January 26, 2021
In this second video of the series, Ruby Sheera speaks to James Chapman-Andrews from Alantra for his thoughts on the tech market today and going forwards, as well as the impact the last 12 months have had.
I’m here today with James Chapman-Andrews. James leads the UK tech team at Alantra, and recently has been involved in a couple of deals that you may have seen headlined in the papers. He helped Graphite buy Babble from LDC, was involved in ECS and GlobalLogic, he helped sell that to GlobalLogic.
He’s here to talk to us about the market today, in 2021 going forwards, and his thoughts of what’s happened from last year – the year that everybody I think, wants to forget, but do we really?
I’d like to start off with asking a very open question as to what do you see being the outlook for the tech market going forwards in 2021? And what impact do you think the last 12 months has had on it?
Interesting. Well, first of all, thanks very much for having me Ruby, and great to be talking to you. I think overall, the outlook for the UK technology market is incredibly positive. It has actually become, dare I say, more positive through the course of the pandemic, or post the pandemic hitting. There was the immediate shock, where everything pretty much ground to a halt and went on hold for a while over the course of late spring and into the summer.
Then, very quickly, as people particularly private equity investors, have shored up balance sheets etc, in their portfolio companies, minds turn back to the day job, which is clearly deploying capital. Virtually whatever the market, and obviously in technology, most businesses in the space, certainly within software, ICT services, and all of the areas into IoT etc, are incredibly resilient. The market is moving towards those companies rather than away from them, so the outlook remains the same, if not more positive.
Clearly that answers the last 12 months question which it’s flight to resilience, in doing that, then there’s been even a valuation uplift in the technology sector. It’s the same number of assets that there are there, but then there’s more particularly private equity firms and trade buyers looking to buy them. So that’s pushing prices up by the simple supply and demand factor.
In terms of the outlook, very positive. There is a current real driver of CGT, potential capital gains tax changes in the market that you get various different views, but there’s a 50/50, between a no change to an 8% rise in capital gains tax, but a lot of particularly smaller companies, so sub 100 million founder entrepreneurs are just very focused on that potential change.
Once that’s washed through, the fundamental market dynamics remain the same from my perspective. As I outlined, that’s demand for resilience, growth, and cash generation remains there, and is very strong from both trade and private equity buyers.
So, based on your comments there, would it be fair to say that there’s been a positive impact on tech valuations?
I think that’s right. As I say, the supply versus demand dynamic and driven by that flight to resilience, has definitely increased the value of technology assets in ICT or in comms services assets, which are a small part of the overall technology market. But valuations on an EBITDA basis have gone up between 1x and 2x, searching for high contracted recurring revenues, from a generally large base of customers that’s relatively stable, that generate a significant amount of cash. That is the resilience of the business model there, even though growth often is not that high, all the way through to businesses that are at the forefront of the technology that they’re selling. Therefore, seeing very rapid growth as a result, and the pandemic doesn’t affect those, if anything it actually drives more volume to them more quickly. And therefore, that it’s such a short-term economic shock is actually irrelevant in the scheme of the long-term macro dynamics that those businesses are addressing.
If you look at public company valuations, both software and most areas of comms and networking and IT services has returned and are now ahead of pre-February levels in reality. Part of that is driven by the overall macro dynamic that their interest rates remain so incredibly low that there’s a huge amount of cash that is looking for a return.
I think the one challenge, to give you a balanced response, is that clearly there is some concern around particularly smaller SME focused businesses. Not an allergy to them, because there’s still a lot of interest in them, but just a question around in the UK, where they’re very SME focused. Given the amount of government funding support that is going to SMEs through the furlough scheme, or all companies through the furlough scheme, then when that comes to an end, does it create a bit of a cliff edge? If you like, for the SME, they call it the SME death rate rather morbidly, but the SME death rates start going up, and then you start seeing churn in these bigger customer bases of smaller SME customers.
Thank you. What about micro-climates? You mentioned a couple of those in that first answer, but things like Brexit, the COVID rollout. What impact if any, do you think these will have going forward on our market?
