Jeff Laborde
Private equity (PE) firms spent a record $226.5 billion on take-private transactions globally in the first half of 2022, which is 39% higher than the same period in 2021. While overall mergers and acquisitions (M&A) activity slowed significantly in the second half of last year with equity market volatility, the volume of large acquisitions by PE firms looking to capitalize on a period of lowered valuation expectations is rebounding as a result of bottoming valuations and a large supply of public company targets.
When public companies underperform, PE firms in pursuit of equity value creation opportunities are eager to purchase and take these organizations private.
Despite economic cycle peaks and troughs, these types of transactions represent a large and growing share of overall M&A activity. With this growth in the volume of PE-backed transactions, it’s increasingly important to understand the basics of these transactions and the potential implications on key stakeholders, including customers, partners and employees of the acquired company, in particular, those who are left to wonder how the acquisition will affect them.
Why do PE firms purchase publicly traded companies to take them private?
PE firms are investment funds that specialize in buying underperforming businesses with the goal of fixing performance and selling the business later for a profit. While PE firms can also buy private companies or take minority ownership stakes in businesses, their traditional approach has most often been to acquire publicly traded companies and take them private.
The software industry has seen significant take-private activity in the last year — Coupa, Citrix, Anaplan, Zendesk, Duck Creek and more — and the volume of such transactions is likely to increase given many newly public software companies (those listed in the last three to four years) are trading below their IPO valuations.
There are many reasons a PE firm chooses to buy a publicly traded company. The most common return on investment drivers (which by no means are mutually exclusive) are to significantly improve cash flows from operations, fix the company’s business operations and take advantage of untapped growth opportunities.
What happens after an acquisition is announced?
After the buyout agreement is signed and publicly announced, typically a deal will go into a multimonth pre-closing period while regulatory approvals are processed, debt financing is raised and closing conditions are satisfied. During this pre-closing period, the management of the acquired business generally freezes new investments, which often includes reduced hiring and the transition to near-term cost-rationalization.
The new PE owner will use this time to firm up its plans to shift short and long-term focus, including weighing the depth and breadth of cost cuts, changes to business practices and operations and defining new strategic priorities. Unfortunately, these pauses and changes create significant uncertainty and disruption for key stakeholders, especially employees and customers.
What happens after the multimonth pre-closing period?
Once all approvals and closing conditions are satisfied, the acquisition will close. The company will be de-listed and the PE firm officially owns the company. Most PE firms have a playbook for optimizing the operations of newly acquired companies and will begin to rapidly implement those strategies. Common changes include new leadership and corporate strategy reflective of the PE firm’s long-term experience managing through economic cycles and industry-specific market nuances.
The shift in priorities and investments typically result in the elimination of many existing initiatives in order to meaningfully improve profitability and service the newly raised debt. PE firms’ playbooks vary depending on the objectives of the acquisition, but in general also shift focus from the short-term quarterly results of public companies to long-term sustainable financial performance as a private company.
Let’s use customer support as a basic example. The PE firm will thoroughly review the function’s structure and benchmark key performance indicators. This will include reducing the layers of management to create a flatter organization, centralizing disparate geographic and product specialty teams, and shifting significant team headcount to low-cost (and often international) geographies.
While each PE firm has differing playbooks for different investment scenarios, there are some immutable truths that almost all PE firms follow. Chief among them is efficiency. Simply put: PE firms run a tight ship. They focus on materially increasing profitability with an eye toward exiting the company they have invested in (i.e., selling or taking public again) for substantially more than what they paid to acquire it.
Regardless of whether the PE firm’s strategy is to enhance cash flows from the acquired company’s business, turn a struggling business around, use additional acquisitions to quickly generate scale or capitalize on untapped growth opportunities, cost rationalization and the ruthless search for inefficiencies across the business are constants. The amount of cost cutting and the resulting impact to the long-term operations of the business and its stakeholders is dependent on how inefficiently the company was run before the acquisition.
If the acquired company had embraced a “growth-at-all-costs” (GAAC) strategy, which entails investing heavily in sales and marketing to aggressively grow top-line revenues with little concern for profitability or cash flow generation, the inefficiencies across the business will be material. This means the cost cutting by the new PE firm will be significant and the business disruption will be more dramatic during this transition of ownership and implementation of the prescribed changes to the business.
If the acquired company embraced a “growth-at-a-reasonable-price” (GARP) strategy, then the cost cutting and operational disruption will likely be much less extensive. For companies that were run more efficiently prior to acquisition, there are fewer opportunities to root out inefficiencies and therefore the PE playbook in this scenario will focus on growth opportunities, new investments and additional M&A.
As a key business stakeholder of an acquired software company, how can I assess the impact to me?
PE firms rarely disclose the details of their strategy or their corresponding playbook for a particular acquisition. A stakeholder’s ability to independently discern the PE firm’s investment rationale or case for the acquisition can make all the difference when attempting to predict how the acquisition, and following actions taken by the PE firm, will affect them. First, determine which primary investment drivers the PE firm is pursuing and whether the acquired company was a GAAC or a GARP company prior to the acquisition. GAAC companies with little or negative cash flow will typically undergo far greater restructuring, business changes, cost cutting and a longer and more uncertain period of disruption for stakeholders.
Shantanu Nayaren, the CEO of Adobe, recently noted the risks of operating a GAAC model when he said, “I think the macroeconomic environment, honestly, is being used as a mechanism to say: ‘Is prioritization being done appropriately?’ There is an element of the financial community that is looking at … where perhaps it was growth at all costs … now they’re looking at a balance of growth and profitability.”
A tough economic environment brightens the outlook for buyouts
All signs point to robust technology PE buyout activity in 2023 supported by lower market volatility, lower public company valuations, a more stable interest rate environment and large pools of available PE capital. M&A is a part of doing business, and it’s important to recognize that the impact and disruption of a PE take-private deal may be felt for years. The accompanying periods of dramatic change will involve hard lessons for a broad mix of stakeholders. Success is not guaranteed — with GAAC businesses in particular, management team turnover, product rationalization and new acquisitions, along with the integration of previous ones, can all complicate the PE owner’s business transformation effort and prolonged periods of disruption.
PE investments can pave the way for long-term and sustainable operational success when coupled with talented and dedicated employees and a commitment to customer success and a responsible growth plan that balances growth and profitability.
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