Take your company private

November 30, 2000: 2:52 p.m. ET

With the markets in turmoil, private buyouts are coming back in vogue
By J.P. Vicente

SAN FRANCISCO (www.redherring.com) - Call it the paradox of the technology economy paradigm. While throngs of entrepreneurs have grabbed the limelight by taking young companies public faster than you can say IPO, a smaller, yet growing, crowd of seasoned executives at more mature technology firms is moving in the exact opposite direction.

They're taking companies private, replacing public equity with private equity and debt, often in association with a new breed of deep-pocketed Silicon Valley capitalist: tech private equity and leveraged buyout (LBO) funds.

According to Thomson Financial Securities Data, 44 tech buyouts totaling $8.48 billion were closed in the first nine months of the year, compared to 34 deals worth $6.53 billion in 1999, and 24 transactions valued at $2.5 billion in 1998.

And because these numbers only include publicly released figures, they may significantly underestimate the market. Silver Lake Partners, a $2.3 billion tech private equity fund, for example, says that by its calculations a whopping $18.5 billion worth of deals were carried out in the first nine months of 2000.

"This is a growing market, and you'll absolutely see more of these types of deals in the future," said David Roux, a cofounder at Silver Lake.

Many forces drive this trend. The coming of age of many segments of technology has created a large enough pool of firms which, albeit out of favor in the public markets, sport steady revenue and positive cash flow streams. Abundant capital, coupled with the fact that private investors see the opportunity for returns above 30 percent a year, also plays a role.

Finally, technology executives -- in a bid to unlock shareholder value and concentrate on the fastest-growing parts of their businesses -- are moving to rid themselves of slower-growing units, creating buyout opportunities in the process.

"As we go forward, you'll see more and more private equity investment firms and traditional leveraged buyout firms seek to make investments in technology. And most activity will likely focus on buying pieces of larger corporations," said Justin Chang, a partner at private equity and LBO firm Texas Pacific Group.

Indeed. Within a year or two, some argue, there will be great LBO targets within tech behemoths like Cisco Systems (Nasdaq: CSCO), Microsoft (Nasdaq: MSFT), and Intel (Nasdaq: INTC) as the markets in which those companies operate mature and become more specialized.

"Cisco is a prime example of a company that sooner rather than later will be ripe to shed some parts of its businesses," said Matthew Zolin, a high-yield market analyst at Lehman Brothers.

Also, the private equity investment trend is not limited to the U.S. market. Some companies are wasting no time getting their feet wet overseas -- Texas Pacific, for example, recently paid $514 million for a 33 percent stake in Gemplus, a private French firm in the smart card technology business.

Investment bankers say that segments of several European technology icons, such as Siemens, Philips Electronics (NYSE: PHG), or even Nokia (NYSE: NOK) could also be up for grabs in the not-too-distant future. "The international market is the next big target," said David Wah, a managing director at Credit Suisse First Boston Technology Group.

The money pot
The clearest indication that a wave of private equity investments is imminent is the huge amount of money raised to accomplish just that. The top ten private tech and telecom equity funds have raised more than $15 billion in capital over the last two years, while a smattering of smaller funds has raised another $5 billion.

Those managers aren't paid to sit on that mountain of cash. Investment bankers estimate that 70 percent of that total -- or $14 billion worth of private equity capital -- is still chasing deals.

Using conservative debt leverage of just twice the initial equity capital, that would suggest there's $42 billion in the pipeline to be spent -- enough money to, for example, buy all four of Apple Computer (Nasdaq: AAPL), Amazon.com (Nasdaq: AMZN), Yahoo (Nasdaq: YHOO), and Silicon Graphics (NYSE: SGI) at their mid-October valuations.

"Large-scale private technology investing has gravitated from a niche business dominated by a few small players to a core business line for some premier LBO firms, which are raising large sums to invest in this market," said Scott Gutterman, an investment banker at Merrill Lynch (NYSE: MER).

So what sort of deal do buyout gurus look for? Although they rush to say that no two transactions are alike, there are some basic criteria used to separate the wheat from the chaff.

For starters, steady revenue and positive cash flow streams are imperative (yes, that rules out 99.9 percent of the dot.com world). Second, they seek companies with technologies that might not be the hottest things on the market, but still hold a captive clientele.

