The LBO Gang Storms the Valley

SILICON VALLEY (Business Week) August 31, 2006 — High-powered private-equity players are talking frustrated techies into the idea of going private—and making billions

Michael Marks has long been a salesman, of sorts. As CEO of Flextronics (FLEX ) for 13 years, he wooed execs into letting his company take over their plants and make their products. "I spent my days calling the people that run technology companies, asking them why they were still doing their own manufacturing: 'Why don't you let us make you an offer to buy your factories?'" Marks recalls. By his retirement last year, he had built Flextronics into a $16 billion behemoth.

Now, Marks is singing another siren song for tech executives: Let me take your company private. He is one in an army of high-powered private-equity players who are stalking the Valley in search of buyout candidates. Marks has traded his cramped Flextronics cubicle for an ornate office in Menlo Park, Calif., with the legendary leveraged buyout (LBO) firm Kohlberg Kravis Roberts. "I pretty much spend my days calling the same people," Marks says, "except instead of trying to get their factories, I'm trying to buy all or part of their company."

That pitch is getting a surprisingly warm reception. After a half-decade of crushing pressure to hit their quarterly numbers, stagnant or shrinking stock prices, and scrutiny on everything from offshoring to stock options accounting, many frustrated techies are ready to entertain the option of going private. They believe their companies can thrive outside the glare of public scrutiny.

Of course, an LBO can also make executives fabulously wealthy: They get a huge pop in their own shares by selling out at the typical 20%-plus LBO premium. And in most deals, top management is invited to invest alongside dealmakers in return for low-priced shares and hefty options grants. "All kinds of people are thinking about bailing," says one leading tech CEO, who asked for anonymity. "If you miss [earnings] by a penny these days, you end up getting fried on CNBC. Then there's this private-equity option, where you can make a ton of money."

EYES WIDE OPEN.  Things started heating up a year ago when data processing giant SunGard Data Systems went private in an $11.4 billion deal, the biggest tech LBO in years. Since then, many have followed. Last November, for instance, Serena Software in San Mateo sold itself to private-equity firm Silver Lake Partners for $1.3 billion. And in August, KKR and Silver Lake bought Royal Philips Electronics' chip unit for $9.5 billion. Meanwhile, outfits that went private at the start of the decade, such as Seagate Technology and Verifone, came storming back with successful initial public offerings.

That opened the eyes of many a tech chief to the possibilities of private equity. Today the companies that are being considered include Sun Microsystems (SUNW ), NCR, Symantec, and a host of troubled telecoms like Siemens (SI ), Nortel, and Avaya. Big contract manufacturers such as Jabil Circuit (JBL ) and Celestica (CLS ) are high on some lists, as are service plays such as Electronic Data Systems (EDS ). And since the Philips deal, many chipmakers have suddenly begun ringing up dealmakers, say private-equity sources.

A wave of privatization would mark a sharp reversal from the classic Silicon Valley playbook. Throughout the 1980s and '90s, tech companies thrived on a high-octane combination of venture capital, stock options, and IPOs. Other than a few boutique firms, the LBO crowd rarely fished around much. Techies were growing too quickly, consuming too much capital, and enjoying their rising share prices too much to consider loading up on debt and milking cash flow to pay it off.

NEW TARGETS.  But times have changed. Now the more mature tech companies are struggling to grow 10% a year. Iconic stocks such as Microsoft (MSFT ), Intel (INTC ), EMC, and Dell (DELL ) have been trading sideways, or worse, for years. With cash reserves on the rise as managers trim growth-related investments, dozens of name-brand companies now pop up on dealmakers' spreadsheets as LBO candidates. In July analysts at Prudential Equity Group screened a database for buyout targets and turned up names like Hewlett-Packard (HPQ ) and Applied Materials (AMAT ).

Private-equity firms worldwide are expected to raise up to $280 billion this year, according to researcher Private Equity Intelligence, making megadeals suddenly seem possible. Says Prudential analyst Edward Keon: "Clearly, I'm exaggerating here, but what's the difference between a $30 billion deal and a $300 billion deal? It's just a few more phone calls. As more money flows into private equity, and the pressure to put it to work grows, it's possible that these deals get bigger and bigger."

Practically speaking, there are limits. Sure, no company fits the slower-growth, high-cash-flow profile better than Microsoft. But it's hard to imagine financiers putting together the $84 billion in cash that would be required to do a $336 billion buyout, presuming buyout firms paid a 30% premium to its stock price and put up a quarter of that in equity. Instead, industry insiders say the biggest deal possible at this point is $50 billion—enough to make a run at chipmaker Texas Instruments (TXN ) or perhaps PC maker Dell.

Executives insist that what excites them, more than riches, is the chance to focus on such long-term decisions as selling off divisions or cranking up research and development, which may be needed to spark their companies but would spook Wall Street. The private-equity crowd encourages that mindset. "Most of these companies are very good companies, and we're setting them free from the 90-day management process," says John Marren, a partner at private-equity firm Texas Pacific Group. "How much of a CEO's day is spent worrying about the latest government investigation, or talking to some hedge fund manager about whether orders are going to be up 0.1% or 1% this month?"

PENNY-PINCHERS' WRATH.   A lot, says SunGard chief Christóbal Conde. He recalls that as the head of a public company he used to walk around with quarterly earnings playing like an annoying ad jingle in the back of his head. "When you run a public company, so much of your personal credibility is tied to the volatility of earnings," Conde says. Before, he could fund only 8 to 10 R&D projects at a time without attracting the wrath of Wall Street penny-pinchers. Now, Conde says, he has 53 different projects under way and five times the R&D budget he had while SunGard was public.

Still, going private is no panacea for all of tech's complaints. For starters, bigger deals are typically financed in part with high-yield bonds, which require quarterly reporting. So you trade complaints from shareholders focused on next quarter's earnings for debt holders with an eye on credit ratings and cash burn.

Private owners also can be more demanding than Wall Street. Douglas Bergeron left buyout firm Gores Technology Group to run VeriFone (PAY ) after the maker of credit-card-processing gear was bought from HP in 2001. Thanks to its 2005 IPO, Verifone saw its value rise from $50 million to $1.5 billion in that time. But it took a total management shakeout and an operational focus that Bergeron says is lacking in much of techdom: "You can hide a lot of problems when you're growing at 25% a year, but that's no longer the case for these companies. And private owners will not stand around and let management be ineffectual."

That sounds scary—but more than a few tech companies are likely to take their chances.