Cloud vendors chasing cheap capital

Expect a flood of cheap capital (and investment bankers) coming to all kinds of tech companies. Some of this capital will go to funding acquisitions, but will cheap, abundant capital cause valuations of acquired firms to soar beyond fundamentals?
Written by Brian Sommer, Contributor on

Why on-premises vendors should be concerned: The math for growth and bigger software suites

Interest rates have been depressed for some time. Ask anyone who's refinanced a home or tried to earn anything with a money-market account. Corporations haven't missed this observation with mainstream businesses retiring older, expensive (ie, high interest rate) debt/bonds with much lower cost instruments.

The impact of lower-cost debt on businesses means that they can:

  • Fund more (and often less impactful) capital intensive programs cheaply: Projects that couldn't clear an internal hurdle rate previously can now get the green light. Low-cost debt makes marginal initiatives look real good re: their future impact on the bottom line.

  • Retire older, more expensive debt and see a marked reduction in interest expense: This lower interest expense has a direct impact on the bottom line, and causes earnings to increase. Higher earnings make a stock more desirable to investors and stock prices (and market value) increase accordingly. Higher earnings can also mean greater dividend payments to shareholders.

  • Take a more aggressive merger and acquisition posture: If you can get bondholders to accept a 1 percent interest rate while the company you acquire throws off a 10 percent ROI, you're basically making a 9 percent spread on every deal you can close. Cheap money is a big stimulator for M&A activity.

  • Repurchase previously issued shares: Some companies repurchase shares (ie, treasury shares) with the express purpose of driving up their stock price. Some do so to make shares available to management or employees for stock options.

  • Use borrowed money to pay shareholder dividends without repatriating offshore earnings: Firms with substantial offshore earnings hate to repatriate earnings to the US, as the taxes due on these earnings can often be a form factor higher than current debt interest rates. See this Wall Street Journal story of how Apple is using debt.

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In recent weeks, the following high tech firms have raised substantial amounts of debt financing:

  • NetSuite: In late May, NetSuite announced that it was raising $270 million in five-year term convertible securities. At maturity, holders may have the option to get cash and/or shares of NetSuite.

  • Workday: Workday is seeking to raise $530 million in convertible securities. Like NetSuite, some of these securities will mature in 2018, while others will mature in 2020. At maturity, the securities can be converted to Workday stock at prices that are currently at a premium to Workday's current stock price.

  • Cornerstone OnDemand: Cornerstone is raising $220 million dollars in convertible securities. Without sounding too repetitive, this debt is due in 2018.

  • Salesforce.com: Salesforce has raised $1 billion in convertible securities that are, you guessed it, due in 2018.

  • Concur: Concur will be acquiring $350 million in convertible securities with a 2018 due date.

Many of the securities above will pay interest between 0.5 percent and 1.5 percent annually.

In late 2012, SAP closed a $1.4 billion multi-faceted deal with several tranches. According to an SAP press release:

Due to SAP's excellent credit profile, the transaction received strong demand in the US private placement market. A group of 33 institutional investors participated in five tranches, 17 of which are new to the SAP credit. The transaction consists of a $242.5 million tranche with a five-year maturity, a $290 million tranche with an eight-year maturity, a $444.5 million tranche with a 10-year maturity, a $323 million tranche with a 12-year maturity, and a $100 million tranche with a 15-year maturity. The interest rates on the notes across all tranches range from 2.13 percent in the five-year tranche to 3.53 percent in the 15-year tranche. SAP's transaction represents one of the largest US private placements of notes of 2012 year to date, and the largest cross-border US private placement of notes ever.

Some of this debt is being earmarked to retire other SAP debt obligations.

These transactions amount to approximately $4 billion in capital. While each of these firms could use the money for many of the same reasons that other non-tech companies would, there are some distinct possibilities that I believe will get higher utilization. These include:

  • Funding hockey stick growth: SaaS/cloud vendors consume cash faster than it initially comes in. Their subscription pricing means more of the cash to be received is back loaded in deals. This is the opposite for older on-premises firms. That said, rapid, hockey stick growth is especially hard on a company's cash flow. Expect SaaS/cloud vendors to use cheap debt money to help them grab a disproportionate share of their markets. Less well-heeled competitors will suffer under this scenario.

  • Acquire their way to greatness: For older vendors who failed to create plenty of their own cloud applications, or for newer vendors who need to rapidly expand their product suite's footprint, acquisitions will deliver the fastest path to scale. The recent acquisition of ExactTarget (and more to come) is no fluke.

Bottom line

More of these equity deals will surely surface (like crabgrass in the summertime). And the availability of deeper cash war chests should embolden a new round of tech M&A. For another time, maybe I'll share with you which firms might be worthy targets.

We should also expect Wall Street bankers to descend on every tech firm pitching similar deals. If these, too, come to pass, there will be a lot of firms paying probably higher than warranted valuations for the companies they want to acquire. Great due diligence will be the order of the day.

On-premises vendors may be ones that should worry the most. The cost to stay relevant will get more expensive if a bidding war develops for newer cloud solutions. Also, cloud vendors that want hockey stick growth will now have the means to steal more on-premises customers away, and faster. This could be a really interesting phenomenon to watch.

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