Spending on technology acquisitions moved at a record pace in 2018. Technology giants including Microsoft, SAP and Salesforce announced billion-dollar deals after not completing any in 2017. Private equity firms spent more money on technology sector acquisitions than ever before. These strategic and financial acquirers focused on the top of the M&A market, completing a record 108 deals of more than $1 billion in value. The stage was set for 2018 to be a historic year in technology acquisitions.

Winter threw a wrench into the celebration. An equity market selloff during Q4 2018 wiped out annual U.S. stock index gains. Global market exchanges were damaged. Corporate earnings normalized, with 2018’s 20 percent growth rate expected to be halved in 2019. Credit became harder to obtain as the Federal Reserve hiked rates for the fourth time.

Mounting corporate concerns led deals to slow down in Q4, leaving 2018 one large deal short of a historic year for technology acquisitions. Though some of the underlying instability that led to Q4’s disappointment persists, 2018’s transaction momentum will carry over due to the strengthened emergence of two key themes.

The technology sector’s movement from a vertical to horizontal market has caused companies from every sector to become involved with M&A. Private equity firms sitting on record levels of dry powder-money firms have not yet invested-have closed technology deals at an unprecedented rate. While macroeconomic concerns are prominent, the technology M&A cycle will persist in 2019 with the continued entry and development of private equity firms and diverse strategic acquirers. Macroeconomic conditions pose a threat to growth but will ultimately fail to drastically slow deal flow.

Technology sector acquisitions by non-technology companies are a strong driver of continued M&A performance in 2019. Software companies have remained disruptors of all sectors from transportation to fintech. Traditional businesses fighting off disruption find developing technology in-house costly and risky as dynamic startups often move faster. For these non-technical companies, purchasing other firms proves a much better process. These transactions are ubiquitous; from Walmart’s purchase of Jet.com to General Motor’s nine percent stake in Lyft. These examples from 2016 demonstrate that technology companies have been pressuring other sectors for years. The pace of disruption, however, is growing into 2019.

The boards and management teams of companies outside the technology sector have well understood the destruction of established corporations at the hands of technological disruption. These company leaders have reacted aggressively to the trend of mass displacement by the likes of Amazon in an effort to survive. Due to the painstaking nature of developing technology in-house, industry leaders maintain their stronghold through the acquisition of the technology companies that threaten their market share. This driver will persist as more firms create advanced underlying technology that provides clients with seamless adoption and a clear return on investment (ROI). Before the prevalence of cloud-based software, enterprise software was incredibly costly to adopt, providing industry stalwarts with a layer of protection against technology. Today, the velocity of software adoption is unprecedented, threatening to crush non-technical companies that fail to move quickly.

Beyond the need for survival, strategic acquirers are becoming more comfortable with the threat and pervasiveness of their technical competitors. As consumers across all sectors become accustomed to technology, traditional firms become more confident in adopting new innovations. Technology has created new business models that lead to quicker product adoption, shorter time to market and faster product iterations. With the prevalence of technology M&A, traditional companies have grown more comfortable with forward-looking valuations centered around growth. As technology continues to move from a vertical to a horizontal, firms will grow at faster rates and increasingly threaten disruption of traditional companies: strategic acquisition outside of the technology sector will persist as a driver of technology M&A activity into 2019.

Increased private equity involvement in technology accelerated the M&A cycle in 2018 and will continue to drive growth in 2019. According to the Financial Times, 75 percent of the most active buyers of $100M+ technology companies were private equity firms in 2018. Firms like Silver Lake, Francisco Partners and Vista Equity dominate the technology M&A space—not Google, Netflix or Microsoft. According to KnowledgeBase, private equity firms participated in over 2,700 technology transactions from 2016 to 2018, solidifying their role as market makers in the technology M&A space. In 2017, financial acquirers had a historic year, out-buying strategic acquirers. This trend continued into 2018, with KnowledgeBase reporting 1126 tech deals by private equity firms compared with 846 by U.S. strategic acquirers.

One key explanation for the dominance of private equity across all M&A sectors is the record-levels of dry powder that they are sitting on. Pitchbook estimates dry powder totals over $1 trillion among private equity firms, with smaller growth equity funds sitting on over $500 billion.

