Francisco Partners – December 1999

Francisco Partners – December 1999

• Dave Stanton + Sandy Robertson + DJ Deb + Ben Ball and Neil Garfinkel
• Become the leading buyout firm focused exclusively on companies in the technology sector
• Business from $50 mi to over $2bi
• LBOs, divisional spinouts, fallen angels, recapitalizations, management turnarounds, strategic restructuring and growth equity situations
• Raise a large buyout fund – not an easy task
• Team was second-to-none

• Technology investing knowledge
• Relationship with Sequoia Capital (Silicon Valley VC)

• Best timing to invest in technology

• Versus conventional “technology LBO” was an oxymoron – Stanton disagreed (High Voltage Engineering)

• Traditional LBO typically done on lower growth, undervalued businesses, with steady cash flows

• Technology wasn’t just about cutting edge of Silicon Valley, in fact, the majority of the money being made in the tech space was being made by older, stodgier companies, like the IBM’s

• By investing in larger companies through LBOs , he thought he could put much more capital to work yet still achieve very attractive rates of return due to the underlying growth of the tech sector

Dave Stanton

• “Math and science geek” chemical engineer from Stanford,

• began to pursue a PhD and
• left it after 8 months to work for Bain, where he worked for 3 years before
• Going to Stanford for an MBA.
• During MBA, discovered a passion for technology and that he wanted to be a principal and not an agent.
• Summer internship in an industrial technology company that had recently undergone an LBO where he witnessed the convergence of finance, technology and operations.
• After MBA, took a job with Venture Capital (Trinity Ventures) – a crash course on computer science and information technology.
• 1994, invited by a former Bain partner, joined TPG as a generalist and after a study on telecom and technology, focusing on specific sub-sectors in which he thought TPG could marry technology and LBOs – became leader of TPG’s technology investing efforts
• TPG’s technology deals (in a generalist funs) ended up comprising a disproportionately large share of the firm’s profits. In 1999, TPG was on track to raise a completely separate technology fund, but being a specialist at a generalist firm was becoming increasingly difficult (it took longer to have TPG generalist guys comfortable with putting TPG’s money into any given tech company, because they were not familiar with the space)
• DLJ advised that with his reputation and track record, he could raise $1 to $2Billion

Recent Trends in Fundraising

• Mid-1999 – PE funds and number of firms increased in the last 10 y – driven by 4 factors

• 1. More institutions were investing in PE (pension, banks and insurance)
• 2. 90s bull market increased the size of institutional funds
• 3. % allocated to PE was increasing
• 4. Re-deployment of PE capital gains

• Consequences for the LBO business

• 1. Demand for deals outstripping the supply- increased purchase price
• 2. Given the increased price and the fixed amount of leverage a given business can support, Equity as a percentage of total purchase price increased
• 1 + 2. Substantial negative impact on buyout fund returns going forward

• 1. PEs partnering instead of competing for deals
• 2. Expand into other less competitive geographic regions
• 3. Specializing in one or two industries instead of remaining generalists

Overview of the Tech industry

• Growth in the tech sector exceeded 10% in the 90s (4xs the average)
• Fueled by business investment – capacity expanding at 40% a year

• Contributed to low inflation rates in the US in the 90s – IT prices declined by 5% a year

→ Industry Structure

1. Sector

1. Hardware - $ 470 bi in annual revenue
2. Software - $ 135 bi in annual revenue
3. Communications - $1.1 tri in annual revenue
4. Services - $290 bi in annual revenue

1. Life stage

1. Start up – compete on technology, focus on developing market, high failure rate
2. Emerging growth
3. Mature – compete on brand and customer franchise, focused on maintaining innovation and low failure rate

1. Strategic position - Strategic “inflection Points” at which future prospects could become unclear creating an opportunity for differential investment insight and for outside resources to bring to bear a favorable resolution to those issues

1. Product transitioning
2. Merger Integration
3. Management change
4. Cultural change
5. Strategic rationalization
6. Technological paradigm shifts

→ Myths vs Reality

• Versus conventional “technology LBO” was an oxymoron – Stanton disagreed (High Voltage Engineering)

• Traditional LBO typically done on lower growth, undervalued businesses, with steady cash flows

• Tech viewed as too volatile; richly priced and rapidly changing to support any meaningful leverage

* Prime Computer – one of the first technology buyouts (1989 – bought by JH Whitney in an LBO)

• Manufacturer of minicomputers and developer of computer-aided-design software – business was solid
• Very high cost debt

• Had to undergo massive layoffs and restructurings

• Set the tech buyout market back for years until Stanton got  active in 1994

1. Volatility – absolute growth rates (appeared) x relative growth rates (not more than overall economy)
2. Product Obsolescence – rapid product life cycles and large product obsolescence risk x more long-waved trends of recreation, reformulation and adaptation than sudden shocks of tech displacement (once passed the proof of technical and commercial feasibility were resilient and adaptable)
3. Failure rates – true for very early stage companies, more mature companies were stable
4. Valuations – relatively few traded at high valuations, but received a disproportionate amount of public attention (techs tended to bifurcated into “haves” – with a track record of success and clear prospects for growth and valuation multiples several times that of market laggards – and “have nots” – depressed market valuations * Francisco Partners disagreed since Capital Markets has little patience for earnings disappointment from tech companies + Wall street did not welcome difficult to explain transitions or complicated stories that required several quarters to prove out)
5. All tech companies were high tech – there were low tech sectors
6. Tech companies could not be leveraged – many could support a prudent amount of leverage, since they had a large installed base of customers and products that resulted in strong and recurring cash flows + had flexible operating expenses and capex requirements should they face temporary sales downturns
7. Tech had to reinvent themselves to survive – most reinvention was evolutionary and incremental rather than revolutionary

