Big, Brazen M&A

By, Erin Griffith, Fortune

PE vs. Corporate: If yesterday’s last-minute buyout of AppDynamics is any indication, 2017 could be less about the return of big IPOs and more about the continuation of big, brazen M&A. That’s bad news for IPO bankers, public market investors, the open marketplace (if consolidation means less competition), and reporters like me who want more transparency about how the so-called unicorn companies are performing.

But a rise in M&A is also bad news for private equity firms, a new study from PitchBook argues. Private equity firms are being “driven out of their own market” by corporate acquirers, according to PitchBook. Strategic buyers can justify high acquisition prices as long term strategic plays, where buyout firms need to be able to see the path to a profitable exit. I’ve heard rumblings of this issue at buyout shops – they’re priced out of auctions for the best assets, and they’re having to get more creative. The result is an increase in carve-out deals, add-on acquisitions, and more firms building their own businesses around assets like wireless towers or servicing mortgages. PitchBook notes that add-on acquisitions made up 57% of buyout activity last year, an increase of 8% from 2010. Nick Leopard, founder and CEO of private equity consulting firm Accordion Partners, says targets are especially hard to come by in the middle market. “Any middle market company probably fields a call a week from sponsors to see whether they’re interested in selling,” he says. But he views the phenomenon as a positive. “It’s good for the industry – instead of trying to buy something cheap, firms are now coming up with creative ways to deploy capital.”

Hmmmm: Millennials are apparently driving M&A, with 74% of executives surveyed by Ernst & Young taking millennial attitudes into account in their M&A decision making.

Not-so-secret sauce: Harvard Management Corp. will no longer manage its own $36 billion endowment; it will lay off around half of its 230-person staff. Writing for Fortune, Roger Lowenstein blames the change on too many universities copying the private equity investment strategy pioneered by David Swenson at Yale:

The problem … is a familiar one in investment annals: widespread adoption has bred a return to the mean. Swensen’s secret sauce consisted of diversifying into asset classes that were relatively uncommon and in which Yale, in particular, enjoyed unique advantages. Back in the 1980s, few endowments were involved in private equity, for example, so practitioners enjoyed a scarcity value. And thanks to Yale’s network of alumni and faculty connections, it could access the best PE firms, the best venture capital, and so forth.

In recent decades, endowments and other institutions have piled into PE, hedge funds, and the like. Results at elite institutions continue to outperform, but by a considerably smaller margin than before. Non-elite schools that adopted the Swensen approach had to shoulder an added burden: the average school, by definition, will merely own the average hedge fund, the average PE firm, etc.

And the numbers show it. The average university endowment has had a poorer record—over one year, three years, five years, and 10 years—than the average public pension fund, according to the Wilshire Trust Universe Comparison Service. And through the decade ended in 2015, (the last year for which such results are available) colleges also trailed a passive stock and bond index.

Lowenstein speculates this could lead to a “fresh round of soul-searching” among other endowments. For more on this phenomenon, read his December feature, ‘Why Colleges Are Getting a ‘C’ in Investing.’

Correction: The AppDynamics deal minted a great return for its venture investors, but Term Sheet’s sources got slightly carried away with their multiple math. As noted, Greylock’s investment in the company returned more than its entire $500 million fund. But the multiple was not a 100x return, as noted. Greylock invested $23 million and expects $590 million in the sale, giving the firm a return multiple closer to 25x. Apologies for the error.

Speaking of that deal: Jonathan Vanian has more analysis on what it means for Cisco here. Two things to note: One, there is nothing stopping the big cloud companies including Amazon / AWS, Google, and Microsoft, from creating their own “AppDynamics-killer” to compete with Cisco. Two, shares of the two publicly traded companies in the same category as AppDynamics, New Relic and Splunk, traded up yesterday. Read more.