Alongside a massive amount of available capital, the rapid movement of financial acquirers into technology is driven by an ideological shift. Private equity firms have thrown out their traditional playbook for technology, increasingly purchasing companies that are not generating any cash flows and even burning cash. Private equity firms began entering technology near 2005 when they viewed technological investments as they did all others—regardless of the industry, they targeted large companies that generated high cashflows but were experiencing limited growth. Cashflows of an acquisition target are critical in private equity because they support the leverage used to fund the acquisition. This model has since been dramatically updated. The valuation environment has become incredibly rich, with many in the industry proclaiming “20x EBITDA is the new 10x EBITDA”. The new attitude of financial acquirers dramatically expanded the companies these firms could target, leading to larger and more frequent buyouts.

The ideological shift of private equity firms extends to strategy. Some of the largest private equity funds are playing a larger strategic role within their acquisition targets, expanding upon their traditional strategies of buying and building companies. Generalist funds, too, are staking their claim to technology companies. As technology firms become more horizontal, generalist financial acquirers understand more product ecosystems. This allows them to become more competitive, develop a hypothesis and hire operating partners to add experience.

The themes of rich valuations by growth-centric companies were present in late 2018 when Vista Equity took both MINDBODY and Apptio private—the firm paid over 8x trailing sales for both software companies, both of which were incredibly growth-centric and burning through capital.

While the entrance of traditional non-technology companies and private equity firms into the technology M&A space spurs optimism for the industry’s continued expansion in 2019, a volatile macroeconomic environment has the potential to both improve and harm the cycle. An EY survey of TMT M&A participants found that shifting geopolitical and regulatory landscapes were the leading cause of deal failure in 2018. The survey found that the volatile macroeconomy is forcing executives to be disciplined—96 percent of executives reported walking away from a deal in 2018 as opposed to 76 percent in 2017. Macroeconomic concerns including volatile global equity markets, reversals of capital flows to emerging market economies, historically rich M&A valuations and increasing protectionism against cross-border M&A deals all threaten the persistence of the technology M&A cycle in 2019. In Deloitte’s 2019 M&A Report, technology executives cited an increased desire to acquire for the purpose of talent acquisition, likely a result of a tight labor market and historically low unemployment.

Macroeconomic concerns may also benefit technology transactions in 2019. Tax legislation and a looser domestic regulatory environment helped M&A in 2018—corporate tax rates were slashed from roughly 35 percent to 20 percent, and penalties in bringing overseas profits home were largely eliminated. This looser regulatory environment spurred deals in 2018 and will continue to boost corporate confidence in 2019. While the Federal Reserve hiked rates four times in 2018, the cost of borrowing is still historically low. Cheap financing and a relatively strong equity market will contribute to increased deal flow in 2019.

Alongside macroeconomic uncertainties, the theme of private equity dominance that will continue to drive technology acquisition in 2019 could have major implications for investors, entrepreneurs and analysts. The IPO market is likely to be affected as technology companies choose private ownership over public scrutiny. Unicorns, including Uber and Lyft, waited for incredibly high valuations before even posturing to go public. Further, Qualtrics and Appdynamics opted to sell in 2018 over pursuing rumored public offerings.

While private equity firms are increasingly accepting of acquisition targets burning cash, they still push for companies to reach profitability sooner. As these financial acquirers further entrench themselves in the technology space, entrepreneurs may focus on positioning themselves for private equity investment. Pragmatic innovation, combining a balance of growth and profitability, may become a dominant strategy among technology companies seeking an exit. The themes of private equity and non-technology firm dominance in the technology M&A space are here to stay. Only time will tell whether the technology industry will slow from a shift to pragmatic innovation or grow through private equity’s ability to pursue long-term, operationally intensive strategies and avoid the public market’s fixation on short-term results.

 

Paul Volcker, former Chairman of the Federal Reserve System, previously wrote that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports and even the level of economic activity.” Given Volcker’s analysis, the US may have cause for concern.

Forces such as rising yields on international currencies such as the Yen and the Euro and corresponding global macroeconomic growth drove investors away from the dollar in 2017. The U.S. Dollar Index, a measure of the dollar’s relative strength against the values of the currencies of several of our major trading partners, fell almost 12 percent over the last year. Considering the US dollar is the world’s most traded currency and accounts for almost 64 percent of all foreign currency reserves, a 12 percent decline is enormous.

