Private Equity Power Play: Why Solution Providers Are The Next Big Bet
When Optiv Security filed for its initial public offering in November, CEO Dan Burns said his phone started ringing.
It was the private equity companies — they wanted in.
After evaluating a number of calls from what Burns said were the "biggest and best" private equity companies in the market, Optiv said in December that it was putting its public company ambitions aside in favor of an acquisition by KKR & Co. — the second-largest private equity firm in the world according to the 2016 Private Equity International 300 — in a deal reportedly worth $2 billion.
Optiv weighed its options, choosing to go the private equity route because it felt KKR understood the company's vision for the future. Burns believes a partner like KKR can lend strategic advice and financial support to help Optiv hit its goal of becoming a global security powerhouse more easily than if it were going it alone.
"They are seeing the value. They are realizing the value. I think you saw that in this deal," Burns said.
"Private equity firms are truly starting to understand the complexity in security. While maybe in the past they have invested in technologies and potentially had some ups and then downs, I think they view us — the cybersecurity solution providers — as the ultimate investment," he said.
Solution providers like Optiv present a unique opportunity, he said. On the front lines with clients, wielding a broad array of security products as weapons in the war against cyberattacks every day, Burns said Optiv has a better view on where technology trends are heading and how to meet business needs.
For private equity, he said that's an appealing value proposition.
"We can be, in a way, the index of security. We see what's going on in security well before investors do and well before most other people see what's going on, what's emerging and what's being written and produced. We're the perfect gateway for emerging companies, as well as maturing companies," he said.
Herald Chen, co-head of the technology, media and telecommunications team at KKR, said he saw the investment in Denver-based Optiv as an opportunity to build "one of the most valuable security companies" in the market. Security threats and technologies are evolving so quickly that customers are turning to trusted third parties like Optiv more than ever, he said, making it an "opportunity to build a very valuable and important company in the cybersecurity landscape."
"This is a very, very big industry for a reason. … Technologies are changing so quickly and customers need so much help that this was a really interesting place for us to make a direct investment into a channel business," Chen said. "The value-add is high and I think if we do it right it will likely only go up."
However, it isn't just cybersecurity solution providers that have piqued the interest of private equity firms. Private equity deals across the channel are at an all-time high, according to exclusive research from martinwolf M&A Advisors of Walnut Creek, Calif., one of the top channel investment advisory deal makers. According to its research, nearly 70 percent of transactions involving solution providers in 2016 also included private equity. That follows on the heels of another busy year for private equity in 2015, which accounted for more than 60 percent of North American VAR and solution provider deals.
"The investments in the channel are still strong," said Anthony Lembo, managing director for supply chain at martinwolf. "Clearly the demand is out there. … Over the past year, demand and channel multiples and valuations have expanded from a few years ago."
Some of the notable channel private equity acquisitions from 2016 include Optiv; AVI-SPL in April by H.I.G. Capital for an undisclosed amount; Data Blue by The Gores Group and Platinum Equity for an undisclosed amount; Fidelity National Information Services' education and public sector businesses by Vista Equity Partners for $850 million; and Lionbridge Technologies in December by H.I.G. Capital for $360 million.
Overall, the numbers add up to well more than $25 billion of investment by private equity firms in the channel in 2016, excluding private equity deals that did not disclose their price. The deals include, but are not limited to, investments in application and systems software, IT services and distribution companies, and VARs.
The result of these deals and those in recent years, Lembo said, is that the influence of private equity on the channel is higher than ever before. That influence is shaping industry consolidation, financing and strategy, he said.
"For the most part, outside of a few private companies, most of the private VAR companies are backed by private equity. There aren't many larger solution providers that don't have some sort of funding behind them," Lembo said.
Larry Jones, executive chairman and CEO of Coalfire, a Westminster, Colo.-based security solution provider, said he had dozens of private equity companies calling to buy his company in 2015. The company ultimately took on a joint strategic investment of an undisclosed amount from private equity firms The Carlyle Group and The Chertoff Group in September 2015.
Jones said he has seen a significant acceleration in the interest from private equity in companies like his over the past two years. That's an attitude shift from years past, he said, where venture capital was eager to funnel money into the channel but private equity was slower to jump in. What changed, he said, is that the channel has matured and now includes larger companies and increased services opportunities. Coalfire had previously taken on venture capital funding — $5 million in 2011 and $3.6 million in 2013 — but decided to pursue private equity because it presented the opportunity to reach the next phase of growth, he said.
"The private equity guys are really just showing up in the last two years. That's probably because the market was immature and the company size wasn't right to invest in. ... We couldn't get anyone's attention three years ago on the services side, and now everyone understands it," Jones said.
Private equity executives told CRN, too, that they are more interested in the channel than ever before. KKR's Chen said with cloud and cybersecurity evolving so rapidly, companies are looking for a "trusted third-party" partner. That factor, combined with more money flowing through private equity as fewer companies go public, creates a perfect storm of demand, he said.
