Are cash-rich UK tech companies set to ratchet up their acquisition strategies in the upcoming year?

Are cash-rich UK tech companies set to ratchet up their acquisition strategies in the upcoming year? Jessica Twentyman investigates.

In otherwise gloomy market conditions, the technology sector has so far given M&A advisers grounds for cautious optimism. A particularly bright spot has been the UK, where in 2008 takeover activity involving homegrown IT companies bucked the trend seen in other countries and industries.

Here, the value of 2008 transactions rose ten per cent on 2007 figures, to reach d17.7 billion (£16 billion), according to recently released figures from consultancy firm PricewaterhouseCoopers. In fact, say PwC’s researchers, UK companies were involved in a third of the world’s technology mergers and acquisitions, as buyers or sellers, during 2008. However, the scales were tipped by a few “mega-deals” in the first quarter and transaction levels slowed dramatically as the year progressed.

With the final quarter of 2008 seeing the lowest level of completions since a historic low in 2002 following the dramatic implosion of the dot-com bubble, market watchers are questioning whether the relative buoyancy of the UK technology M&A market is sustainable in 2009.

“The big question is: has the technology deal environment developed some truly defensive attributes, or will the inevitable impact of the downturn on corporate IT budgets hit home in 2009?” asks Andy Morgan, technology sector leader, corporate finance at PwC. The answer remains to be seen.

Cash rich

In its favour, the IT industry can boast high levels of available cash, relative to other industries. Nearly half of the 20 public companies with the most cash to hand in the US are technology businesses, according to a recent Standard & Poor’s analysis.

Networking company Cisco, for example, trailed only Exxon Mobil and Ford among S&P companies in cash terms, with IBM, Microsoft, Hewlett-Packard and Oracle also featuring among the top 20. That points to a market where cash-rich US tech leaders may look to buy up smaller UK competitors in order to fill technology gaps in their portfolios or simply to expand their geographic footprint. For their targets, acquisition by a larger, richer US company – albeit at a depressed valuation – may seem like a good bet. After all, opportunities to raise new capital are limited, as available venture capital funding has dwindled and the prospects of an IPO have all but dried up. 

Get the Message

US-based security software company Symantec’s October 2008 acquisition
of UK-based email filtering company MessageLabs is a case in point. MessageLabs had been forced to shelve earlier plans for an IPO, while Symantec needed the company in order to get a foothold in the lucrative software-as-a-service (SaaS) arena. “They approached us,” confirms Stephen Chandler, formerly MessageLabs’ chief financial officer and now working as vice president of the SaaS business unit at Symantec.

“It was a difficult time to do a deal – economic conditions were starting to get pretty sticky. But even though the market was getting worse, we knew our investors had firm views on the long-term value of MessageLabs, and we weren’t prepared to enter into an uncomfortable deal because of wider market conditions.”

Although it was an all-cash deal, fluctuating currency exchange rates were a particular challenge, he says, which is why the transaction was conducted on an unusual mixed-currency basis, with Symantec paying £310 million and $154 million (£105 million) for its target. “With exchange rates moving all over the place, our advisors felt it was important to give US shareholders certainty in dollars and our UK shareholders certainty in sterling, according to the make-up of our investors register,” says Chandler.

MessageLabs was advised by Citibank International and JPMorgan Cazenove, and its legal adviser was Heller Ehrman White & McAuliffe, a San Francisco-based firm that was dissolved shortly after the conclusion of the deal and has since filed for Chapter 11 bankruptcy protection.
 
The two founders of MessageLabs, brothers Jos and Ben White, meanwhile, pocketed some £100 million of the proceeds of the sale and are investing £20 million of it in a new venture capital fund, Notion Capital, which will fund fledgling SaaS companies.

Valuations slide

The outlook for UK buyers is less clear, especially given the current weakness of sterling compared with other currencies. Many publicly traded tech companies have seen their market capitalisations cut in half over the past few months and aren’t prepared to sell at a discount, unless they really need to.

Privately held targets, meanwhile, may offer more promise. In a recent survey of corporate development officers in technology companies, conducted by IT market research company the 451 Group, nine out of ten respondents said they expect prices of private companies to drop in 2009, with 45 per cent expecting them to “decline substantially”.

Either way, the January 2009 acquisition of US-based content management company Interwoven by UK-based search specialist Autonomy can be seen not as an example to other would-be UK buyers, but as an anomaly, and in no way representative of the state of the UK technology M&A sector. For a start, Autonomy’s recent high performance – it announced revenues up 47 per cent to $503.2 million for its last fiscal year – meant it was able to finance the deal not only with cash, but also via an offering of new shares and a revolving Barclays credit facility .

Even when the deal is concluded, Autonomy will still have “at least” $75 million in cash, while Interwoven’s last financial reports show a cash balance of some $163 million.  “On the face of it, a transaction including bank debt and a placing should be very difficult in the current environment,” says Autonomy CFO Shushovan Hussain. “But Autonomy has many long-term supporters and, as a result, our main banker, Barclays, was happy to provide $200 million of debt on extremely favourable terms of 225 basis points above US three-month LIBOR rates.”

Signed and sealed

The £222 million placing, he adds, was completed in just over an hour and was five times over-subscribed. In addition, Interwoven’s stock was artificially depressed for much of 2008, due to an options backdating investigation that has since been concluded. So while software stocks are generally down about 40 per cent, Interwoven had stayed mostly flat. For this reason, say market analysts, Interwoven’s shareholders would not have had the option of judging the deal against any other recent offer.

Plus, it was a high-performing company in the hot, rapidly consolidating enterprise content management sector, where most of the competition has already been bought up, arguably justifying the 33 per cent premium on its market capitalisation
that Autonomy was prepared to offer. Regardless of the dynamics of specific deals, it is clear that the IT M&A sector will not be immune to the economic challenges facing all industries worldwide. But deals will still get done, insist analysts at US investment bank Updata, even though they may look a little different from their pre-credit crunch counterparts. “As we expect buyers and sellers to continue to be risk averse, we do not expect M&A in 2009 to be driven by large and risky transactions; rather, we expect continued activity in the sub-$200 million mid-market range,” they predict in a recent research report.

“The development of new technologies, such as cloud computing, virtualisation
and software-as-a-service, coupled with increased spending in selected sectors – government, healthcare, energy, security – will be a source of stability, growth and probable M&A activity. For these reasons, we look forward to 2009 as a year of opportunity for thoughtful and creative combinations.”