Yet, all of this seems a bit counterintuitive. Ostensibly, there was nothing wrong with the United States economy in 2017. The recent passage of the Tax Cuts and Jobs Act, corporate earnings growth and low unemployment numbers helped the S&P 500 to a robust 24 percent gain since the time of President Trump’s inauguration last January. This represents the best annualized domestic growth realized since markets rebounded from the Great Recession in 2009. Even so, the dollar lost ground to superior growth abroad.

A number of factors, including the trade benefits from the weaker dollar and a long overdue global economic rebound from the previous recession in 2009, propelled Chinese, Korean, Indian and a number of emerging markets indices to returns greater than those seen domestically. For example, with Eurozone unemployment falling over one percentage point during 2017 to 8.7 percent, forex yields proved far more attractive overseas than at home, causing many institutions to shed portions of their dollar holdings.

A number of factors in the coming year provide evidence that the dollar rout is not over yet. The aforementioned global growth has shifted the thinking of many foreign central banks. In the European Union, the monetary policy debate has changed from ‘if” to “when” the European Central Bank should end its quantitative easing program originally designed to restart economic growth and boost asset prices after the Great Recession.

In Asia, the tone is no different. While lagging annual inflation of around 0.8 percent in 2017 has yet to signal any definitive need for a monetary policy shift, the Bank of Japan expects strong exports and quickening GDP growth to push inflation to its long term 2 percent target by early 2020. According to Reuters, Japan is ahead of schedule on eradicating the deflation seen in past years, leading many to believe an end may be near to the negative interest rates set by its central bank.

In sum, there remains ample reason to believe foreign currencies will continue to strengthen against the dollar in 2018. On the back of such data, Citibank projects a further 5 percent decline in the dollar index over the next year. All of this begs the question: what are the consequences?

While it’s true the current exchange rate climate benefits previously siloed sectors of the economy such as manufacturing and materials by effectively giving foreign buyers a discount on American goods, a weak dollar does not come without its costs. Aside from reduced spending power during travel, serious cause for concern comes from the increased prices of goods at home. Total spending on imports in 2016 amounted to a sizeable 12 percent of our $18.6 trillion dollar GDP, with the largest contributions from spending on electronics, computers and petroleum respectively.

Even though typical core inflation measures exclude the prices of more volatile commodities like food goods and petroleum, price increases on these trade items could certainly lead to inflation. Taken alongside a 4.1 percent unemployment rate — the lowest since December of 2000 — and the wage and bonus benefits given to millions of Americans by employers such as Walmart, AT&T and Capital One as a result of the recently passed tax plan, inflationary pressures seem to be rematerializing to levels not seen in recent years.

In macroeconomic terms, these numbers are significant. Current unemployment is below the Federal Reserve’s estimates of the non-accelerating inflation rate of unemployment (or NAIRU), the level at which economists expect inflation to rise. Indeed, with core inflation from last December rising to 1.8 percent according to the Bureau of Labor Statistics, the Fed’s long run target of 2 percent seems well within reach for 2018.

To counteract price pressures from the weak dollar, wage increases from unemployment below the NAIRU, and, more broadly, to maintain price stability, the Fed must look to rapidly raise rates. The aforementioned factors form the basis for the generally accepted argument that the Fed will raise rates in 2018. However, their severity will determine the answers to the more important questions such as “How soon?” and “By how much?”

According to the Federal Reserve’s most recent dot plot, which measures the Board of Governors’ opinion on future interest rates, three rate hikes of 25 basis points each is the most common expectation for 2018. This projection largely factors in what the Fed thinks will be appropriate based on their projections for the strengthening of inflation metrics. However, the consensus at the Fed belies the concerns of a more rapid return of inflation, which given the falling dollar, is entirely likely.

Moreover, the 75 basis point projection does not adequately account for the strength of the business cycle. Now almost 10 years out of the last recession, major financial institutions such as Barclays and Goldman Sachs have begun to include the possibility of a recession in their near term economic forecasts. With current interest rates at just 1.25 percent, the need to raise rates takes on more importance given the propensity to lower them during economic downturns.

Considering the uncertain success of the negative interest rates central banks used to stimulate economic activity in Europe and Japan after the Great Recession, the Fed tends to look to lower rates no further than a nominal 0.25 percent or so, which does not give it much room if it had to undertake a course of sustained easing in the near future. As a point of context, the Fed lowered rates by 5 percentage points during the last recession. Effectively, the low interest rate environment leaves the Fed with its hands tied behind its back, without the ability to further stimulate the economy.