Competitive Landscape for LBO’s @ tech companies

1. New Tech-focused Buyout Firms

1. Silver Lake Partners (Hambrecht & Quist – IB, Blackstone – LBO, Oracle – software, Integral Capital – tech focused HF) – Kleiner Perkins Caufield & Byers VC firm

1. Sep 199 closed a $2.3 bi – largest first-time buyout fund in history

1. Thomas Weisel Capital Partners

1. Existing Buyout Firms Tech Efforts

1. Investing money from generalist funds into tech companies – KKR, Blackstone
2. Forming dedicated tech efforts
3. Raising separate dedicated tech funds - TPG

1. Middle Market Tech Investors and Venture Capitalists

1. MM - General Atlantic Partners

1. Targeted investments in the $5-$100 mi range in private companies in exchange for minority positions
2. Focused on straight equity investments rather than complex structures as LBOs

1. VC – migrate into larger-sale and larger-stage investing

1. Substantial industry knowledge and deep personal connections through the tech world

Establishing Competitive Advantage

1. The team: one of the most experienced teams focused on structured PE investment in tech companies

1. Sandy Robertson – founder of 2 highly successful tech IBs and in his 30y had been involved in more tech IPOs and Mergers than any other individual in the world

1. Unparalleled network of relationships with the tech space would books Francisco Partner’s deal origination, due diligence and fund raising capabilities

1. Track record: facilitating fundraising, sellers would have greater desire and confidence in working with them, execution advantage (debt mkt was thin)
2. Domain expertise: tech was indeed complicated and difficult to understand, but comprehensible when rigorously researched and analyzed.

1. Research intensive top down industry analysis in order to identify and exploit trends in targeted sub-sectors of the tech industry
2. Leverage its knowledge base to identify companies at strategic or operational inflection points (potential for substantial value creation; attractively priced)
3. Leverage its expertise in crafting complex structural solutions to tech transaction problems (create value by virtue of the transaction structure itself)
4. Tech focus: generalist LBO firms would have difficulty keeping pace with the changing tech sector – steep learning curve
5. Speed advantage in making decisions and consummating transactions

1. Sequoia Capital: Sep 1999 entered into an exclusive long term relationship with Sequoia Capital + co-location + Sequioia partners committed to invest $100 mi in Francisco Partners first fund on a no-fee, no-carry basis (junior partner)

1. Exclusive and proprietary source of deal flow for companies that fall outside the scope of its venture capital operations
2. Network of executives, entrepreneurs, consultants and LPs would be available for Francisco Partners due diligence efforts
3. Presence and knowledge in tech markets through the relationships built – continue to develop its own intellectual property base in tech investing

1. Strategic Investor Base: 50 to 100 prominent Silicon Valley CEOs and executives to invest
2. Executive council: group of prominent industry executives who agreed to invest in Francisco Partners and act as strategic advisors to the firm
3. Executive-in-residence program: rotate 2 or 3 senior executives through the Francisco Partner’s office at 3 to 6 month intervals and have them participating in active, full time due diligence on deals and provide a source of idea generation and deal flow – potential operating executives for portfolio companies

Fundraising issues

• DLJ would be the exclusive placement agent for the first fund
• DLJ’s team had collective raised over $50 bi in commitments to PE funds, more than any other placement agent
• Placement fee for fundraising effort

• Give access to a much larger investor network
• Help draft the offering memorandum (formal marketing document sent out to prospective investors) and investor presentations

• Summary of key terms of the fund
• Prior investment performance
• Overview of investment strategy
• Background info on the tech industry
• Employee bios
• Summary of prior transactions
• List of risks
• Legal considerations
• Tax implications

• Coordinate the firm’s marketing strategy
• Advise on the best set of fund terms
• Help with regulatory filings
• Plan and schedule investor roadshow
• Help negotiate the final LP partnership agreement

• Key economic terms of the fund

• Committed capital

• How much money set out to raise for the first fund?

• Not bite more than could appropriately invest
• Oversubscription

• More leverage to negotiate terms
• Appear “hot”

• Too large (hard to reach) x too small (difficult to raise significantly more than the cover amount, limitating the potential size of the fund)

• GPs Commitment

• Sequoia - $100 mi
• Human capital invested x LP like to see GP commit to keep interests aligned

• Return Formula

• Preferred return (8-10%)
• Catch up
• Carry (80/20)
• Clawback provision – deals that made money compensate LPs from lost in other

• Management Fee (1-2%)

• How much?
• Give back? – GP would have to return management fee to LPs before see any proifts – interest free loan from LP against GP profits
• “first dollar carry”

• Transaction, Break up and other fees

• Advisory, director, monitoring fees
• Keep of give some or all to LPs by crediting against management fees?

• Investment restrictions

• % invested in any single portfolio company
• Geography

• Organizational expenses

• Who should bear the legal, accounting and regulatory fees?

• Placement agent fee (0.5-2% of total fund size, payable over several years by GPs)

• How much DLJ be compensated?
• Ratchet up with amount raised?
• All amount raised or only the one clearly attributable to DLJ?