Private Equity Investing in Cloud Computing and Managed IT Services
- Apr 12, 2023
In this episode of Private Equity Dealbook, Elana Margulies-Snyderman, Director, Publications, speaks with Sean Frank, CIO and Founder of Cloud Equity Group, a private equity firm that invests in, acquires or lends funds to startup, emerging, established or distressed companies in the cloud computing and managed IT services space. Sean shares his outlook for investing in those sectors, how if at all higher interest rates and the strong U.S. dollar has impacted the firm’s ability to finance leveraged equity investments in and bolt-on acquisitions for portfolio companies, how the economy impacted the financial and operating performance of the portfolio companies and more.
Elana Marguillies-Snyderman:Hello and welcome to EisnerAmper's Private Equity Dealbook podcast series. I'm your host, Elana Margulies-Snyderman, and with me today is Sean Frank, CIO and founder of Cloud Equity Group, a private equity firm that invests in, acquires, or lends funds to start up, emerging, established or distressed companies that operate in the Cloud computing and managed IT services space. Sean will share his outlook for investing in those sectors. How, if at all, higher interest rates and the strong US dollar have impacted the firm's ability to finance leveraged equity investments, and in bolt on acquisitions for portfolio companies, and how the economy has impacted the financial and operating performance of the portfolio companies. In addition, he will share how the PE community is approaching due diligence in the current economic environment, and finally he will give recommendations and planning opportunities for companies considering a potential exit transaction. Hi Sean, to kick off the conversation, can you give us an overview of Cloud Equity Group's differentiated investment strategy to invest in, acquire or lend funds to startup, emerging, established or distressed companies that operate in the Cloud computing and managed IT services space?
Sean Frank:Hi Elana, thank you for having me. Cloud Equity Group is a specialized asset management firm focused on tech-enabled business service providers on the lower end of the lower middle market. We primarily target strong businesses where we can be the first institutional capital into the company and really the conduit to transition it from being a small business into an institutionalized and investible company. Our primary business is traditional private equity, whereby we'll buy a controlling equity of the business typically from the original founders. However, we also have a minority equity slash direct lending business as well. This really allows us to provide just about any capital solution to a small and medium sized business. In our minority equity or direct lending business, we look to be a strategic partner and to help add value beyond just providing capital. Similar to what we do on the equity side so that we could really help the businesses to scale. We really do look at ourselves as a strategic capital provider, irrespective of the type of capital that we are providing.
Great. Sean, as a follow-up question, with everything going on in this economy, higher interest rates, an anticipated recession, inflation, supply chain issues, the war, many more, where does your firm see investment opportunities that generate an acceptable risk rate of return model consistent with your operating guidelines and required limited partner returns?
SF:I mean, look, we are not market timers, and so we have a fiduciary duty to deliver returns to our limited partners irrespective of what's going on in the economy. I think that we've probably seen a slowdown in M&A in the last 12 months, but I don't necessarily think it's because investors are leaving the space, but more so because there's a spread in valuation expectation between sellers that are expecting late 2021 valuation, and buyers who are taking these challenges into consideration in their valuation analysis.
I also think that buyers are performing more scrupulous due diligence to really understand things like how the expense of the business may change in an inflationary environment, what logistical risks may exist given supply chain issues, how much of the recent organic growth is just inflationary growth? The list goes on. Things that may have not been much of a concern for buyers a few years ago may lead to price adjustments or even deals falling apart in today's market. That all being said, I still think there are great investment opportunities out there, particularly among sellers that are motivated to sell. For us being in a market segment where we're often competing against not other institutional investors, but most often against founder run businesses that might rely on SBA loans or other forms of bank financing to do a deal, we've seen a decline in competitions on the deals that we are doing as banks pull back on their lending, and that's really allowed us to make some great value investments over the past year.
EMS:Sean, I'd love to talk about higher interest rates and the strong US dollar, how those have impacted your firm's ability to finance, leverage equity investments in and bolt on acquisitions for your portfolio companies?
