apax Partners (sponsor)

Hardware

Software

Software

Communications and networking

IT services

IT services

$24,900

$1,100

$1,050

$891

$640

$420

0%

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40%

50%

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70%

0

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40

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60

70

80


2008 2009 2010 2011 2012 2013

Add-on Non-add-on Add-on % of buyout Source: PitchBook

Source: PitchBook



Exit activity in the IT industryIT private equity exits (count) by exit type

Despite high valuations being paid for both public and private companies, exit activity fell for the first time in four years in 2013, dropping to its lowest point since 2009. The amount of capital exited also fell substantially—from $37 billion in 2012 to $17 billion in 2013. Both corporate acquisitions and initial public offerings (IPOs) were up, with the entire decline in exit activity being a result of weakness in secondary buyouts. PE firms executed a record 47 secondary buyouts of IT companies in 2012, but that total fell by 60 percent, with just 19 transactions in 2013.

“I’m a little bit confused by the drop in secondary buyouts,” Van Wert admits. “You would expect those deals to be taking place, and I anticipate that they will increase in 2014. That

being said, you talk to a lot of PE software buyers, and the higher return is coming from the initial buyout, as opposed to the secondary transaction.”

Exit activity did accelerate in Q4, but remained below the levels seen over the last two years. IPOs were a bright spot in Q4, as three PE-backed IT companies went public following a six-quarter drought. “The lack of IPOs is likely a result of that fact that PE firms feel like they can get just as good of a return in the private market,” Van Wert says. “There is a lot of headache that goes along with bringing a company public that a lot of PE groups may shy away from if they can get a similar return through a private exit.”

IT private equity exits (count) by exit type IT private equity exits (count) by sector

0

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40

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120

Corporate acquisition IPO Secondary buyout

0%

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100% Other

Software

Services

Semiconductors

Hardware


Source: PitchBook

Source: PitchBook

Source: PitchBook

0

5

10

15

20

25

30

35


2008 2009 2010 2011 2012 2013

Corporate acquisition IPO Secondary buyout



Top 10 accounting due diligence observations1. Complexities with software revenue: Software revenue

recognition continues to be the most common and most complex problem in the IT industry. The concepts are very hard to understand and equally difficult to apply. The easy part of software revenue recognition is that even as the accounting issues impact EBITDA and reported revenues, they do not affect the timing of cash flows.

2. Phased diligence: Buyers and sellers are performing more due diligence and identifying the most important issues upfront. We are frequently asked to phase our diligence scope to first address the areas of revenue recognition (deferred revenue) and sometimes, software development cost capitalization. If those areas pass muster, then on with the quality of earnings.

3. Software or SaaS: Does the business sell software or software as a service (SaaS)? There is sometimes confusion about this question, particularly now that many companies are selling both. The accounting issues are very different, depending on the answer.

4. Setup fees for SaaS: It would seem only natural that revenue would be recognized as services are provided to customers. That couldn’t be further from the truth for accounting purposes when setting up or implementing a SaaS customer. Instead, suspend your rational thought and recognize the setup revenue over the longer of the contract term or the expected customer relationship period. This can mean that instead of recognizing setup revenue in the first month or two of a contract, it could be recognized over the next seven years, if that is the expected customer relationship period.

5. What about the hardware?: Many companies have recognized the complexity of software revenue recognition, capitalization of software development costs and other industry-related issues, so they have hired experts in-house. Given the level of expertise, it may come as a surprise that inventory and cost of sales are sometimes recorded incorrectly for hardware businesses, because they are often overlooked to focus on the more common risk areas.

6. The deferred revenue “haircut”: The concept that deferred revenue can vanish or receive a significant “haircut” as a result of the transaction is hard to grasp. Typically, deferred revenue from the closing balance sheet of oldco jumps off a cliff from the application of U.S. GAAP purchase accounting onto the opening balance sheet of

newco. To elaborate, deferred maintenance, subscription or implementation revenues are reduced to the cost to provide the service, plus a reasonable (normal) gross margin. The buyer should understand this concept to model future revenue and earnings, as well as structure the loan covenants (if the transaction is leveraged).

7. Capitalized software development costs: Investors want to know what a company’s EBITDA looks like with and without capitalized software development costs. One common pitfall is that the management teams sometimes don’t recognize that the accounting guidance for the capitalization of software development typically differs for software and SaaS businesses.

8. Working capital or a cash peg?: The idea of a working capital peg seems age-old now, but is highly nuanced in the IT industry, due to the treatment of deferred revenue, where the target is in its life cycle and bookings seasonality. If deferred revenue has not historically been recorded in accordance with U.S. GAAP, structuring or setting the working capital peg and the subsequent working capital settlement can be extremely complicated. We work with investors who run the gamut for treatment of deferred revenue in working capital, from excluding it completely, to adjusting down to the cost to provide the future services (see observation No. 6), to including the entire unadjusted amount. In the absence of good reference points to establish a peg for working capital, sometimes the solution is found in settling for a peg on cash instead.

9. Sell-side due diligence: As the process for the sale of a business becomes more and more standardized, sellers are increasingly including sell-side due diligence as part of the process. Sell-side due diligence helps uncover unknown issues before buyers are involved (i.e., software revenue recognition), supports or increases the seller’s value proposition and helps decrease the risk of deal breakage.

10. Taxes really matter: The tax ramifications on financial due diligence and quality of earnings are particularly acute in the software industry. Rules and regulations for sales taxes, which should be included in EBITDA, can vary state by state or country by country. If a company cannot collect back taxes from customers, the related amounts should be a reduction of EBITDA, or at least considered a debt-like item to be paid (with interest and penalties) by the seller at close.

6. Information Technology

The following list shows a detailed breakdown of the PitchBook industry codes for the IT industry.

6.1 Communications and networking6.2 Hardware6.3 Semiconductors

6.4 Services6.5 Software6.6 Other information technology

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