Legacy Systems: Vendor Consolidation a Catalyst to Obsolescence (By Dan St. Onge, Eagle Investment Systems)
Vendor M&A typically comes with promises of synergies and added value, though recent history suggests it can also shorten the runway that leads to a legacy system
Over the past 30 months, technology-focused investment bank Hampleton Partners has tallied 596 acquisitions in the financial technology sector, with 75% of the activity involving either enterprise software or enterprise services companies. Parallel to the escalating deal volume has been a significant bump in valuations, as the median purchase multiple has grown from 12x EBITDA in 2013 to 15x EBITDA last year. While many in the industry may be inclined to celebrate this activity as a coming of age for financial technology, for clients – when their vendor is acquired – it’s often a signal that their relationship is about to undergo an abrupt and significant change.
Consider, for instance, the announced retirement of the Barclays POINT risk analytics platform. Barclays sold the platform in December, and soon after Barclays POINT users were informed the new buyer was only interested in the IP and would be shuttering the POINT platform within 18 months. According to a Citisoft survey, 80% of users now plan to initiate a process to find a new vendor.
Of course, this is an extreme example of what can happen when a vendor is acquired. It’s more often the case, particularly as purchase prices climb, that buyers pursue a far more passive “sunsetting” strategy. At a high level, this may take the form of an acquisition in which the new owner effectively “orphans” the acquired product set through lack of attention, lack of resources and minimal, if any, investment back into the solution set. The new owners may assert nothing has changed, but in an era in which relationships are critical to a vendor’s value proposition, it often becomes apparent the acquired platforms are no longer a priority.
“One of the biggest mistakes we’ll see is when companies fail to look hard enough at the viability and strength of the vendor,” Tom Secaur, COO of Citisoft, said at a recent Eagle Summit. “A byproduct of a vendor being sold is that clients may be forced to shop for a new platform because they have no other choice…For those on the client side, you might undertake these kinds of projects every fifteen years — or once, maybe, twice, in a career — so it’s paramount that you’re thorough in your due diligence.”
In many ways, the consolidation spree kicked off a decade ago, during the height of the private equity boom. It continues on today as evidenced by the rising M&A volume and surging purchase price multiples, which is why this analysis is so critical.
A likely starting point for due diligence resides on the balance sheet, at least for those companies that publicly disclose their financials. If the annual debt service exceeds the R&D commitment, that should be an immediate red flag. This is particularly true for companies that pursue rollups, absent any true integration strategy, and are faced with hard decisions around which assets to prioritize in a given year.
Even without public disclosures, obvious giveaways to a sale might be found in the vendor strategy. If they haven’t articulated a plan for the cloud, for instance, or shown that they’ve considered a managed service offering, these omissions should suggest at a minimum that they’re not thinking about the long-term.
There may also be a number of other telltale signs. For instance, if a vendor is owned by a private equity firm, most buyout shops will seek an exit within roughly five years of their original investment. If they’ve had the same PE-owner for seven years or longer, a sale could probably be considered imminent. Publicly held companies, meanwhile, will typically disclose when they hire an advisor for a potential sale. Even before that point, however, those in the market for a new system will want to be aware of softening sales and margin trends, particularly over an extended period of time. Also worthy of note, a run of defections at senior posts within HR, marketing or other areas often rolled into the M&A “synergy equation” can also foreshadow a sale.
The biggest threat to clients following the sale of their vendor isn’t necessarily an abrupt decision to retire the acquired assets; the biggest worry should be that the buyers view the assets as a cash cow to be bled dry with minimal, if any, reinvestment back into the product set. This is how a “best-in-class” platform can effectively turn into a “zombie” system overnight, whose revenue merely funds future acquisitions versus subsidizing the necessary R&D to remain relevant.
In a previous Eagle blog post, we highlighted the risks that come with operating a legacy platform, which range from operational inefficiencies to enterprise risk. And beyond just impacting the value proposition, clients often struggle to update these so-called zombie platforms, and many have wasted millions of dollars trying. There are also potential ramifications from system outages or security lapses, which become more common as a legacy system becomes the weak link in the data chain.
The opportunity costs, meanwhile, stem from an inability to grow assets under management or introduce new products. These opportunity costs can also be reflected by the shortcomings facing front-office executives or portfolio managers who can’t leverage, or even trust, their data to guide decision making or strategies.
While consolidation can help drive costs down, it’s too often the case that it’s a catalyst for obsolescence. And if any organization is going to spend 12 to 18 months standing up a new system, not to mention the significant monetary costs involved, they will want to make every possible effort to ensure their vendor is as stable as the platform they plan to install.
Dan St. Onge is Chief Operating Officer at Eagle Investment Systems