SF:Fortunately for us, our investment funds utilize committed acquisition facilities from senior lenders, and so we don't need to try and go raise debt capital for each deal that we do. We, like most buyout firms, have very long-standing relationships with lenders of all sorts, and so it's easy for us to continue to perform and deploy capital, despite the current environment. At the end of the day, most lenders are still looking to earn return on their capital as well, despite the current macroeconomic challenges. Credit has definitely tightened in the past year and spreads have obviously widened. However, the debt capital markets are still very much active in supporting ongoing M&A.
EMS:And what about the economy? How has that impacted both the financial and operating performance of your portfolio companies, along with your approach to managing and further investing in such companies?
SF:Yeah, so we are actually fortunate in that we invest in industries that tend to do well in inflationary environments. So the past year has actually been a positive one for us from a portfolio company performance perspective. The types of tech enabled business service providers that we invest in are all B2B, where clients are contracted and those contractors have price escalators built in that are tied to the CPI. On the flip side, we can only attribute about 30% to 40% of our cost centers as having negative exposure with inflation. This means that in an inflationary environment, we see effectively a hundred percent of our revenues increase, but only about 30% to 40% of our cost centers increase. In other words, we've actually seen improvement in margins in the past year on the types of businesses that we invest in.
EMS:That's great news to hear Sean. On the next topic, I want to talk about due diligence and how is the private equity community approaching financial, operational, commercial, technology and legal due diligence given the current economic climate?
SF:Sure. So look, despite what I said in your last question, the current state of the economy does present challenges. As it relates to due diligence, I'd say the impact is that private equity investors tend to perform a much more stringent due diligence process today than maybe what they did a few years ago, particularly with respect to financial and operational due diligence. Things that may have been overlooked in previous years or less important in previous years, tend to get much more attention now. For example, understanding the revenue drivers of a business and how much of a business' growth is truly organic versus how much is just inflationary growth is a very important thing to understand. Similarly, cost centers, which are expected to rise in an inflationary environment and how much of those can be passed onto the consumer, versus what's just going to be impactful to the bottom line is another really important thing.
Operationally, understanding where inventory is being procured and the risk given current supply chain issues, all things that may have been less prevalent in previous years are much more important for private equity to focus on now. I mentioned before that private equity investors still have an obligation to deliver returns even in the down cycle, and so all that really means is that with respect to evaluating new investment opportunities, we really just need to put increased scrutiny on the evaluation process and in selecting opportunities that we feel confident can still perform, even given the current economic environment.
EMS:Sean, as a follow up question, what key recommendations and planning opportunities do you have for companies that are considering an exit?
SF:I've actually been asked this question a lot lately. There's a saying in banking that goes, the best time to know a banker is when you don't actually need any money. And I think that the same thing can be said about exit planning. The best time to meet acquirers and have a conversation about the things that they look for in a target, where they place value, how they come up with an exit multiple, is really before you're even on the market for an exit. And having these conversations early, you can really get valuable information as to what investment groups are looking for, so you have some runway and we can really focus on these themes in advance of going to market. It goes without saying that advanced planning will maximize your likelihood of the highest valuation upon exit.
EMS:Sean, we've covered a lot of ground today and I wanted to see if there are any final thoughts you would like to share with us?
SF:Sure. I would just say that despite all the negative aspects surrounding today's economy, capital markets are still very active and institutions like ours continue to deploy capital. So if you're a business owner looking to raise capital for some liquidity, or even to completely exit your business, you can still do so. I would just encourage you to plan ahead and probably allow some additional time to run the process compared to what you may have needed a couple years back. But there are still plenty of groups like ours still looking for great companies to invest in today.
EMS:Well Sean, I wanted to thank you so much for sharing your perspective with our listeners.
SF:Sure Elana, thanks for having me,
EMS:And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.
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Elana Margulies-Snyderman is an investment industry reporter and writer who develops articles, opinion pieces and original research designed to help illuminate the most challenging issues confronting fund managers and executives.
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