It's duck hunting season but instead of ducks it's Duck Creek and instead of hunting it's private equity
Hello from baby-land. I’ve had the notes for this post doodled for a week now, but thanks to my little tot the words were delayed. Here’s to getting back into a better writing rhythm for the back-half of my parental leave. Thanks also to Liza for editing my little blogs before they go out so that they are readable. — Alex
Private equity seems like a scam. Not a scam in the sense of overpaying for a warranty, or buying insurance that doesn’t seem to actually cover any cost that crops up. No, a scam in that it doesn’t seem like it should be legal.
As a category, private equity (PE) actually encompasses venture capital. I don’t mean venture when I say scam. Instead, I’m referring to the debt-fueled sort of PE transaction that I think we are going to see more of this year in the technology market.
Such deals go a bit like this:
A group of folks raise a pile of money for their private equity fund.
They pick a target company, and buy it.
Instead of using their own money to buy the shop, however, they put in only some of their own capital, borrowing the rest.
Now here’s the brilliant bit: The debt raised to buy the target company doesn’t accrue to the private equity group, or fund. No, the acquired company gets saddled with the debt while the PE crew gets all the ownership.
Burdened with huge new debts, the company cuts staffing and other costs to the bone so that it can service its lending, and keep operating.
Later, presuming that the PE team has selected a target that they can either improve in financial terms either operationally or by the axe, the company can later be resold or taken public at a premium. In the latter case, the IPO can even help clear debts.
Why is that a scam? Because it’s a bout of aggressive financial engineering in which the human costs are utterly precluded from the calculations. Cost cutting in staffing terms does not merely mean trimming positions where there are clear redundancies; instead, work is shifted to fewer hands, and other folks are simply canned.
The result? Often mega returns for private equity teams, while targets can get hobbled, gutted, or taken apart for spares and spread around their industry like a plate of dropped charcuterie. Such deals are often a war on anything that makes a workplace kind.
Perhaps PE seems scammy — one vowel away from scummy — because it’s too clever by half. (Not all PE deals work out like this. Private equity groups are diverse, and the leveraged buyout [LBO] model doesn’t always apply.)
Anyway, keep in mind the above when we discuss this year’s tech exits, as it seems that we’re going to see more PE-style buyouts than traditional IPOs.
This brings us to Duck Creek!
What can we learn from Duck Creek’s $2.6B PE exit?
Lazily quoting my coverage from Duck Creek’s 2020 IPO, the company is a “Boston-based software company that serves the property and casualty (P&C) insurance market.” It initially targeted an IPO price range of $19 to $21 per share, wound up pricing at $27 per share, and then opened at around $42 per share.
If that’s a weird paragraph to read, that’s because we are very far today from the 2020-2021 era software highs that helped fuel a period of reckless investment.
Valued at $3.46 billion at its IPO price, Duck Creek started life as a public company worth around $5 billion thanks to its first-day pop, and later saw its value scale as high as ~$7.8 billion (YCharts data). The company’s value, already on the decline, fell sharply in late 2021 before settling into range that put its value at around the $1.6 billion mark this year.
Until private equity showed up. Offering $2.6 billion for Duck Creek, Vista Equity Partners is paying $19 per share for the company — a lot less than its IPO price, and far, far less than the company’s peak share price set back in 2021. Given how far valuations have shifted since the ebullient highs of the COVID-era, what should we make of the Duck Creek deal? Are the PE folks about to swoop a huge deal at discount prices and make out like bandits?
Not really. In fact, by some math the deal is actually a bit expensive. That fact makes the transaction far more interesting than it might otherwise be, shifting our question from how bad does the latest mega-PE deal in tech make peak valuations look to what does Duck Creek have that makes it worth a premium to present-day market prices?
The second question is more fun than the first as it’s somewhat actionable; if there is a clear signal from the Duck Creek deal, it may help founders and tech execs more generally steer their companies this year towards a better exit price, if that’s in the cards. To work!
Is Duck Creek extra special?
Parsing the value of a software company can be as tricky as you want it to be. There are shortcuts, of course. One way that we get a shorthand understanding at the value of a company is to compare its revenue to its worth. This is often expressed as a revenue multiple, or how many times the company’s value is greater than its top line. If a company put up $50 million in revenue last quarter, and had a valuation of $1 billion, it would be worth 5x its present-day annualized revenues ($200 million).
Another, similar method is to calculate value based on just recurring revenues, say ARR or similar. This is slightly more conservative as it makes the company appear more expensive; stripping out service revenues and other non-recurring items makes the company’s top line smaller, and its resulting multiple larger, and therefore appear more expensive.
Multiples get tossed around a lot as they are useful. Mostly we take benchmark numbers, and then compare individual companies to them, hoping to figure out why or why not a certain concern appears valued richly (a higher multiple) compared to the norm, or the other way around.
Back to Duck Creek. In its most recent quarter, the first of its fiscal year 2023 (or the three-month period ending November 30, 2022), the company posted the following revenue results:
Revenue: $80.6 million, up 10% on a year-over-year basis ($322.4 million annualized)
Subscription revenue at the company counted for $43.8 million of that total, up a far greater 23% compared to the year-ago period
Duck Creek’s annual recurring software revenue (ARR) reached $180.6 million as of the end of the quarter, up 24%.