"I can certainly see there being more activity in private equity in the channel," Chen said. "This is a very big industry for a reason. There's a huge value-add for both customers and vendors."
Zaid Alsikafi, managing director at Madison Dearborn Partners, said he also sees IT services as a growing opportunity for investment. The Chicago-based private equity firm has made multiple investments in channel companies, including Intermedia and CDW. "Overall IT services is a growing area.
… I do think you are seeing more investments and we will continue to see more investments in this space," Alsikafi said.
A complex technology landscape and a push for companies to "figure out how to operate in a more digital world" is driving up private equity demand for channel companies, he said, noting that Madison Dearborn Partners continues to look for opportunities for investment in MSPs, managed cloud providers and managed hosting application providers.
"I don't think we're in the late innings of companies having to manage through the transitions and complexities that they face. There will be a place for IT services, IT service providers and solution providers to be successful. It's on us as investors to find where we believe that challenge is most acute or where we think that opportunity is the most attractive," Alsikafi said.
Alsikafi said that a complex technology environment can also make it difficult to place winning bets on a single technology. There can be more "consistency" in the investment in a channel company, which spans a greater range of technologies and relationships, he said.
"In IT services, you are really investing typically in either a skill set or relationships the companies have been able to develop and manage over a long period of time. ... On the vendor side, you might be making a bet on a technology — a specific technology — being successful over time. … If you pick the right vendor or right technology, you have the opportunity to be very successful, but there's a lot more downside if that changes," Alsikafi said.
An executive from another large private equity firm, which has recently done a large deal involving a channel company but did not want to be named for competitive reasons, said the emphasis for investment falls particularly on value-add, consulting and services businesses, rather than more traditional distribution or reseller businesses.
"People's appetite for these businesses is higher than in the past," the executive said. "People really see the growth. … All of the shifts [in technology] are only benefiting these businesses and that's why [private equity firms] are more interested in them."
However, is all this interest and investment from private equity a good thing for the channel? When asked what value private equity brings to the channel, private equity firms and acquired companies CRN spoke with almost unanimously agreed the appeal of an investment for a partner includes capital, connections in the industry and strategic guidance.
"I think it's a terrific thing. Private equity money is usually smart money," said Michael Gold, CEO of Mountain View, Calif.-based Intermedia, a cloud platform provider and No. 189 on the 2016 CRN Solution Provider 500, which was bought by Madison Dearborn Partners in September. "The fact that they are making these investments should make the good companies in our space feel like we're in a good area. This is an area where smart money wants to come in."
Gold said he sees private equity bringing increased capital and industry experience to the table.
However, it is key to choose a private equity partner that has similar goals, that you can trust, and has experience in the market you operate in, he said. Without those factors, it could turn out to be a negative move.
Martinwolf's Lembo said he sees private equity firms also providing significant capital for acquisitions, citing a recent example of NWN, No. 68 on the CRN SP 500, which acquired Collabramind in November after assuming private equity majority ownership in 2015. Those types of acquisitions help solution providers expand geography, customer bases and service areas, he said. Private equity also adds management capabilities and strategic guidance to the channel, Lembo said. Optiv's Burns said the solution provider plans to leverage KKR for international expansion and further investments in cloud security. Those plans likely will include acquisitions, where Optiv can leverage KKR's global brand and international expertise.
However, not all companies are jumping at the chance to be private-equity-owned. Kudelski Security, a global security solution provider that is part of $1 billion Swiss security conglomerate Kudelski Group, is one company that thinks it can do better as a stand-alone company. CEO Rich Fennessy said Kudelski's status as a global business without private equity ownership provides it with a marked advantage over its competition, which includes Optiv. He said private-equity-owned competitors have a shorter-term investment perspective than Kudelski.
"A long-term mind-set is very challenging in a private equity-owned environment when it is all about the next quarter," Fennessy said. "Kudelski Group has been around 65 years, and is going to be around another 65-plus years. We are thinking long term."
Fennessy said that perspective gives Kudelski an innovation edge, investing in high-level advisory consulting, a security reseller and services business, managed security services and a customized R&D security innovation unit. Kudelski has also made multiple major acquisitions in recent months, including M&S Technologies in January and Milestone Systems in May.
There's no doubt, however, that private equity is here to stay. All of the private equity firms CRN spoke with said they plan to look for further investments in the channel and continue to invest in their existing portfolio channel companies.
"I think it will continue to be an opportunity for investment in the future, just given the environment," Madison Dearborn Partners' Alsikafi said.
Adding to that interest is what martinwolf's Lembo predicted would be a "second wave" of investment, as private equity firms that already have bought into the channel look to expand their existing investments through acquisition.
The result, he said, is that private equity is not only here to stay, but will likely play a larger role in shaping the future of the channel going forward.
"It's clearly still on the rise," Lembo said. "We think this next year will continue the same trends."
Steven Burke contributed to this story.