Third, they look for companies with low levels of debt (see "Anatomy of an LBO"). Seemingly tough criteria to meet, but analysts say that many technology firms will likely fit the bill.

"Many public companies no longer need the public equity market to raise cash, and many times their business economics do not match the preference of public investors. For such companies, remaining public may mean chaining themselves to an inappropriate capital structure that forces management to waste energy, and, eventually, lose frustrated senior executives," said Larry Shulman, a vice president at the Boston Consulting Group.

Let's not forget that executives chasing deals are, like any shoppers, looking for bargains: the cheaper, the better. So it should come as no surprise that many of them are relishing a recent meltdown in technology stocks.

"Market turmoil is the best possible news for us," said David Stanton, a partner and cofounder of Francisco Partners, a $2.5 billion LBO fund. "The more chaos and uncertainty in the marketplace, the better." If so, Mr. Stanton must be in seventh heaven. As of mid-October, the Red Herring 250 had plunged 15.4 percent for the year, and 26.7 percent from its March high.

To LB or not to LB
Unlike the infamous deals carried out in the heyday of the LBO market in the '80s -- when management and takeover executives staged high-profile battles for control of companies -- the new batch of leveraged buyouts are mostly friendly. In fact, senior executives today often take the initiative themselves and seek out LBO fund managers.

"Tech LBOs have become an option that technology executives are now aware of. That's a sea change from where we used to be just a few years ago. We used to walk in the office to talk to CEOs, and they used to look at us and say 'Why are you here?' We never hear that anymore," said Chip Schorr, a managing director at Citicorp Venture Capital Equity Partners, a $3 billion fund.

There are two main reasons behind that change in behavior. First, the notion of taking over an entire multi-faceted technology company is more daunting than, say, purchasing the world's largest consumer products company. (If Bill Gates can have his troubles at the helm of Microsoft, how well do you think a couple of inexperienced LBO hotshots would steer that ship?)

The idea now is to buy the pieces themselves, recapitalize them, and, if possible, bring them back to the public markets. Second, senior managers have been under tremendous pressure to keep up with the public markets' addiction to double-digit growth rates, and shedding slower-growing subsidiaries is a viable option to unlock shareholder value.

Take, for example, analog and wireless integrated circuits maker Intersil (Nasdaq: ISIL), which CVC Equity Partners bought for $630 million from Harris Corp. (NYSE: HRS) in 1999 and brought back to the public markets last February.

When CVC Equity Partners approached Harris for a deal, the company had missed earnings estimates for four quarters in a row, had hundreds of millions of dollars in debt, and was seeing its stock get hammered. The sale of Intersil paved the way for Harris to pay off that debt and refocus on its core digital TV business. From that perspective, the LBO deal accomplished multiple corporate goals.

It's ironic, however, that in mid-October Intersil's market capitalization of $4.8 billion was three times larger than that of Harris. So what are company executives doing to avoid looking like fools if the unit they sell ends up more highly valued than the former parent? Simple: they keep some stock. Most LBO deals are now structured to allow the mother company to retain an equity stake in the unit being spun off. In the above example, Harris kept 10 percent of Intersil.

Francisco Partners' recent acquisition of Legerity -- a telecom semiconductor maker that was previously a division of chip maker Advanced Micro Devices (NYSE: AMD) -- is another example. As structured, the $400 million deal -- made up of roughly $275 million in equity and $125 million in debt -- allows AMD to retain a 10 percent equity stake in the company, with the option to buy an extra 10 percent. So if Legerity is successfully brought back to the public markets (as Mr. Stanton expects), AMD can cash in on the IPO.

While Mr. Stanton won't reveal his actual return projections, he did give a hint about his expectations in the Legerity deal. In it, the company's total cost was equivalent to 6.6 times its $60 million EBITDA, or earnings before interest, taxes, depreciation, and amortization (in simple terms, the cash generated from operations).

If Legerity's EBITDA grows by 20 percent a year over the next four years, the company could be worth $821 million, assuming the multiples don't change. Assuming, again, that the debt was paid down with a portion of the company's $350 million-plus in EBITDA over those four years, Mr. Stanton and his investors would stand to earn a 30 percent annualized return on the equity portion of the deal.

