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January 19, 2007

Why buyout firms like enterprise software cos.

Hedge fund manager (and former VC) Bill Burnham has an interesting take on why US buyout firms have taken a strong liking for acquiring publicly US software companies.
Rather than targeting fast growing software firms, PE shops typically target "mature" software companies as they not only tend to have lots of cash but they also derive a large percent of their revenues from maintenance revenues. These revenues are seen by private equity investors and, more importantly their lenders, as a stable source of cash flow that can be used to finance lots of debt.

Seven Steps To Carry
The basic private equity software play book goes something like this:

1. Buy software company
2. Do dividend recap in which you simultaneously lever up the balance sheet and dividend out all the cash you just borrowed plus most of the existing cash on the balance sheet.
3. Raise new fund off of massive IRR created by dividend recap.
4. Do lots of acquisitions to make organic growth impossible to discern
5. Raise prices, slash R&D, increase sales and marketing.
6. Take company public/sell it at same PE you bought it for to investor/large company apparently unfamiliar with the concept of enterprise value.
7. Repeat.

Now I admit this is a bit of snarky characterization of PE software deals because software offers some unique scale effects in SG&A, but I think this characterization is probably closer to the truth than a lot of mumbo jumbo about "value add" "synergies", etc.

Arun Natarajan is the Founder of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.