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TechWeek: Pop Goes the Equity Bubble

Bill Snyder

The mortgage bubble is bad enough. The specter of thousands of homeowners and their lenders going belly-up after an orgy of subprime lending has Wall Streeters reaching for the Xanax.

Even worse, though, could be a private-equity bubble, warns Eric Gebaide, managing director of Innovation Advisers, a technology-oriented investment bank.

Mortgage brokering and investment banking are very different businesses, of course, but there is a scary parallel. The downfall of many homeowners has been the ability to borrow large amounts of money for very little cash down, with the expectation that rising equity will make the transaction work. But when interest rates rise and selling prices fall, the math gets ugly.

Similarly, some private-equity firms have engaged in their own version of that high-wire act, says Gebaide. Leverage by the purchaser of four or five times EBITA is reasonable. But when that ratio climbs as high or seven or eight times, it gets risky, because the debt has to be serviced while the owners are trying to increase the value of the company.

That may work in good times, but a string of bad quarters, whether caused by an economic hiccup or a company-specific issue, can erase the equity the firm has built up.

"Debt is a fixed cost, and that's a lesson that should have been learned some time ago," Gebaide said in an interview. "But it seems to have been forgotten."

That's a real worry in the technology sector, where about 35% of the $295.8 billion in M&A transactions were financed with private equity, according to Capital IQ, a division of Standard & Poor's. A year earlier, the total value of M&A transactions in technology was just $146.6 billion.

That reminds me of a conversation I had in December of 2005 with Bill Teuber, then-CFO of storage giant EMC(EMC Quote). "What keeps you up at night?" I asked him.

His answer: "There's approximately $125 billion [in private equity] sitting on the sidelines. Historically they've stayed out of tech because they couldn't leverage the balance sheet enough." But that's likely to change, he added.

Exactly right. Private-equity money going into tech M&A is generally much lower than it was in 2006; over the years, the average probably ranges from 15% to 29%, says Gebaide.

Teuber worried that private capital would drive up the cost of acquisitions and slow down the pace of bargaining because there are more players at the table -- and that is what's happening. And that's not great news for shareholders of companies such as EMC or Oracle(ORCL Quote), companies that have pegged much of their growth to aggressive M&A strategies.

There's also a relationship between rising equity dollars and increasing M&A activity: Formerly public firms are more likely to make acquisitions once they are freed from the tyranny of quarterly earnings reports. Frontrange, to cite just one example, was taken private two years ago by Francisco Partners.

Now the software company is back on the M&A stage, but as an acquirer. It recently purchased Germany-based Enteo to broaden its technology portfolio and get a foothold in the European market.

Who's Next?

If you don't have a multimillion-dollar bank account, profiting from the tech M&A boom isn't easy. But it's not impossible. Step one: Get a sense of what companies can and should makes acquisitions -- and why.

Brenon Daly, a financial analyst with The 451 Group, a technology research firm, says Hewlett-Packard(HPQ Quote), for example, hasn't done much in the enterprise content-management space and has lost opportunities to EMC, which snapped up Documentum a few years ago.

There's been speculation that a buy of Open Text(OTEX Quote) could be on CEO Mark Hurd's agenda, but Daly doesn't believe that will happen.

The smaller company has $400 million in debt, and late last year it acquired Hummingbird. Buying a company that probably has not finished digesting an acquisition could make the task of integrating it with H-P's much larger operations more trouble than its worth, says Daly.

A better bet might be Vignette(VIGN Quote), a long-established player in content management. A point in favor: Tom Hogan, who runs H-P's growing software unit, is a former Vignette CEO.

Security is another area that H-P will likely move on, particularly in response to IBM's(IBM Quote) 2006 acquisition of ISS and EMC's takeout of RSA.

Many of the remaining players are privately held, but McAfee(MFE Quote), wounded by the options scandal, would offer H-P expertise in both consumer and enterprise security. Bundling its own security software with its line of notebooks and desktops would be a natural play, says Daly.

One deal you probably won't see: an Oracle purchase of BEA Systems(BEAS Quote). Although Oracle CEO Larry Ellison used to talk about buying the middleware vendor, that talk has faded.

Ellison bragged that middleware sales soared by 82% during the just-reported third quarter; BEA grew new license revenue by an anemic 8% in its recent fourth quarter.

Although he didn't offer hard-dollar figures to prove it, Ellison said his company now books more middleware revenue than BEA -- and remember, middleware is pretty much all that the San Jose, Calif., company sells.

With numbers like that, why should Larry open his checkbook again?