Avoiding the debt-end street
The use of larger chunks of equity in the deals -- and smaller portions of debt -- is, in fact, becoming the rule rather than the exception in the brave new world of tech buyouts.

"Part of the idea behind tech LBOs today is to use as little debt as you can, and unlock the value of the equity portion of the deal," said Mr. Stanton. Some of the deals simply don't use any leverage at all.

Consider Submitorder.com, a distribution and e-fulfillment firm that Silver Lake acquired from privately held Digital Storage for $75 million.

To structure the deal, David Roux of Silver Lake called former Netscape Communications CEO and President and Federal Express Vice President Jim Barksdale -- "because he would understand a thing or two about the Internet and about delivering packages," joked Mr. Roux -- and offered him a cut in the deal.

Mr. Barksdale liked what he heard, and Silver Lake and the Barksdale Group bought a majority stake in Submitorder.com without raising a single dollar in debt. Unlike most venture capital investments, which tend to be merely a stake of a company, nonleveraged private equity purchases of an entire company usually take much longer to be structured.

Submitorder.com, for example, was in the works for almost a year before it was announced in December 1999. "The venture capital business is a batting game. If you hit one out of four, you're a solid player. But in the equity buyout business, since we're putting larger chunks of money into each deal, we can't afford to swing and miss," Mr. Roux said.

Like Mr. Stanton, Mr. Roux won't reveal the returns he expects on the Submitorder.com deal or on any other, so we thought we'd look elsewhere to check on his batting average. That's possible because some funds, Silver Lake included, are taking the concept of tech private investment a step further, using a rather un-LBO-like investment strategy known as PIPEs, or private investments in public equities. The deals usually consist of buying a small stake in a public company through the acquisition of either common stock or convertible debt, a lot like a run-of-the-mill mutual fund.

The difference, however, is that LBO funds' overall fees can be as high as 20 percent of the profit. In a private placement last March, for instance, Silver Lake bought $300 million in five-year convertible notes from the GartnerGroup (NYSE: IT) with a 6 percent coupon. The notes -- which Silver Lake can exchange for common stock or cash -- were priced between $14 and $16 a share. Because the GartnerGroup stock plunged 46.5 percent since the deal was struck, to trade at $10.80 in mid-October, Silver Lake's PIPE turned into a busted convertible.

At this point, unless the GartnerGroup stock rebounds dramatically, Silver Lake will have to make do with a 6 percent annual return on invested capital. Not exactly a home run, but not a strikeout, either.

Good to grow
As technology LBOs grow in volume and diversity, an inevitable question is whether the market will see a deal like the 1989 buyout of RJR Nabisco by Kohlberg Kravis Roberts & Company for $30 billion, still the largest LBO ever.

The answer is maybe, but it'll be a while, if only because valuations of technology blue chips still remain relatively high. But some LBO tech funds are certainly trying.

Last April, Silver Lake, together with Texas Pacific, announced a complex deal to bring hard-disk maker Seagate Technology (NYSE: SEG) back to the private market. Although the total deal involved $20 billion in transactions-most of it stemming from a buyback by software maker Veritas Software (Nasdaq: VRTS) of Veritas stock Seagate held -- the leveraged part of the transaction accounted for some $2 billion.

"My experience tells me that we'll see more and bigger deals going forward," said ON Semiconductor CEO and President Steve Hanson. He should know. Texas Pacific bought ON Semiconductor (Nasdaq: ONNN), an analog semiconductor maker, from Motorola (NYSE: MOT) last year for $1.6 billion and took it back public in April 2000. Even with the market tumult since then, it now has a market capitalization of nearly $2 billion.

Red Herring believes that private equity and leveraged buyouts are viable alternatives to the public markets for many technology companies.

We expect most of the upcoming deals to focus on units of larger corporations, mainly those operating in less-fashionable segments -- such as corners of the semiconductor business (like analog chips and devices), or PC equipment manufacturers. That's barring, of course, a stock market crash of Homeric proportions, in which case the defanged, wolf-turned-sheep LBO executives of the 21st century might revert to their carnivorous instincts.