There’s a lot in these numbers that’s useful. First, the company is not growing very quickly overall. That’s not good. But as its subscription (more durable) and ARR (more durable, higher margin) revenues are growing more quickly, and the company’s overall revenue mix is shifting away from lower-margin incomes, Duck Creek’s growth rate is really a little better than the headline number implies.
Investors, of course, want more durable, and high margin revenue from Duck Creek than low-margin service revenues; seeing ARR grow the quickest of three different revenue perspectives we took above is healthy.
Now let’s put all of that into multiples terms:
At its $2.6 billion exit price, the company’s annualized revenue run rate of $322.4 million gives it a revenue multiple of around 8.1x
At its $2.6 billion exit price, the company’s software ARR of $180.6 million gives it a recurring revenue multiple of 14.4x
The latter figure is more for fun, as Duck Creek’s non-recurring revenues are substantial enough as to be impossible to strip out from its valuation calculation. So where does that 8.1x number fall, compared to peers?
Per Altimeter’s Jamin Ball, low-growth software companies (<15% projected year-over-year growth) are worth a median of 2.8x their future (next-twelve months, or NTM) revenue today. Inside the same cohort of public software companies, those growing 15% to 30% in the next year are worth a median of 5.6x, and those growing more than 30% in the coming year are worth 9.2x.
Given that Duck Creek’s growth rate was 10% in its last quarter, 14% in the quarter preceding, and 7% and 22% in the quarters before that, it’s hard to say that it deserves the highest median multiple that we have in hand. Given that fact, the company’s exit price seems somewhat expensive.
That’s good for Duck Creek; if it appeared to be selling cheap, that would be bad. Companies like to have lots of value, especially if they are exiting to a single entity, as they can demand a premium compared to their current share price when they do so. Indeed, in the case of Duck Creek, the company is selling for “a 46% premium to Duck Creek’s closing stock price on January 6, 2023,” and “a premium of approximately 64% over the volume weighted average price of Duck Creek’s stock for the 30 days ending January 6, 2023,” per its own deal math.
If Duck Creek appears expensive when we consider its revenue multiple compared to current market norms, what gives? Are we just seeing a PE deal pay a fat premium on a company’s depressed share price — while still paying less than its IPO price of a few years ago, mind — to get the transaction done?
Nope, though that is certainly a factor in the price. I won’t drag you through the math I did on the company’s stated projections, analyst predictions, and trailing intra-revenue bucket growth rates. It was good fun but you don’t care. Here’s what’s really going on: Duck Creek is a cash-rich, modestly profitable company, making it a perfect candidate for PE takeover.
The stock market has decided that Duck Creek, with its slow overall growth rate, is just not worth what it once thought. In contrast, you and I can spy a very salubrious revenue mix shift afoot at the company, allowing us to anticipate that in time it will become more valuable as its overall revenue quality improves. Even more, as Duck Creek has both lots of cash and better-than-average profitability, it can likely better manage a huge debt load, making it a more attractive private equity target. Hence the PE-sale premium being so fat not only in terms of the company’s share price, but also compared to current market valuation norms.
How much cash and profit are we talking? Here’s the data:
Cash: “As of November 30, 2022, Duck Creek had $263.9 million in cash, cash equivalents and short-term investments and no debt.”
1QF23 GAAP net income: -$5.2 million (non-GAAP +$2.6 million)
1QF23 adjusted EBITDA: $3.2 million
Cash burn was also dramatically down from a year ago, with Duck Creek posting $5.9 million in operating cash burn in its most recent quarter, off from $24.6 million in the year-ago period.
Summing, Duck Creek had plenty of cash to keep financing its own growth, very modest GAAP losses, and minor non-GAAP profits to boot in its latest quarterly report. That means it can probably take on a lot of debt and not drown. And, as private equity can afford to hold the company while it converts legacy revenues to recurring revenues, the company might get sold later for a nice premium on its exit price. Hell, if the market for tech valuations improves over the same time period it could cough up a mint for its new owners.
If we are going to see more exits to PE this year than via IPO, then we care more about how tech companies appear to the private equity buying cohort than to the stock market per se. So, while the stock market was bored with Duck Creek’s modest profits and slow growth rate, for PE the company was likely far more attractive. Hence the premium it wound up snagging compared to market norms.
There are other things we could consider. In its most recent earnings call, the company announced that it had purchased a company called Imburse that might bring more fintech flavor to Duck Creek. And in the same call the company expressed pretty good confidence about its market. Those could bear good in time.
But for our needs, the Duck Creek deal is not merely an indictment of how wacky valuations got in 2020 and 2021, but more a signal that limited cash burn and perhaps even break-even-ish profitability will have an outsize impact on exit suitability — and price! — in 2023.
Unicorns will therefore face a choice between spending to keep growth up in hopes of raising more venture dollars, and slowing spending at the cost of revenue growth to reduce red ink and hope for a winsome PE deal. I doubt that private tech companies will be able to straddle the question well, meaning that it’s deciding time.
2023 is going to be interesting as all hell.
The featured image on this post is an excerpt from a piece of Pawel Czerwinski work, whom I wish to thank.