Tilman E. Pohlhausen

Technology Buyouts

GABLER EDITION WISSENSCHAFT

Tilman E. Pohlhausen

Technology Buyouts

Valuation, Market Screening Application, Opportunities in Europe

With a Foreword by Prof. Dr. Roswitha Meyer

Deutscher UniversiUits-Verlag

Bibliografische Information Der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet uber <http://dnb.ddb.de> abrufbar

1. Auflage Februar 2003

Aile Rechte vorbehalten © Deutscher Universitats-Verlag GmbH, Wiesbaden, 2003

Lektorat: Brigitte Siegel/Nicole Schweitzer

Der Deutsche Universitiits-Verlag ist ein Unternehmen der Fachverlagsgruppe BertelsmannSpringer. www.duv.de

Das Werk einschlieBlich aller seiner Teile ist urheberrechtlich geschutzt. Jede Verwertung auBerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verla.9s unzuliissig und strafbar. Das gilt insbe­sondere fUr Vervielfaltigungen, Ubersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen.

Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten waren und daher von jedermann benutzt werden durften.

Umschlaggestaltung: Regine Zimmer, Dipl.-Designerin, Frankfurt/Main

Gedruckt auf siiurefreiem und chlorfrei gebleichtem Papier

ISBN-13: 978-3-8244-7758-6 e-ISBN-13:978-3-322-81456-2 001: 10.1007/978-3-322-81456-2

Foreword v

Foreword

The public market valuation of technology companies throughout the 1990s is

probably one of the most interesting phenomena in recent financial history. No

sector has generated more enthusiasm among investors, and no sector has created

more millionaires, albeit mostly on paper. Once the bubble burst, the correction

process was brutal. The price of technology companies dropped by over 70

percent on average, and a significant number of companies went out of business,

while others were simply avoided by the investment community. I

Tilman Pohlhausen asks a valid question: Did this downturn in valuation lead to

some companies being unjustly undervalued, given their past and expected cash

flows? If so, he continues, would such companies be suitable for a concept rarely

heard of previously for technology companies: a buyout, possibly even financed

to a high degree by debt?

The idea is not new. In contrast to Europe, a number of well-financed private

equity funds in the United States exclusively target the technology sector for

buyouts. What is new, however, is that many more technology companies,

because of their lower valuation, could become targets of buyout investors in

Europe, as well.

Ultimately, with his analysis of the buyout attractiveness of European technology

companies, the author attempts to estimate the validity of this perception.

Keeping in mind that the applied model clearly has both practical and theoretical

limitations, its findings appear to support the view that buyout opportunities in

the technology sector might now exist in Europe. As part of his analysis, the

author also provides a Microsoft Excel-based tool to screen markets for

companies with certain buyout attractiveness characteristics.

The NASDAQ composite drop from its all-time high in March 2002 to July 2002 was over 70 percent, while its much smaller German equivalent, NEMAX, lost over 90 percent during the same period.

VI Foreword

It is too early to tell whether we can confidently speak of technology buyouts as

an established concept. What we can say. however. is that technology companies

are increasingly valued in the same manner as companies in any other sector.

Today we know that the same rules apply; why. then. should there be no buyouts

in technology?

Prof. Dr. Roswitha Meyer

Chair of Decision Sciences

European Business School, Schloss Reichartshausen

Acknowledgments VII

Acknowledgments

The following text is entirely based on a master's thesis I wrote in early 2002

while studying at the European Business School, Schloss Reichartshausen,

Germany. It was created in a short period of time, and being the first significant

textual work of a student it is of course far from perfect. I nevertheless decided to

make the thesis available by publishing it, mainly for two reasons: First, when I

started exploring the field of technology buyouts, I was stunned by the lack of

available public information, be it in form of academic, press, or professional

publications. 1, personally, would have liked to read any even imperfect thesis

about "technology buyouts". The second reason is the encouragement I received

during various conversations with banking and private equity professionals.

There seems indeed to be an actual interest in this topic - particularly for the

European market where technology buyouts have not been given as much

attention as they have in the US.