Someone said to me recently, that in the context of COVID, in the pandemic and the effects of that, then Brexit is largely irrelevant. What they meant by that is the effect of Brexit was forecast to be 3% in the first year or two, low single digit percent impact on output for the UK. Whereas COVID has been high teens to even 20% impact. Now, clearly, some of that will bounce back, but the question is, to what level. Actually, in that context, I think that the commentator was right in saying COVID is by far the greater impact that we need to look at and assess.
I think in terms of the micro-climate, I alluded in that first answer to private equity and the funding still being there. Some private equity funds have said, and they’ve done their numbers in looking at the mid-market in the UK and the amount of dry powder in private equity funds in the UK, where I’ve had estimates between four times, and six or seven times the amount of dry powder that was available immediately post the global financial crisis in 08/09.
That gives you a sense of the scale of capital that is out there now, looking and chasing assets, in what could be a downturn question over what period of time. That is a micro-climate, or it’s really a macro-climate now, in the amount of capital that is searching for a return because of the lack of return that there is in interest rates.
I think that those are the main ones to me. Then in terms of technology, so macro ones, specifically in terms of technology, the demand for a resilient quality of earnings is certainly paramount and investor focus has increased on that quite materially.
Underpinning, beyond that in the technology market, there are the usual macro drivers, but it’s the shift to cloud, the need for cybersecurity, the increasing use of automation, AI. Micro-climates from a macro-economic dynamics perspective are also macro drivers within the technology industry. Those are the key bits that will continue driving M&A activity, in the short to medium term.
How supportive are the debt and public equity markets of M&A activity?
I think the debt market is very much so. I’ll come back to that, but I think in public equity, that the real challenge that public equities have, and I’ll talk more for the AIM market than the main markets, although the point is the same across both of them.
The real challenge that they have had with the rise of private equity in the last 10 to 20 years, is that public equity investors are still allergic to leverage, to debt. The real challenge that you have when you’re looking at floating businesses, as we sometimes do, and IPO activities has returned materially from where it was two/three years ago, is the amount of leverage that those investors are willing to bear is in the region of 2 to 3x their EBITDA, at the point at which you float the business; versus private equity, that now are very comfortable at say 5 to 6x. This gives you an idea that’s the leveraging effect that you can get on the equity that you invest. Therefore it actually often makes public equity just a less attractive route for all investors, including the management teams than going with private equity. That’s how private equity has sort of come to the fore, so much of which makes up a significant part of the M&A market today.
The IPO market activity is increasing at the moment and asset prices continue rising in public tech assets. I think that that balance needs to be re-found. I think part of it is the same as with the public markets; investors being able to or being willing to accept a bit more leverage than they have done historically.
In terms of debt, the hitting of the pandemic definitely saw some nervousness from the senior banks or the High Street banks in the UK, and there’s probably still relatively little new lending activity from the senior banks; they’re still focused on their existing asset. But clearly, because they have bigger holes in multiple sectors, they’re facing challenges within some of those sectors that are seeing significant headwinds, given the pandemic.
Then debt funds have made up, because it hasn’t actually been a slowdown in activity, because there hasn’t been the availability of debt. I think the market is just being made up by the debt funds, which was already happening anyway.
We’re now finding out the answer to whether debt funds really are a loan to own it, or they’re just putting in this bigger and bigger leverage. So they will eventually over leverage and then they own it. That’s been the sort of bearish view of debt bonds, but this has proven out that that isn’t the case. Clearly, some of those businesses they’ve lent high leverage will face challenges, and then the debt funds will own them.
They’ve been hugely supportive and much more so than some people seem to expect of businesses that just need to shore up as balance sheet move very quickly. This is where the debt funds have played and managed to make the market that they have made for themselves today, versus the senior banks in being that sort of flexible, and yet understanding of specific business issues that businesses face in these extraordinary times.
Very interesting. Another question, just following up from that is, in your view, what are the key objectives of corporate buyers and private equity when they’re making acquisitions?