While dovish sentiments would suggest reactionary rather than proactive measures to manage the return of inflation and fewer rate hikes rather than more to avoid the risk of steering the economy toward a recession, it is important to mind the damage untamed inflation could wreak on the economy. With market volatility at historic lows, downplaying the consequences of inflation could prove fatalistic, removing the Fed from control over powder-keg factors that could threaten the peaceful gains seen by equity markets in 2017. Four rate hikes, rather than three, and a prolonged plan for additional increases in 2019 will enable the Fed to maintain price stability and, more importantly, position it better to accommodate the next recession.

Background

Private equity (PE) and venture capital (VC) firms generally view the initial public offering (IPO) as the most desirable exit scenario by which to realize their returns, sparking keen interest in the risk-return profile of these stocks as compared to the overall market.

In his seminal work on IPOs, Ritter (1991) first drew attention to the significant underperformance of newly issued stocks during their first three years in the aftermarket. Interestingly, subsequent literature has found evidence that private-equity-backed (PE-backed) IPOs defy this trend. For example, studies by Degeorge and Zeckhouser (1993) and Holthausen and Larcker (1996) show that leveraged buyouts (LBOs) returning to the public markets outperform other newly listed stocks. In the case of venture capital, a study by Brav and Gompers (1997) establishes that venture-capital-backed (VC-backed) IPOs significantly outperform non-VC-backed IPOs.

Previous studies have sought to identify risk and return characteristics that might explain the differential performance of PE-backed IPOs. Most relevant to this paper is a study authored by Levis (2011) that uses Fama and French’s three-factor model to analyze a sample of PE-backed, VC-backed and other non-backed IPOs. Levis finds that PE-backed IPOs have larger market capitalizations and are more profitable than their non-sponsored counterparts. In examining the aftermarket performance of these IPOs, he also finds that the three-factor alphas of VC-backed IPOs are poorer than those of PE-backed IPOs, but that both of these groups generate higher returns than non-backed IPOs.

Although the three-factor profiles of private equity IPOs has been well established in the financial literature, such studies have yet to incorporate the factors from Fama and French’s most recent five-factor model (2014). In addition to the traditional factors for market risk (MKTRF for “market return over risk free rate”), size (SMB for “small minus big”) and value (HML for “high minus low”), this model includes two new factors: operating profitability (RMW for “robust minus weak”) and investment (CMA for “conservative minus aggressive”).

RMW is particularly relevant to the private equity industry in two respects. First, operational improvement is one of the primary means by which sponsoring funds seek to create value in their portfolio companies, with operating multiples such as EV/EBITDA serving as key metrics for evaluating investment performance (Axelson et. al, 2010). Additionally, expectations for operational profitability differ significantly by fund strategy. For example, a paper on private equity performance by Ljungvist and Richardson (2003) finds that venture capital investments tend to be significantly less profitable than private equity investments.

The investment factor was first introduced by Zhang et. al (2008) in response to the apparent underperformance of equity and debt issuers as compared to matched non-issuers. The authors propose that the reduced cost of capital from issuing securities incentivizes firms to increase investment, which in turn lowers average returns. They find that the new factor does indeed explain a significant part of the new issues puzzle, reducing 80 percent of IPO underperformance.

Fama and French (2014) find that positive exposures to RMW and CMA capture the high average returns associated with low market betas and conservative investing, whereas negative exposures explain the low average returns characteristic of unprofitable firms that invest aggressively. Given the differing return characteristics of PE and VC investments, it is likely that the loadings on these two factors would differ based on the stage of an investment’s sponsoring fund, although no research has been conducted on this topic to date.

In addition to five-factor analyses, there is also a notable lack of research on the specific risk and return characteristics of distressed stage funds. This gap in the literature is surprising, as distressed deals have become more popular over time, accounting for 3.2 percent of all LBO transactions from 2001-2007 versus 1.2 percent from 1970-2000 (Stromberg 2007); moreover, the most recent financial crisis in 2008 sparked further opportunities for distressed strategies. Research into the characteristics of distressed investing has potentially interesting implications, given the highly differentiated platform of such funds. For example, Stromberg (2007) establishes that distressed investments are the most risky form of LBO deals, with bankruptcy rates that are twice as high as other deal types.

