They once seemed like unlikely partners. But these days, our Technology, Media and Telecommunications Deals leader, Marc Suidan, comments, most of his corporate M&A projects with tech involve PEs. A record number of tech-focused PE deals are taking place, and several PEs are focusing exclusively on the tech sector. As technology is expected to remain a significant portion of the economy, the PE investment trend is expected to continue through 2018.

How does involving private equity firms change the dynamics of deal making? How can tech and PE firms bridge their complementary, but distinct, mindsets to create a win-win scenario? And what’s ahead? Marc and Ben Gillikin, Private Equity Deals Partner, recently discussed what PEs are looking for in a tech acquisition and what tech companies should consider as they look at partnering with private equity investors.

Marc: This trend began about 10-15 years ago but in Q3 2017, a whopping 43% of tech M&A was funded by PE sponsors*. What’s driving the increased focus on tech? Why now?

Ben: A number of factors are coming together right now. First, there’s the general macro trend of the role of technology in our lives and in business. Tech is here to stay and it’s transforming nearly every industry—financial services, health care, manufacturing. At the same time, tech companies are transitioning from traditional service delivery models to XaaS (Software/Infrastructure/Platform-as-a-Service) in a cloud centric environment. This new business model offers recurring cash flows, which is very attractive. These developments definitely appeal to private equity. Companies truly delivering their product through multi-tenancy software platforms have the ability to scale and gain operating leverage. This is something that will continue to interest PE.

Marc: Tech companies know in their bones that innovation is the lifeblood of revenue growth, but do PE buyers appreciate this? What do PEs want to see in potential targets?

Ben: PE investors understand that tech companies need to innovate and require investments to achieve their revenue targets. And when growth and revenue expansion are critical elements of the investment thesis, PEs need to see that a company has a clear path to deliver success. There are three critical areas where private equity wants management to execute seamlessly and simultaneously:

1. Transforming the business model to reflect how consumers and businesses want to purchase and use technology today
2. Growing through effective sales motions, including new joint ventures, alliances and, most importantly, new customers
3. Reducing costs and creating efficiency within their existing structure

The technology is important, of course, but the quality of management is paramount. PEs are investing in your management team as much as your technology. To keep PEs interested, management must be realistic about what it can execute well, present a clear roadmap, and above all, simplify the message. One frequent hurdle that trips up PE buyers is underappreciating the complexity of the R&D organization. I can’t stress this enough. Sellers must simplify the message.

Marc: You mentioned changing business models, which represents a fundamental shift in a tech company’s growth strategy. How does a changing business model translate to deal valuations?

That’s right. Tech companies are in the process of transforming their business models — for example, from hardware, software and internet solutions to a service model. PEs have been willing to take on the associated risks with this shift, but as more companies make the transition to XaaS or to the cloud, the reduction in risk is likely to be accompanied by an increase in valuations.

Marc: In addition to the classic PE buyouts or carve-out acquisitions, there seems to be plenty of other transactions taking place. How should corporates think of PEs and how it relates to relinquishing control over their company?

PEs are getting more creative in their investment strategies, which can reduce risks and enhance returns. They’re more open to alternative ways to putting their money to work outside of traditional control, such as mezzanine investments (which are a hybrid of equity and debt financing), minority growth capital and change capital. Before sellers give up control of their company in a deal with a corporate buyer, they should consider the alternative investment avenues a PE can offer.

Marc: You know the PE mindset through and through. For a moment, put yourself in the shoes of a tech company executive being courted by a PE investor for the first time. What advice do you have?

There are several factors I find to be underappreciated by the average tech company M&A exec, whether the company is selling itself entirely or as an asset/division:

1. Sellers should be sure to create the right peer groups and benchmarks for the company/asset they are selling. Potential investors will want to know whom you can be compared to in the market based on the complexity and maturity of your organization and, of course, on your products.
2. It’s incredibly important to show how the R&D organization can be a competitive differentiator. Do you have higher quality code? Are you producing code faster than your competitors? Are you improving the overall end user experience?
3. You must create the right expectations around what R&D should be spending to support differentiation in the marketplace because this is what will drive the additional revenue needed to support high valuations.
4. PEs will expect a complete financial view with proper assumptions documented. Management must be prepared to fully explain the company’s financials, which I’ve seen derail deals more often that you’d expect.
5. Finally, realize PEs are investing in your company because of the strength of your people as much as the potential of your product. They want to invest in organizations that are agile and can facilitate change. You’ll want to demonstrate that you have a solid, cohesive management team with a transparent communication style.

Marc: Much of the media coverage around technology is centered on cutting-edge innovations that are radically changing industries from banking to automotive—AI, machine learning, robotics, blockchain, to name a few. As 2018 begins to take shape, do you expect PEs to go after these emerging technologies in earnest?

That’s a whole conversation in itself, but the short answer is no. PE firms are unlikely to make significant investments in newer ventures. I expect PEs will continue to focus on more mature businesses with strong recurring cash flows such as tech service companies that improve business processes and create efficiencies across multiple industries. For instance, enterprise software companies have demonstrated a consistent recurring cash flow stream from their installed base.

Marc: One final question on the new tax bill signed into law on December 22, 2017. Will the Tax Reform Act impact private equity tech deals? How?

The Act could impact the taxation of PE investors in a variety of ways. There will be a new limitation on interest expense deductions for all business taxpayers, including private equity investors. PEs typically include significant debt in the capital structure of their portfolio companies; limits on tax deductibility will generally make this debt more expensive on an after-tax basis. This could potentially impact investment decisions, especially around more high-risk targets or around alternative investment strategies.

For insights on related topics, read on:

Technology Quarterly Deal Insights Report – Q3 2017
Private Equity Quarterly Deal Insights Report – Q3 2017
Lead or lag: What Industrial IoT means for Deals
Monytree Venture Capital Report – Q3 2017
Tax Reform Legislation impact on Private Equity

*Source: Thomson Reuters and PwC analysis