BDO Studies reveal where PE and tech CFOs agree, and disagree, on 2020 - and potential M&A

Private equity firms’ interest in technology companies remains strong. Pitchbook data shows that there were 1,616 PE-tech deals in 2018, worth a combined $223.2 billion. In BDO’s inaugural U.S. Private Capital Outlook, PE professionals point to technology as the sector most likely to see increased deal activity in 2020.

The interest is mutual. The new BDO 2020 Technology CFO Survey reveals that four times more tech CFOs are looking toward PE investment than toward pursuing an IPO.

However, PEs and CFOs’ expectations of what the coming years may hold diverge. A fact that may impact reciprocal expectations during M&A negotiations, as well as post-investment collaboration. Misalignments between the parties can have dire consequences – especially for the CFOs. The recent BDO survey of U.S. PE professionals shows that three-quarters of PE investors will look to replace CFOs who fail to see the importance of their role in driving value within the scope of a holding period. CFOs will be expected to deliver results almost immediately, with up to half of PE investors replacing a CFO within 18 months of investment.

Simultaneously, the technology CFO role is changing – both in the eyes of the CFOs and of PE investors. Oversimplified, gone are the days when a CFO was mainly tasked with ‘number crunching’ and quarterly reports. Modern CFOs are in the vanguard of driving technological change and optimising company value through increased digitisation and navigating a constantly changing business landscape.

Economic downturn waiting in the wings
One area where the two agree is that an economic downturn may be looming on the horizon. Almost three quarters (72%) of PE professionals surveyed expect to see an economic downturn within two years. It is virtually identical to the number of tech CFOs (70%) forecast a recession in the next one to two years.

Both parties view technology as somewhat resistant to a downturn with 54% of PEs pointing to the sector as most likely to experience increasing deal activity in the year ahead. Again, it corresponds with technology CFOs, who expect to see more M&A activity (60%) and more PE investment (58%).

In spite of a looming downturn, CFOs remain upbeat about their businesses’ potential, with 84% saying that their business is thriving. 91% expect to see company revenues increase and 89% forecast profitability increases in 2020. Companies across all industries need to continue their digital transformation, which might be why tech CFOs are optimistic about revenues. In other words, they see their industry as more resistant to an economic downswing than cyclical industries, such as durable goods manufacturers.  An ongoing trend in the technology sector where companies, as well as their financial backers, are increasingly focused on profitability and sustainable business growth and veering away from high burn rates may be contributing toward the expectations for increases in profitability.

PE taking stock and refocusing

PE investors and CFOs may have differing views on the likely effect of a downturn on revenues. One indication is a marked shift in how PE firms plan to deploy their capital during 2020. 28% of BDO survey respondents indicate that they plan to put much of their available funds into working capital for portfolio companies, up from 1% a year ago. Half of firms expect most of their money to wind up in new deals, down from 89% last year. Furthermore, many PE firms are considering – or have already launched – long-hold funds. All are indications that PEs may view the looming downturn as a reason to postpone investments in new companies and possibly prolong holding periods.

Many PEs may see the potential downturn as an opportunity to take stock of their current positions and tweaking financial modelling to factor in detailed downturn scenarios. Furthermore, they may be turning toward more defensive investment strategies and refocusing resources towards growing and futureproofing existing portfolio companies.

However, PEs are currently sitting on huge amounts of dry powder. For example, U.S. PE Funds have raised the largest amount of capital on record during 2019.  As a result, deal interest, as well as asset prices and valuations, continues to be high – especially in areas where PEs and VCs see huge future upsides.

Tech, Asia and distressed companies proving popular

A third of U.S. PE deals during 2019 involved technology companies. Artificial intelligence (AI), Internet of Things (IoT), robotics, and extended reality (AR, VR and mixed reality) are among the subindustry spaces seeing strongest interest. The same can be said for Software-as-a-Service (SaaS) companies, whose recurring revenue models help make them attractive targets. Company finding ways of deploying such technologies, and business models, will be well-placed to secure investments or positioning themselves for sale.

Both PEs and VCs are following developments in Asia (outside of China) and Southeast Asia with great interest. PEs identify these geographic regions, along with North America, as presenting the greatest opportunities for new investments. Investments in distressed businesses are among the top deal drivers for PEs for 2020, up from one percent of PE respondents in 2018 to 40% of respondents in 2019. While the current number of distressed opportunities remains low, fund managers seem to be anticipating a rise in numbers in the near future, if a downturn materialises.

New potential challenges for CFOs
Some technology companies may find themselves showing signs of distress in the advent of an economic downturn. In such cases, PE investors will be looking to understand the reasons why the company is distressed, as well as why the current CFO and financial team are the best people to increase company value.

Detailed forecasts and analysis of an economic downturns’ impact on business profitability, why a company is distressed, and expectations should be discussed during the early stages of a potential deal. Otherwise, CFOs risk appearing overly confident and underprepared in the eyes of PE investors, lowering trust even before a deal is finalised. The same extends to granular forecasting of how the technology assets and intellectual property that many CFOs (39% of all those surveyed) identify as the top factor influencing deals this year help futureproof revenues in a potentially more challenging market.

The high value placed on innovation tracks with where tech CFOs are investing their resources: 66% will increase R&D spending this year to help enhance their competitive positioning and market value. There is some overlap with PEs in this regard. However, PEs (100% of those surveyed see it as either very or moderately important to their investment decisions) are likely more focused on companies’ long-term digital potential. A company’s digital potential includes analysis of potential bottom-line and top-line growth that can be realised through digitization and digitalization strategies.

How CFOs and PE investor can align expectations

Both PEs and CFOs are growth-focused, but PEs tend to emphasise aggressive mid-term (traditionally three to five years) growth. As a result, realising digital potential is an area that PEs will likely expect a CFO to devote time and energy toward after a deal is completed. The timeline for such projects may be shorter than CFOs would otherwise be considering.

PE investment may also lead to changes in strategy and reporting. PEs are looking for CFOs of their portfolio companies to drive the implementation of systems and processes that ensure that a company reaches the next stage. Beyond traditional focus areas such as finance, CFOs may also be tasked to oversee parts of IT, legal, HR, and supply chain optimisation, as well as function as a crucial link between the company and the PE. For example, in relation to communicating financial results, addressing capital structure issues or discussing further bolt-on M&A opportunities.

CFOs will perhaps be surprised by the granularity of and cadence of financial reporting that PEs often require. For example, when it comes to FP&A, EBITDA bridges, cash flow projections, etc.

Thankfully, a range of new technologies can be implemented to help increase efficiency and ease communication with financial backers. For example, dynamic reporting tools that include visual, interactive aspects (for example the use of Tableau and Microsoft Power BI), Robotic Process Automation and the use of predictive technologies like AI and Big Data.

All of the above can be influenced by an economic downturn – and misalignments of expectations between the parties. While a company – or individual CFO – may be capable of handling the integration of new technologies, realising digital potential, or handling M&A internally, it will far from always produce the best results. Collaborating with specialist firms not only eases the process but can help align expectations between purchasers and vendors already before a deal is signed.