Don’t Let Private Equity Make a Fool of You

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Where stock-market investors see digital disruption, buyout firms see opportunity. The cheap valuations of strategically challenged stocks are proving a draw to private equity firms. But the corporate prey are hardly soft targets: Traditional takeover premiums are — rightly — proving inadequate for some beaten-down shares.

The latest example is Temenos AG. U.S. buyout firm Thoma Bravo has approached the Swiss financial-software provider about a potential deal, Bloomberg News revealed last week. Prior to that, Temenos’s share price had almost halved since June amid fears the company’s core banking customers could defect to new rivals that rent software online.

Temenos is itself switching from a license model to multiyear subscriptions. The shift will reduce short-term cash flow as previous lump-sum sales will be spread out over time. Even bearish analysts agree with the strategy, and management has set out ambitious revenue-growth guidance. But the stock market sees upfront pain and won’t take a successful transformation on trust.

There are echoes here of Apollo Global Management’s recent failed attempt to acquire educational publisher Pearson Plc and Elliott Management Corp.’s March deal, in partnership with Brookfield Asset Management, to buy TV-ratings business Nielsen Holdings Plc. Temenos, Pearson and Nielsen were trading at the low end of their five-year valuation range when bidders pounced.

All can also service considerably higher borrowings that would help a buyout bidder fund a transaction. Such targets offer private equity the chance to nab an asset at a discount, reset the strategy away from the public glare and sell the spruced-up company a few years later.

But buying companies whose shares have fallen rapidly isn’t as easy as it sounds. For instance, a 30% takeover premium on Temenos’s undisturbed market price would imply an offer at 108 Swiss francs ($110) a share. The stock was trading above that level as recently as February, and such a bid would be well below the 12-month high. These benchmarks tend to matter in M&A: No one wants to sell below recent trading prices if they don’t have to.

Pearson rightly rejected a proposal from Apollo at a 36% premium (after adding a dividend), and just above the shares’ 12-month high. In their offer for Nielsen, Elliott and Brookfield are close to matching the stock’s recent peak. They are still being vigorously opposed by the top shareholder. That said, the premium crunches out at an unusually fat 60% and is good enough for the Nielsen board.

Apply the same top-up to Temenos’s undisturbed share price and an offer would be worth 134 Swiss francs per share. The full transaction value including including assumed net debt would be $11 billion, or $3.8 billion above its late-April market value (Temenos reports in dollars.) This could still be a tough sell since the shares were trading higher than that as recently as November. The valuation of 23 times this year’s earnings before interest, tax, depreciation and amortization would compare with a five-year trading average of 26 times.

A deal would need a sizable equity check — say $8 billion, assuming lenders provided debt up to around six times this year’s expected Ebitda. But growth might compensate for limited leverage. Some analysts forecast Temenos’s revenue could expand by around 75% from 2022 to 2027. Assuming profit margins hold firm, this then approaches a $20 billion business at the same earnings multiple.

What if an exit could be achieved at a higher valuation? Normally that’s a reckless assumption, but in transformation situations it may be more reasonable. Factor in some debt reduction, and it’s plausible that even with a large premium, a buyout could achieve the requisite doubling in equity value over around five years.

Of course, buying companies that need a drastic makeover isn’t risk-free. Private equity’s fee structure incentivizes firms to put money to work on deals, so it’s wrong to assume that the buyout industry is necessarily a lot better than the stock market at spotting bargains. But when private-equity firms go bottom fishing, the best insurance policy against seller’s remorse is to be shameless about demanding a takeover premium that would normally be seen as greedy.