Information Technology: McGladrey Quarterly Private Equity Deal

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1 Information Technology: McGladrey Quarterly Private Equity Deal Insight Analysis Experience the power of being understood. 2Q 214 Powered by

2 McGladrey announces the 2Q 214 Private Equity Deal Flow Profile The IT industry was one of the few strongholds in regarding private equity (PE) investment. Deal flow actually increased last year from levels, making IT one of the few industries that didn t see a decline in PE activity in. Last year, unsurprisingly, also recorded a strong upswing in PE capital invested ($96 billion total), thanks largely to the $24.9 billion acquisition of Dell that closed in the fourth quarter. Even taking the Dell deal out of the equation, however, was still a relatively strong year in terms of capital invested. Sans Dell, PE firms poured $7.7 billion into the IT industry last year, leapfrogging the combined $62.6 billion invested in. High purchase price multiples continue to hamper the industry. Valuations are as high as I ve seen them for the past few years, says David Van Wert, director of transaction advisory services at McGladrey. A lot of prospective investors just don t see the return on investment based on the purchase prices that are being asked. Despite the high valuations, Van Wert expects another strong year in 214. The lending markets are flowing freely, he points out, which can ease the pain for buy-side PE firms looking to make investments. If we re doing an LBO, our clients are saying, at least the loan is cheap. companies in particular are popular among PE investors, and for good reason. Technology continues to permeate more and more aspects of our personal and professional lives. Industries that previously didn t incorporate software on a large scale are increasingly doing so, like education and health care, even ground transportation. PE investments got off to a noticeably strong start in Q1 214, accounting for 64 percent of all deal activity in the IT sector in the quarter, compared to about half of all activity in a given year. The software as a service (SaaS) subsector has been active recently, as well. Many of the software deals Van Wert has seen recently are SaaS-centric, some focused on previously licensed software in the past, but moving into more cloud-based applications. Exit activity was fairly robust in Q1 214, though initial public offerings (IPOs) of IT-backed portfolio companies are still few and far between; no PE-backed IT companies went public in the first quarter. Still, exits should be strong in 214 overall, predicts Van Wert, who adds that several McGladrey clients are looking to take advantage of the booming sell-side market while it s still around. Focusing on the middle market, McGladrey provides PE firm and their portfolio companies with integrated transaction advisory, tax, assurance and consulting services. Our work with 1, technology companies and 1,1 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 1,5 deals, more than 15 of which were IT transactions. Check out our top 1 list of accounting due diligence observations for the IT industry on page 6. Donald A. Lipari National Executive Director, Private Equity Services McGladrey LLP don.lipari@mcgladrey.com Kartik Sundar Raj Partner, Transaction Advisory Services McGladrey LLP kartik.sundarraj@mcgladrey.com David Van Wert Director, Transaction Advisory Services McGladrey LLP david.vanwert@mcgladrey.com Stacy Dow Technology Industry Practice Leader McGladrey LLP stacy.dow@mcgladrey.com [1]

3 IT private equity deal flow IT private equity deal flow by quarter $6 $5 $4 $3 $2 $1 $ $5 $4 $5 $5 $2 $3 $3 $1 $7 $6 $1 $9 $14 $14 $12 $18 $17 $1 $16 $2 $8 $17 $21 $49 $6 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 214 Capital invested ($B) # of deals closed Deal flow was remarkably steady between the second and fourth quarters of. The 95 deals completed in Q2 were just bested in Q3 and Q4 (98 and 99 completed deals, respectively). Activity was relatively muted in Q1 214, however, with just 79 deals, only 21 of which were in platform buyout investments. High valuations continue to be a headache for PE investors, according to Van Wert, who points to several failed transactions in the industry recently. One thing we re seeing more of are broken deals and auction processes, where we are brought in and we re providing due diligence services, but the deal doesn t end up closing. There s plenty of movement in the industry, and McGladrey s IT team is staying busy. But the biggest factor that s going against deal flow, Van Wert says, is pricing. We re seeing a lot of deals where our clients really like the business and they want to make an investment, but they just can t rationalize the price tag. Even so, given the amount of background activity in the market, Van Wert anticipates a pickup in deal IT private equity deal flow by year $14 $12 $1 $8 $6 $4 $2 $ $46 $76 $116 $16 $2 $32 $59 $63 $96 $6 activity through the rest of the year, especially with the increasing trend of add-on acquisitions, which make up about 63% of all majority investments by PE firms these days. companies, in particular, benefit through acquisitive growth, says Van Wert. We re seeing companies buying smaller and then try to grow Capital invested ($B) # of deals organically, but also continuously bolting on new acquisitions to either increase their customer bases or expand their product offerings. Rather than one big buy, he added, McGladrey is helping PE firms make smaller buys and more add-ons, helping portfolio companies reach their growth objectives. [2]