Well, private equity is the easier one in a way, to give a glib answer. Clearly, that is an amount of equity that is looking for return. All of private equity’s behaviour ultimately is driven by that goal. That sort of suggests that private equity don’t add value, which I think they materially do. Clearly beyond though, that is the core aim, because it is always the core aim, however you dress it up.
Beyond that core aim, the intent ultimately, is to invest in specific macro dynamics, like the ones that I talked about earlier. There is a growth path, so investing in businesses in certain spaces, unless you really get it wrong, or you don’t back the right management team, then the chances are that you’re going to see significant growth and therefore return on that value.
Then the next piece is, as long as they can add value along the way, then that’s why all the guys in private equity do their jobs; because it’s fun, you can help teams to create material value. I think that’s why most PE guys are in the game.
In terms of corporates, clearly it’s different. There is a hybrid there, which we won’t go into too much, but there’s the rise of private equity-backed corporates because of the rise of PE. And then many, many corporates that you’re talking to in sale processes that we run now have private equity backing anyway.
So is that private equity or is it corporate? Fundamentally corporates are looking to either materially change and diversify their business model, which is because there’s a new opportunity and there’s growth; and/or because their existing model needs to fundamentally change or they will die.
There’s the need to add on additional technology capability, geographical region, presence, all sorts of different pillars of the operational structure. Clearly there is, but people always think it’s the first sort of third or fourth, but there is the synergy benefit you get from M&A, where you don’t need all of the costs. The ‘1+1 = 3’ type argument which is the key element. You need to show that a deal has worked, and that it’s getting cost synergies, but also revenue synergies from cross-selling to both customer bases, etc. I’d say those are some of the key things that corporates are looking for.
One of the questions that I’ve been pondering and maybe you have perspective, is if technology is a strategic enabler in value creation, then why aren’t we seeing more tech businesses acquire larger non-tech businesses and drive value creation through that route?
I guess that’s ‘why don’t more businesses vertically integrate’ is how I call that. I think that you do see it more. There’s a reason that SaaS is called SaaS or software as a service; it was always the software guys doing the software, and then the product, and then someone else is providing the service wrap around it. So there has been some merging of software and services.
I think that buying a much bigger services business and pushing your tech through it, I think the natural counterweight to that being the norm, is that services business normally is selling lots of other different software products for lots of other vendors. Therefore you’re going to get a conflict in your channel.
From the vendor’s perspective, if you just buy into your distribution channel, then you’ve been selling into other distributors as well. Suddenly, you’re actually competing with them. I think that there’s a natural friction there, but that doesn’t mean it doesn’t happen.
Interestingly, certainly in the voice communication space, as voice technology has moved to hosted, like many technologies, from being on-premise, or even legacy type technology. Actually those providers have been able to have a much more blended delivery model where they can compete quite a bit with their channel before the channel actually starts thinking ‘All right, I’m not going to going to use you.’
I think over time, and certainly over the course of my career, you’ve seen that increased materially, versus where it was when I started. I don’t think you’ll ever see small tech vendors buying big service provider partners, but you will see them start to compete potentially with some of their channels.
In your experience, how does the transaction affect senior executive teams? Is the impact between a deal involving trade different from the one involving private equity?
I think naturally, given the answer that I gave before, then you get much more of a mixture with trade is how I characterise it. So if you think about PE, it is always or almost always looking to back the existing management team. Now, clearly, some of the team may change, they may bring new people in…
Can I just interrupt you on that point? That’s a really good answer, and the stock answer I get in the UK. Do you think that varies if it’s a non-UK fund – the backing of the management team?
What do you mean, so if the non-UK fund then is more likely to bring in their own management team?
So US funds, if I’m being candid, tend to be a little more upfront about the fact that they’re looking at the asset, and it’s the asset they want to grow and develop. That they were not necessarily backing the management team.
