At a glance
- Even relatively early-stage opportunities have been considered by private equity
- Three key areas are mobile and wireless, SaaS and the Cloud, and IT services
- US interest in the UK and European tech scene is rising
- There is an increasing convergence between later-stage venture and lower mid-market private equity
- Due diligence has become paramount in that many firms are unfamiliar with the sector
- Lessons seem to have been learned from the dotcom crash
The UK tech sector is proving robust in the downturn and has attracted much interest from private equity bidders, with several deals in the £20m to £100m region having recently been made. This is in stark contrast to the stock market, which hasn’t been the strongest source of fundraising for tech companies in the past year.
What is it that is making this sector so attractive to private equity investment, and what opportunities are there in the current and future markets as London and the UK matures as a global technology centre?
The prospects for UK tech have picked up speed lately. While high-profile public company M&A activities, like Hewlett Packard's $12bn deal for British software firm Autonomy, have provided global headlines, the evidence points to surging vitality across the sector reflected in deal activity for venture, as might be expected, but also reflecting increased interest from private equity investors over a quite prolonged period now and, intriguingly, more recent interest from public market investors for relatively early-stage opportunities (see, for example, the recent IPO of Sphere Medical).
As private equity investors seek opportunities which allow them to write equity cheques without necessarily needing leverage, reasonably mature companies with strong growth prospects are emerging from the development of the UK technology sector in various sectors:
Mobile and wireless
Mobile technology is the largest information technology trend since the arrival of the personal computer 25 years ago. In particular, the combination of wireless broadband and video has the potential to lead to a further spike in the demand for new products. For example, the potential for wireless technology to be employed in operational applications in all areas of business is producing opportunities. ECI Partners backed the management buyout of Wireless Logic from Dragons’ Den entrepreneur Peter Jones. Wireless Logic is the largest independent operator in the machine-to-machine (M2M) communications sector, a market which is anticipated to experience growth of more than 30 per cent per year, while rapid expansion is also forecast in other sectors which have developed on the back of M2M technology, such as vehicle tracking, smart utility metering, healthcare and security. On the hardware side, the sale of Bristol's venture-backed wireless processor producer and developer Icera to US-based NVidia for £224m was announced back in May.
SaaS and the Cloud
Software as a service (SaaS) is a software delivery model in which software and its associated data are hosted centrally and are typically accessed by users via their web browser. It has increasingly become the default delivery model for most business applications. The SaaS sector has increasingly centred on cloud-based technology and services, with the key premise behind cloud offerings being the opportunity for SMEs to benefit from the economies of scale the cloud provides through data centre consolidation. SaaS has the potential to produce strong and predictable cash flows, being generally based on recurring revenue drawn from monthly billing models. It's not typically considered a capital-intensive model, and is bankable. Accordingly, we are seeing many private equity investors looking at SaaS-enabled companies to add to their portfolios. In April 2011, LDC acquired a majority stake in UK2 Group, an international hosting company. There has also been some divestment, with Alcuin Capital Partners having exited its investment in Glide Technologies, a London-based SaaS provider specialising in corporate communications and reputation management, in a sale to NASDAQ-listed OMX which was announced in October.
By contrast, perhaps, to these sectors, investment in IT services is seen as a more well-trodden path. Recent private equity investment has focused on potential consolidation and/or sector-specific investment, particularly IT service providers to the banking and insurance industries. Lumison, backed by Bridgepoint Development Capital, acquired data centre business Blue Square Data for £22m in the first quarter of 2011 and Penta Capital has backed Six Degrees Group to pursue a buy-and-build strategy. Meanwhile, Synova Capital invested in Actimax and RJD Partners has backed a buyout of Intrinsic Technology.
As the volume of transactions has grown, it is possible to pick out some discernible trends.
1. We are seeing more US private equity investment in UK and European tech companies. The general perception amongst the US houses is that there are some great opportunities over here.
2. There continues to be an increasing convergence between later-stage venture and lower mid-market private equity. Not only do they find themselves competing for deals, but we see some co-investment structures that allow houses to leverage off VC knowledge of the tech sector. The renewed private equity focus on technology has meant that the dividing line between venture and private equity is becoming greyer. There have also been some good examples of successful VC investments providing private equity deal flow. For example, Clearswift, a digital security software company, was acquired by Lyceum Capital in a deal announced in November. It was acquired from a group of VC investors including Amadeus Capital Partners, DFJ Esprit and Kennet, which had held a stake in Clearswift since 2002.
3. Listed company opportunities remain in the sights of private equity, not least owing to the strong cash flows being generated, but market volatility is perhaps making it difficult to put together deals, as evidenced by the abandonment back in August of talks between FTSE-250 listed Micro Focus, the Berkshire-based software firm and Advent International.
4. Investors place much emphasis on diligence. Many firms that are perhaps not established tech investors are developing their own sector-specific appraisal methodologies. One by-product of this learning process is that we may be seeing more “no” decisions at a later stage of the appraisal process. There are some recurring features of deals in the sector. Specialist assessment of technology risk is common, and even where the opportunity is based on relatively mature technology, there is extra emphasis on intangibles like IP, with diligence focusing on appropriate documentation and procedures being in place establishing ownership of that IP. Core contracts, both for licensed IP, and with customers and suppliers, need to be checked carefully for termination provisions, including change of control clauses. Furthermore, it tends to be the case in many companies in this sector that a small pool of key people constitute the core of knowhow and goodwill of the business, so it is important to get their service terms and equity incentives right.
There is understandable concern that the re-emergence of the tech sector should not spiral into a repeat of the dotcom years. This concern stems largely from the multiples being seen for the IPOs of social media businesses such as LinkedIn and Twitter. However, while the future of the current resurgence of tech remains to be seen, and notwithstanding continued question marks over some of these high-profile valuations, the sector as a whole does not seem to be reliving the dotcom cycle seen between 1995 and 2000. There are more repeat entrepreneurs who have a clear vision of their business models, reflecting the collective memory of the sector. This time, there is a much greater basing of investment on real cash flows and validated business models. The "growth over profits" mentality of the dotcom bubble is generally treated with much greater scepticism in the UK.
These days, there is a sense that tech has the substance to offer a robust proposition to the private equity investor. The industry's role in supporting one of the key high growth sectors the UK has to offer should be celebrated.
David Mardle is head of venture capital and Charles Fletcher is a senior associate in the corporate department at Taylor Wessing.