Given the encouragement and support I received, I would like to express my

gratitude to those involved with my thesis at various stages. I would not have

been able to write about "Technology Buyouts" had not Professor Roswitha

Meyer of the European Business School accepted my proposal. I would like to

thank her for her support throughout the writing process; I would also like to

thank her research assistants Heiko Rhode and Andre Kleinfeld who gave their

time and effort when I "tormented" them.

The thesis was written with the support of Dresdner Kleinwort Capital, the

private equity group of Dresdner Bank. Thomas Wiegand provided me with

crucial guidance and feedback for which I am truly thankful. His understanding

of technology markets and equity as well as debt financing was of great value to

my conceptual efforts. Additionally, the Technology Group at Dresdner

Kleinwort Wasserstein provided me with essential access to their resources. I

would like to thank Cornelius Clotten, Rainald Roth, and the whole team for their

kind support.

VIII Acknowledgments

Furthennore, I thank research assistants Hady Farag and Mischa Ritter of the

Chair of Investment and Risk Management at the European Business School for

their help at some stages, as well as Konstantinos Karamanlis for his diligent text

review. Finally, I would like to express my gratitude to Professor Omesh Kini of

Georgia State University, who generously provided me with his feedback and

advice on some key points of the text.

appreciate comments and feedback. My email address IS

t.e.pohlhausen@usa.net.

Tilman E. Pohlhausen

Table a/Contents IX

Table of Contents

List of Figures ..•.•..•••••....••••••••..•••••...•••••••••••...•••.•••••••••••••.....••••••..••....•••••............ XI

List of Tables ..••••••••.••••.•...••••••••....•.•...•••••.•...•..••••..........•••.••...•..•.•..••••..•....•..••• XIII

List of Abbreviations .•.••.•..........•.••.........••.••.....•••••••....•...•.....••••....••••.••••.••.•.•••• XV

1 Introduction ••••••.......•••....••......••••...•....••••••••.....••••••..•.•.••.•...••••....••••..••........•.. 1

1.1 Theoretical Fonnulation .......................................................................... 3

1.2 Method and Procedures ........................................................................... 4

2 The Market for Leveraged and Management Buyouts ......••••.•••••...•••••••••• 5

2.1 Definitions ............................................................................................... 5

2.2 History ..................................................................................................... 7

2.2 Value Generation ..................................................................................... 9

3 The Emergence of Technology Buyouts ................................................... 15

3.1 Definition ofa Technology Company ................................................... 15

3.1 Investment Rationale ............................................................................. 17

3.2 Technology Buyout Investors ............................................................... 20

3.2 Current Trends ....................................................................................... 23

3.3 Findings and Interpretations .................................................................. 26

4 Overview of Leveraged Buyout Valuation ............................................... 29

4.1 Weighted Average Cost of Capital Method .......................................... 30

4.2 Adjusted Present Value Method ............................................................ 31

4.3 Changing Costs of Capital Method ....................................................... 32

4.4 Equity Cash Flow Method and Internal Rate of Return ........................ 33

5 Simplified Valuation Model •............................•.•.•...................••••.............. 39

5.1 Inputs ..................................................................................................... 41

5.2 Leverage ................................................................................................ 45

5.3 Projections ............................................................................................. 49

5.4 Valuation ............................................................................................... 52

5.5 Special Cases ......................................................................................... 57

5.6 Model Limitations ................................................................................. 61

x Table of Contents

6 Adjusting for Technology Risk and Return ............................................. 63

6.1 Technology Risk ................................................................................... 64

6.1.1 Increase Hurdle Rate ...................................................................... 65

6.1.2 Lower Cash Flow Projections ........................................................ 66

6.1.3 Increase Cost of Debt ..................................................................... 67

6.1.4 Plan for Investments ...................................................................... 68

6.2 Technology Return ................................................................................ 69

6.2.1 Increase Growth Rate ..................................................................... 69

6.2.2 Add Real Options ........................................................................... 70

6.3 Implications ........................................................................................... 72

7 European Technology Market Screening ................................................. 75

7.1 Model Extension ................................................................................... 75

7.2 Model Application ................................................................................. 80

7.1 Top European Technology Buyout Candidates .................................... 84

7.2 Findings and Interpretation ................................................................... 86

7.3 Suggestions for Further Research ......................................................... 88

8 Summary and Conclusion .......................................................................... 89

References ........................................................................................................... 91