I personally haven’t seen that so much, but then I’m not a barometer for that point necessarily. I think that certainly US PE investors are much more okay with playing around with management teams, although UK firms are increasingly getting there, but obviously it’s not a strategic intent. And as you say, maybe US funds are just much more open about it and just say ‘Right, we want to bring in our team, because we’ve already got a team that have done this three times before.’ I think I can understand that logic.
I think that there is always more risk, certainly people like me and possibly you, in the interest of what you do, but I think there’s actually more operational risk in changing a management team then you would know. Unless you’ve actually been in and operated it, or been the PE investor and doing it, because it’s hard yards, and it takes a long time. If you get the decision wrong, it takes a really long time, because you have to go through two cycles of a year and a half to work out that it hasn’t worked. I think that I can understand that as part of a US dynamic.
In terms of going back to the trade versus PE, I think in general the PE fund will typically try and back the existing management team, or at least enough of it that they’re not going to break the business by just changing it, unless that’s what they want to do. You then have to look at trade and that’s much more nuanced.
I’ve seen trade deals where, ECS that I did recently, is a good example. GlobalLogic who bought it, have no presence really in the UK, and they will have the entire management team, other than the Chairman who’s Non-Exec anyway, running that business and that is the aim. Over time, that will probably change, and some will come over from GlobalLogic, etc. But that’s much more accretive, aiming to really buy the entire asset and management team and get it to grow with the support of a bigger corporate. But all the way through to most smaller bolt-ons that the comms and networking platforms do, like Southern Comms or Focus and Wavenet, etc. will aim to get rid of the vast majority of the management team but they won’t always say that.
The one thing I would say, because of synergies, clearly that’s the biggest cost at the top of the P&L, the top of the cost base that they can get rid of and yet still run the business to the way that it should be run, and here you get huge accretion, obviously to profit for that.
The one nuance to that, and that’s in the middle, is any corporate that is looking at M&A should, and almost always they are, be thinking about: ‘How am I going to get the best team out of both sides of this deal. I’ve got my own team, and then I’ve got that business that I’m buying.’
Of course, it’s a great opportunity for corporates to just refresh the entire team, take the best of two teams, which are always going to end up better than either one of them. That’s really where corporates should be able to realise a huge amount of value; it’s self-selecting and doing the M&A, and you’re actually going to end up with the best team.
Thank you. My final question, looking forward at the market in 2022 and 2023, what do you see as being the big trends in tech?
I touched on them a bit earlier that once the pandemic has washed through, but even the pandemic is kind of irrelevant in the context of these tech mega trends that are going to take place. No matter what, it’s not ‘a two-year downturn, and then we’re back to where we were’ type thing. Companies that are buying technology, whatever the company is, taking a 5/10/20 year view of their technology needs and what/how they can use technology to drive their business and create value.
The underpinning themes are: the shift to public cloud (anything from infrastructure to voice to Teams, like we’re talking on today), all of these are cloud based services when historically they’ve been on-premise based services; the increasing complexity of IT ecosystem, all of our IT has only got more complicated over time, rather than less, we use more complex applications that are more data heavy, etc. That’s the sort of underpinning theme, and there is the digital transformation of the workplace, like how do we better interact with the information and content that we’re all producing, and everything to use it for all/and information gathering on our clients, customers, etc., and their customers. How do you use that for business intelligence, and then to create value?
Cybersecurity risk, in the context of all of that and everything being online, only goes up. Then I guess the last piece is the explosion of ‘big data’ – it was a buzzword three, four years ago, but I think it’s finally starting to come to pass. It’s the proper use of automation technology in data and analysis, all the way through to how do you automate the communication with the customer, AI, chatbots, etc. These were things that were wanted for a long time, but now, I think that the technologies are starting to become much more mainstream. I think those are the key ones.
Those themes will run for way beyond 22/23. They are fundamentally driving the transformation of all of our lives and the tech industry is at the heart of that.
Thank you very much for the investment of your time and talking to me and providing a bit of a view of how we see the market going forward, and it sounds like it’s in a positive hue, so thank you.
No, not at all. Thank you very much for having me.
Tech & Tech Enabled Practice