Ok, first the disclaimer: I don’t watch a lot of television and I particularly don’t watch reality TV. If you’re looking for an analysis of the Alfresco transaction that is tightly aligned to the reality television show of the same name, you’ve come to the wrong place.
Yes, this post is about Alfresco and their recently announced acquisition by private equity investor, Thomas H. Lee. But, I also wanted to go a bit further and talk about the ongoing consolidation in the ECM market, the role of private equity investment and, in particular, what impact all of this has on these organizations and their customers.
So, let’s start with the “Flip or Flop” analogy. If you are unfamiliar with the American TV show, or with “flipping” real estate in general, here’s a 1-minute primer:
1. First, you find a distressed property, or one that is undervalued and needs some work.
2. Second, you do some remodeling to make the property more marketable. You update the kitchens and baths, redo the landscaping and maybe take out a wall or two along the way.
3. Next (and this part is optional, but very applicable in my analogy), you find some renters to occupy the property to generate some cash flow until you are ready to sell.
4. And, finally, when market conditions are right, you sell the property off at, ideally, a sizable profit.
Alfresco and Private Equity
Now, some of you might ask, how does this apply to private equity and the Alfresco acquisition?
To begin with, Alfresco is an undervalued property. They have a good brand and, up until recently, were viewed as an innovator in the ECM market. However, they’ve recently lost some of their early momentum; they’re struggling to maintain growth; and, if you believe some of the deal analysis, their investors and employees are looking to get their money out.
Along comes a private equity investor, Thomas H. Lee. They purchase Alfresco; but how do they get a return on their investment? Well, the first thing that a private equity firm looks for (particularly in technology) is a solid and sustainable revenue stream from maintenance. The second thing they look for is a company with low profitability that they believe they can operate more efficiently.
So, going back to the “flip or flop” analogy, what remodeling are they going to do? This part is simple – they are going to reduce operating costs wherever they can. Typically, this means they will cut sales, R&D, and in particular, marketing investment. In an ideal world, they will try to do this while maintaining revenues or even generating a little growth.
But, growth is not their first concern – nor is innovation. Reducing costs is.
And this is where their “rent” comes from. Typically, a private equity firm is looking to take a company from low, single-digit profitability to 30%+ profitability, primarily by reducing costs.
After a few years, particularly in good market conditions, the acquired company begins to look much more valuable. It’s stable, or perhaps even growing a bit. It is tremendously profitable. It probably has new leadership, good financials and a good story for how it is poised on the edge of explosive growth. It attracts new interest in the market and is sold for a considerable profit. And, this is where the analogy ends.
The acquired company is in much better shape, private equity has its money out, and everything is rosy, right?
What Happens to Alfresco and its Customers?
Well, maybe not. Let’s look a little closer at this from the perspective of Alfresco and its customers.
First, remember Alfresco is a company that lost its momentum in the ECM and Content Services segment and is already struggling to grow. Second, Alfresco is a company that has deservedly built its reputation around innovation.
So, how do you return to growth, how do you better compete in the market by taking cost out? How can you win more deals while you are reducing your sales capacity and marketing investment? They’ll be trying to “do more with less,” and new leadership can certainly inject some new energy and new ideas into an organization. But principally, are you going to attract top-tier sales and marketing talent to an organization that is designed for profitability? Maybe at the leadership level, but certainly not at an everyday operational level.
Further (and this is particularly important for Alfresco customers), how do you maintain an innovation agenda while you’re taking cost out of R&D? And, don’t kid yourself, you can’t get to solid, double-digit profitability without making cuts in R&D.
The simple and sad truth is that you can’t sustain innovation and cut costs at the same time.
Over time, what happens is that the pace of new releases falls off and the engineering team begins to focus more and more on sustaining activities – staying current with underlying technologies like browsers, databases and operating systems. As a result, existing customers suffer from the gradual (yet unavoidable) decline in innovation and, along the way, the product also becomes less competitive in the market.
Private Equity, Consolidation and the ECM Market
The point of my analogy (and this post) is not to single out Alfresco or to pick on Thomas H. Lee as their acquirer. As a longtime ECM advocate and a proud former FileNet and EMC (Documentum) employee, I’m actually saddened by the continued influx of private equity investment into this market as well as the ongoing market consolidation. In fact, some of the ECM consolidators actually behave more like private equity than the private equity companies.
More competition, not less, is always a good thing for an innovation-driven market. It fuels modernization and an influx of creative new approaches to age-old challenges, while giving customers more leverage from a purchasing perspective. So, as more and more private equity comes into the ECM and Content Services market, and as consolidators continue to gobble up competitors, what does this mean for the future of our segment? Well, as we’ve already discussed, the bad news is that innovation isn’t going to come from private equity or the market consolidators – they’re both too concerned realizing profits from their acquisitions.
But, the good news is that this consolidation also makes room for new market entrants and allows for new growth. We can see this by looking at the results and growth from Nuxeo as well as companies like Box, M-Files and other visionaries in the content services market. Notice also who the visionaries are in this Content Services market. These are companies investing heavily in innovation, shaping the future of this market, and who will ultimately become the next-generation market leaders.
So, if you’re investing in ECM, who would you rather buy from? The house “flipper” who put in some new appliances and slapped some paint on the walls? Or, the builder who wants to sell you an entirely new home, complete with the most modern conveniences? I know which one I would spend my time and money with.