A rash of transactions in the financial technology industry in the past several months likely will have an impact over the next few years.
The private-equity company Kohlberg Kravis Roberts & Co. acquired First Data Corp., Fidelity National Information Services Inc. bought eFunds Corp., Fiserv Inc. announced a deal to buy CheckFree Corp., and Metavante Corp. revealed plans to spin off from Marshall & Ilsley Corp. However, the ability for private-equity companies to generate financing for highly leveraged transactions in the future may have been reduced.
We believe consolidators will continue to make acquisitions, but since their balance sheets are more leveraged than they have been historically — Fiserv, Fidelity, and Metavante would each have about $2 billion to $5 billion of debt when the deals close — it will be harder for some companies to participate in transactions.
With buyers in a less aggressive mood, sellers may accept lower valuations than they have in recent months — a good situation for those with financial capacity. For example, Jack Henry & Associates Inc. used its net cash position to buy AudioTel Corp. of Addison, Tex. Though the pace of mergers and acquisitions may slow, we acknowledge that the consolidators generate significant cash flows — we expect over $500 million from both Fiserv and Fidelity in 2008 — and could use this money for deals if valuations become increasingly attractive.
M&A activity has been one constant in the ever-changing financial technology landscape over the last few years. We expect the trend to continue, given the technology's attractive investment characteristics. (And keep in mind that every time a small firm is acquired, there's an entrepreneur who's likely launching another little company that could become part of one of the giants one day.)
Through acquisitions, we have seen buyers attempt to add scale, to expand offerings, and, in some cases (such as with private equity), simply to capitalize on the strong, stable cash flows inherent in financial technology.
However, we could see a slowdown in dealmaking over the next several quarters, as some consolidators have reduced capacity. In addition, the debt market has dried up somewhat for highly leveraged private-equity takeovers, as banks are avoiding the credit risk.
Several financial technology consolidators have had great success. For example, Fiserv has made at least 81 acquisitions over the past 10 years and has shown strong earnings growth since its founding in the mid-1970s. Fidelity has grown over the past several years through the acquisition of a handful of core processors and has shown solid growth and strong margins. Jack Henry has made 29 acquisitions over the past 10 years and has performed very well. Its stock is worth about 300 times what it was when the company was launched in 1990. Metavante has made a number of acquisitions in core processing.
In many industries, this strategy means many bumps along the road, such as lost clients and revenue and the costs of integration and management changes. In the financial technology industry, integrations may not be simple, but acquisitions often have been accretive to revenue and earnings growth. The core processors have added significant value for shareholders.
Financial buyers also have been active.
The First Data acquisition was a high-profile example of private-equity buying within the financial industry. Two important reasons for the acquisition were undoubtedly the strong growth and stable cash flows of card processing. Such buyers also benefit from the sellers' networks of possible management candidates, offshore resources, and potential for strategic partnerships.
Their goal is generally to monetize the investment within one to ten years. (Five to eight years is standard.) Investors generally expect returns above the S&P 500, given the illiquid nature of the investment.
Financial technology companies operate in normally stable growth conditions, somewhat insulated from economic cyclicality.
For example, core processors benefit from bank asset growth, which has been 3% to 12% during the past 20 years. Card processors are paid according to transaction volume, which generally has grown 3% to 8% over the past several years, in part because of the ongoing shift toward electronic payments.
Stable growth is a favorable characteristic for acquirers, given the reduced risk of a dramatic fall in revenue after an acquisition.
Strategic buyers also benefit from the potential for high incremental margin revenue from cross-selling.
A particular technology may be expensive to develop, but once it is completed, upkeep costs may be limited. Thereafter, each additional revenue dollar can generate a significant margin. For example, we believe the pending acquisition of CheckFree should allow Fiserv to sell online bill-payment services to many of its current clients at high margins, since CheckFree's platform is already well developed.
Cutting costs is another key consideration. We have seen acquisitions where 10% or more of a company's cost structure was expected to be removed over time. In some situations, costs for the executive team, other employees, certain facilities, and the sales force can be eliminated.
The high barriers for entering the financial technology industry create a ripe environment for acquisitions, because it may be easier to buy a product than to create one, and a purchased asset may be difficult for competitors to replicate.
During the past several years most financial technology companies have been sold for around 5 to 15 times expected earnings over the 12 months after an acquisition before interest, taxes, depreciation, and amortization — a wide range. Many ask why EBITDA is the most widely used metric, as opposed to multiples of earnings or free cash flow. We believe the formula is used for a few reasons.
First, interest is added back to earnings, since the buyer's debt structure is likely much different than the seller's. Second, taxes are added back, since the buyer may have a different tax rate than the seller, and with a new capital structure, the existing tax payments become less relevant.
Third, depreciation and amortization are not a cash expense, and buyers generally care more about cash flows than reported income. In a new debt structure, the cash outflow associated with such expenses may be reduced, meaning they are no longer a good gauge for the real cash outflow. (Financial buyers may underinvest to harvest cash flows; strategic buyers may not need to invest as heavily, given synergies with their core products).
The difference in the multiples paid is generally a result of two key components: growth and risk.
In recent years publicly traded payment companies, such as First Data, Digital Insight Corp., and CheckFree, often have been sold for 12 to 16 times EBITDA, since investors generally expect strong growth from the shift to electronic payments and reasonably low risk because of consistent spending growth.
Publicly traded companies such as Certegy Inc., SunGard Data Systems Inc., and Open Solutions Inc., have been sold for around 10 times EBITDA, because investors expect stable growth with limited risk.
Sales of private companies have the widest range of prices (often 5 to 8 times EBITDA for stable, slower-growth situations, but 10 to 25 times for aggressive growth situations).
Investors often perceive private companies as riskier investments than public companies, given their smaller scale and the dearth of information on them, yet they provide the greatest growth potential.