4 Deal flow details PE transactions (count) by deal type 1% 8% PE transactions (count) by sector 1% 8% Other Services 2% % Buyout Add-on PE Growth/Expansion Other 2% % Semiconductors Hardware Communications and networking companies are the backbone of PE deal activity, typically accounting for about half of all deal flow in the IT industry. 214 should be a continuation of the same; software companies brought home 5 deals in Q1, which, if the pace were to hold, would catapult 214 over and levels. s first-quarter magic didn t rub off on other IT industries. Communications and networking companies got off to a visibly slow start, recording only nine deals in Q1 (from 7 in ). Likewise, hardware companies and IT services providers both accounted for ten deals or less in Q1. Minority transactions make up a healthy portion of PE investment, though their popularity has declined recently. In, minority deals accounted for 28 percent of overall activity before incrementally falling to 23 percent in. So far this year, 22 percent of all PE deals have been for minority stakes in IT companies. Capital invested details Median deal size ($M) $2 $15 PE transactions ($ amount) by sector 1% 8% Other $1 $5 $ Buyout Growth 2% % Services Semiconductors Hardware Communications and networking Predictably, capital invested in Q1 214 was down substantially from Q4, the latter of which included the $24.9 billion take-private buyout of Dell. Even taking that massive deal out of the equation, capital invested in the first quarter ($6.3 billion) was quite a bit lower than the prior three quarters, and represented the lowest quarter for PE capital invested since Q2 recorded $5.8 billion. companies took the lion s share of PE capital invested in Q1 relative to other IT sectors. Firms wired a combined $4.2 billion into the software space in Q1, accounting for 66 percent of industry-wide capital invested. Barring any massive buyouts in the sector, it would be hard for software companies to receive as much capital in 214 as they have in recent memory, most notably the $44.2 billion software companies raised in. [3]

5 Add-on deals in the IT industry Add-on deals as a percentage of buyouts % 5% 3% 2% 1% % Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 214 Add-on Non add-on Add-on % of buyout Add-on deals made up half of overall buyout activity in for the first time ever, but in the IT industry, they have been popular for the past few years. Add-ons made up 63% of overall buyout activity in Q1, which wasn t far off the multiyear high of 65% seen in Q2 and Q2. The 44 add-ons completed in 4Q were the most in any quarter on record. Add-ons are sought after in the IT industry because of the dynamic nature of the sector, particularly in the software segment. Trends and customer demands can shift quickly for software providers, making add-ons an easy way for platform companies to redirect their business lines. Van Wert also notes that attractive platform acquisitions have been harder to come by recently. The availability of a solid, $1 million software business with great growth projections and all the right metrics those are few and far between these days. Add-ons, he believes, should continue to make up a large portion of deal activity in the software sector for the foreseeable future. Select IT Q1 214 transactions Company name Investor Sector Amount ($M) Renaissance Learning Hellman & Friedman, Google Capital $1,1 BlackLine Systems Silver Lake Partners, ICONIQ Capital $22 Compuware Professional Services Marlin Equity Partners $16 Aclara Sun Capital Partners IT Services $15 Azubu Sapinda Group $34.5 [4]

6 Exit activity in the IT industry IT private equity exits (count) by exit type Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 214 Corporate acquisition IPO Secondary buyout Thanks to high valuations and a frothy deal market, exit counts got off to a strong start in Q PE firms exited 21 IT-focused companies in Q1, not far off Q4 levels, which recorded the highest number of completed exits since Q1. Many of McGladrey s technology-focused clients, Van Wert says, are trying to take advantage of this market on the sell-side. One exit route PE investors haven t taken advantage of are the booming public markets. Despite the widespread popularity of IPOs, only four PE-backed IT companies have been taken public since the start of, and none were taken public in Q Counterintuitively, higher valuations in IT companies have directed IT companies away from the public markets and back into private hands. The disparity between what you d get in the PE market versus the public market is going to be IT private equity exits (count) by exit type a lot smaller for tech deals, notes Van Wert, adding that deal multiples on revenue or EBITDA for a SaaS business are much higher compared to manufacturing or retail businesses. Other industries are pivoting toward IPOs because they think they can get higher returns through that exit. Secondary buyouts have, in recent quarters, been a preferred exit route for PE sellers. SaaS businesses, in particular, boast higher recurring revenues and have more predictable cash flows. Even so, there was a noticeable drop-off in SBO activity in. The second half of recorded an abnormally high number of secondary buyouts, but that may be due to the massive sell-off in Q4 ahead of impending tax changes in January. Despite the decline, Van Wert anticipates an increase in sponsor-to-sponsor activity in 214. IT private equity exits (count) by sector % 8% Services Semiconductors Corporate acquisition IPO Secondary buyout 2% % Hardware Communications and networking [5]

7 Top 1 accounting due diligence observations 1. Complexities with software revenue: 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. 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. 1. 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. The following list shows a detailed breakdown of the PitchBook industry codes for the IT industry. 6. Information Technology 6.1 Communications and networking 6.2 Hardware 6.3 Semiconductors 6.4 Services Other information technology [6]

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