The purpose of my analysis is two fold. First, I apply Fama and French’s most recently published five-factor model to establish the risk and return characteristics of IPOs backed by buyout, venture and distressed stage funds. I then proceed to parse out significant differences in the alphas and betas of IPOs based on each of the three types of sponsor in my dataset. My analysis is one of the first to apply the new five-factor terms for operating profitability and investment to the private equity industry, as well as one of few papers to give specific attention to distressed stage investments.

Analysis

The main dataset on private equity IPOs is from Thompson One, which covers all private equity exits since 1970. I filtered this data to focus on companies that were backed by either venture-, buyout- or distressed-stage funds and exited via IPO. The sample I obtained from Thompson One only includes IPOs that took place from 1970 to 2014 on the New York Stock Exchange, NASDAQ Stock Market or American Stock Exchange. Of the 4,131 total IPOs in the dataset, venture-backed firms comprise over half of the sample with 2,729 IPOs; the 1,329 buyout- and 73 distressed-backed firms account for the remaining observations. Table 1 provides summary statistics for the price, shares issued and proceeds of IPOs based on sponsor stage.

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Table 1

Table 2 shows the output from the five-factor regressions. Results are broken down by each of the five time intervals following a firm’s IPO date: 1 month, 6 months, 12 months, 24 months and 36 months. These panels are further subdivided according to the stage of the firm’s sponsoring fund—venture, buyout or distressed.

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Table 2

The findings indicate that the five-factor model has significant descriptive power for sponsored IPOs. Venture-, buyout- and distressed-backed firms are similarly characterized by greater volatility, smaller market capitalizations, lower book-to-market values, lower operational profitability, higher levels of investment and some degree of abnormal returns in the first month following an IPO.

While these initial results hint at differences in alphas and risk factor loadings between sponsor stages, they do not establish whether such differences are statistically significant. To follow up on this point, I conducted a second analysis adding interaction terms to the five-factor model to test for IPO performance differentials based on sponsor stage.

Thus, in addition to the original five factors, the regressions shown in Table 3 include dummy variables for buyout and distressed sponsorship, plus interaction terms between these dummies and each of the five factors. Because the base case is venture, the constant and all five uninteracted factors in this table are identical to the coefficients from the venture regressions for the corresponding periods in Table 2.

Table 3
Table 3

Although there were no consistently significant differential effects for distressed terms, the analysis does reveal a few points of significant difference in the performance attribution of venture- and buyout-backed IPOs. Buyout sponsored firms are less volatile than venture sponsored firms during the first six to twelve months following an IPO. Consistent with previous studies, buyout-backed firms also tend to be larger and more value-oriented than venture-backed firms.

While there are significant differential effects for the original three Fama-French factors, no such differences appear to exist for RMW or CMA. Consistent differences in abnormal returns are also lacking, although the end-period alpha differential for buyout-backed IPOs is significant and negative with respect to venture-backed IPOs.

Conclusions

My results generally confirm findings from previous studies based on the original three Fama-French factors—market risk, SMB and HML. Regardless of sponsor stage, I show that all firms backed by private equity funds tend to be smaller and more growth-oriented than other public companies, even generating some degree of excess returns in the first month following their IPO date. Furthermore, venture-backed IPOs are more volatile than the market, as to be expected from the riskier strategies that characterize venture capital industry. Differential analyses for the three factors are also consistent with preceding financial literature; buyout-backed IPOs are less volatile, larger and more value-oriented than their venture-backed counterparts.

The new RMW and CMA factors shed light on previously unexplored aspects of private equity performance attribution. My results show that sponsored IPOs as a whole exhibit lower operating profitability and higher levels of investment during their first 36 months on the public markets. These results are consistent with Fama and French’s five-factor correlations (2014), which show that RMA and CMA vary positively with book-to-market value. Unlike the first three Fama-French factors, however, I find no evidence of differential effects for RMW or CMA by sponsor stage.

This paper set out to profile the risk and return characteristics of private-equity-backed IPOs based on the stage of their sponsoring fund. In addition to confirming previously established findings, the analysis also contributes new insights to the performance attribution of private-backed-IPOs via the five-factor model. These findings lay the groundwork for future research on the value-add of private equity funds in managing their portfolio companies.

This article is an excerpt from Ms. Eubank’s paper for her finance class at Dartmouth.