Private Equity In The Emerging Mixed-Source Software Environment

Despite the volatile economic environment, 2011 has been good to the technology sector.  Forrester and Gartner forecasts a 7% increase in technology spending for the year. PwC US technology M&A insights similarly projected a positive outlook, crediting strong performance to the sector’s “ample cash balances, inexpensive debt and previously established strategic objectives.” The software industry is leading the pack, capturing $2 billion in venture funding in the third quarter, representing the highest level received by any industry. The third quarter also delivered the highest deal volume for the industry, with 263 rounds completed. Golden Gate and Infor’s $2 billion buyout of Lawson Software, and Providence Equity Partners’ $1.9 billion bid for SRA International ranked among the most notable private equity acquisition announcements in the technology sector.

Difficulty of Software Valuation

As these figures suggest, confidence in software has grown by leaps and bounds since the early 1980s when critics were doubtful of software’s inherent value.  The genesis of software valuation only dates back to 1985 when the Supreme Court ruled in Digidyne Corp. v. Data General Corp. that software was valuable independently of the hardware that it attached to.  While the ruling ended the debate surrounding the exploitability of software, the fast-paced sector that is no stranger to game-changing innovation presents continuing valuation challenges for appraisers.  Technology investments carry unique risks, not the least of which is the looming possibility of the emergence of disruptive technologies (think connected tablets, peer-to-peer communications, cloud computing).  At the same time, technology investments also carry potential for huge returns, including unexpected profits linked to the commercialization of killer applications (think Twitter).

The rapidly changing landscape of technology requires investors to be particularly attuned to industry trends and developments in order to assess the risks and rewards attached to assets under consideration for investment.  This may prove to be a more difficult task for financial investors in comparison with their corporate counterparts.

A study of 1,441 European firm acquisitions in the period of 1997 to 2003 revealed that financial investors systematically overvalued their targets in relation to strategic acquirers.[1] The results were linked to knowledge asymmetries that exist between strategic and financial acquirers.  While corporate investors benefit from knowledge developed through their own R&D, financial investors tend to lack specialized knowledge due to portfolio diversification and avoidance of industry concentration.

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