List of Appendixes ............................................................................................ 101

Appendix A: Field Description Sheet ............................................................ 103

Appendix B: Excel Instructions ..................................................................... 107

List of Figures XI

List of Figures

Figure 1: Increase in LBO equity contribution ...................................................... 8

Figure 2: Estimated sources of value in buyouts ................................................. 13

Figure 3: Development of public technology stock markets ............................... 23

Figure 4: European technology buyouts by value ................................................ 26

Figure 5: Common business valuation techniques ............................................... 29

Figure 6: Equity cash flows in a typical buyout .................................................. 34

Figure 7: Model overview .................................................................................... 40

Figure 8: Inputs & assumptions (data from Software AG) .................................. 42

Figure 9: Projections (data from Software AG) ................................................... 50

Figure 10: Valuation (data from Software AG) ................................................... 53

Figure 11: Extended model overview .................................................................. 79

Figure 12: Parameter weightings ......................................................................... 82

List of Tables XIII

List of Tables

Table 1: Rates of past LBO returns ...................................................................... 10

Table 2: Technology diverstures and public-to-private

transactions 1998-2002 ........................................................................................ 21

Table 3: Fundraising activity ............................................................................... 21

Table 4: Model assumptions ................................................................................ 44

Table 5: Synthetic rating estimation .................................................................... 47

Table 6: Additional attractiveness parameters ..................................................... 77

Table 7: Applied weights and scales .................................................................... 81

Table 8: Analyzed indices .................................................................................... 82

Table 9: Highest negative EV technology companies ......................................... 83

Table 10: Highest negative EV communications companies .............................. 84

Table 11: Top 20 European tech buyout opporunities given model assumptions

and Bloomberg historical data ............................................................................. 85

List of Abbreviations xv

List of Abbreviations

a

AG

AIM

API

APV

BIMBO

CapEx

CAPM

CF

CFBDR

CHF

CMBOR

CSFB

CY

D

DCF

E

e

ed.

Ed.

EASDAQ

EBIT

EBITDA

EBO

ESOP

EUR

EV

FTSE

GBP

HLT

actual

Aktiengesellschaft

Alternative Investment Market

Application Programming Interface

Adjusted Present Value

Buy-in Management Buyout

Capital Expenditures

Capital Asset Pricing Model

Cash Flow

Cash Flow Before Debt Repayment

Swiss Francs

Center for Management Buy-out Research

Credit Suisse First Boston

Calendar Year

Debt

Discounted Cash Flow

Equity

estimated

edition

Editor

European Association of Security Dealers Automated

Quotations

Earnings before Interest and Tax

Earnings before Interest. Tax. Depreciation and Amortization

Employee Buyout

Employee Share Ownership Plan

Euro

Enterprise Value

Financial Times and London Stock Exchange

British Pound

Highly Leveraged Transactions

XVI

IIBIEIS lAS

IPO

IRR KKR

LBO

LMBO

m

M&A

MBI MBO

MC

MDAX

MS

n.a.

NASDAQ

NEMAX

P2P

PE

PEG

PLC

R&D

S&P

SMAX

SWX US-GAAP

vol.

vs

w/oa.

w/o pg.

w/o pI.

Institutional Brokers Estimate System

International Accounting Standards

Initial Public Offering

Internal Rate of Return

Kohlberg Kravis Roberts & Co.

Leveraged Buyout

Leveraged Management Buyout

million

Mergers and Acquisitions

Management Buy-in

Management Buyout

Market Capitalization

Midcap Deutscher Aktien Index

Microsoft

not available

List of Abbreviations

National Association of Security Dealers Automated

Quotations

Neuer Markt Index

Public-to-private

Price Earnings

Price Earnings to Growth

Public Limited Company

Research and Development

Standards and Poor's

Smallcap Aktien Index

Swiss Exchange

United States Generally Accepted Accounting Principles

volume

versus

without author

without page

without place