Growth Capital vs. Venture Capital

In 2006, when we began speaking about a growth capital fund in Israel, people had no idea what we meant. Invariably the response was, "Like a VC Fund, right?" Wrong.

What we, and other growth funds like us, target are:

• Already successful businesses which can be made more successful;
• Management teams building real businesses and focused on old fashioned things like profit and loss; and
• Businesses for whom technology is a barrier to entry, not an way to create a new market.

Five years later the Israeli market now understands what we've been talking about. We see a steady stream of companies for whom growth capital is the right fit. And the VC-style companies tend to stay away.

The growth capital market is still in an expansion phase. But it isn't a huge market, and we don't expect it to become huge. VC will remain the predominant private funding market in Israel - and I expect that market to heal itself through a combination of reduced capital supply and a trend from consumer tech back to enterprise tech. But the growth market is a great niche market and an important addition to the private funding landscape in Israel.

Dodgy going ons in Italy!

Very very interesting. Indeed. Something smells rather fishy here. Earlier today Italy sold €5 billion in 1 year Bills at an average yield of 6.087%, the highest since September 1997, and almost 3% higher compared to a month ago, when it prices at 3.570%. However, what really catches the eye, is the fact that just before the auction, the 1 year was trading at a huge 7.75%, almost 200 bps ABOVE the auction. Who is prepared to receive a 6.09% yield in a new auction when they can receive a juicy 7.75% in the secondary market? Unless someone (read ECB) had alternative interests in forcing the yield lower. Now that certainly would be interesting, as the ECB is prohibited by law from intervening in the primary, auction market.

Once the Euphoria wears off.....................

Some initial thoughts from last weeks European party:

• 50% proposed haircut that the headlines were full of, actually closer to 16%. Why? Greek debt approximately EUR 350b. Of which approx. EUR 150b held by Greek and European central bank, which is not subject to any restructuring. Leaving us with about EUR 200b. Greek banks and pension funds own about EUR 85b. This is contentious and debatable, but if they take a 50% haircut, they will essentially be bust. Hence, they may well be absolved too. That leaves EUR 115b that will "voluntarily" take the haircut. 50% of which, is EUR 57.5b, or 16%.
• The initial reaction was euphoria, with PIGS bonds falling drastically. But once the euphoria wore off, Spanish and Italian bonds made a quick u turn, and are back to the levels they were trading at pre-announcement, dangerously close to the 6% level where other countries have required help. Why? Because EFSF doesn’t take a default off the table. It delays the time until default, by rolling maturities, but all it really does is shift who takes the loss. And Italy and Spain are too big for ANYONE to take the loss.
• The EFSF is leveraging EUR 440b 4 or 5 times, just 3 weeks after Merkel promised the Germans that it would not be leveraged. The leverage would use the EFSF AAA credit rating to enhance new debt and set up Special Purpose Investment vehicles to obtain the leverage. I.e. more of the problems of the 2007/08 credit crises.
• How does the leverage work? EFSF is like an empty box filled with promises of money- many of them from the very people who are most likely to need to borrow that same money. So should they need to borrow the money. They won't be able to fulfill their promise, so there will be less money for them to borrow. And then they've decided to leverage these empty promises of nothing.
• Who is going to buy into the new leveraged EFSF fund? Sarkozy seemed to imply if China WANTED to contribute, then Europe would probably be open to allowing them. However, Chinese Prime Minister said "Countries must put their own houses in order". A member of the Chinese central bank went on to say "It is in China's long term and intrinsic interest to help Europe because they are our biggest trading partner, but the chief concern is how to explain this decision to the Chinese people. The last thing China wants is to throw away the country's wealth and be seen as source of dumb money". China is extremely likely to invest in the EFSF, but on terms that are favorable to China.
• This was no solution. It’s a plaster for a long term problem. Don’t forget that at the last stress test, Europe's strongest bank was Dexia ……
• Also, the fact that these private investors were forced to take a voluntary haircut to the tune of 50%, does not create a credit event. I can't imagine the big banks who hold CDS's will take that lightly.
• And further, who is going to want to buy sovereign bonds now? At least beforehand, I can buy protections in the form of CDS's. Now that CDS's have been deemed worthless, why should I buy these EFSF bonds? Who is going to buy these bonds? Someone has to, otherwise Europe will blow up. And best case scenario, is that there are buyers, but too few of them, hence an - oversupply, a low price, rising yields ...... problem sounds familiar?

BusinessWeek: Israel Punches Above Weight as GDP Beats Developed World

Normally, we have our own proprietary articles, but I thought this time it is worth it to just post the following BusinessWeek article:
http://news.businessweek.com/article.asp?documentKey=1376-LRW4M01A1I4J01-2QDQJL3HHA3827O7MR2OENNQ8E

Sept. 22 (Bloomberg) -- Never mind the collapse in confidence in Europe, the Palestinian proposal for United Nations recognition and heightened tensions with neighboring Egypt and longtime ally Turkey. The Israeli economy just keeps growing faster than the rest of the developed world.

The International Monetary Fund this week raised its forecast for the country and cut its estimate for the global economy on the impact of the European debt crisis. Israel's gross domestic product will expand 4.8 percent this year, according to the Washington-based lender. That's up from an April forecast of 3.8 percent and triple the pace for the average of the 34 advanced economies.

Citigroup Inc. said on Sept. 18 it would establish a new Israeli research center and Standard & Poor's a week earlier raised the country's credit rating. It cited the discovery of two gas fields off the coast of Israel that hold an estimated 25 trillion cubic feet of the fuel. Mellanox Technologies Ltd., the 12-year-old Israeli adapter maker part-owned by Oracle Corp., says sales will grow 80 percent in the third quarter.

“The Israeli economy is very vibrant,” Finance Minister Yuval Steinitz said in a Sept. 20 interview with Bloomberg Television. “We enjoy very low unemployment and nice economic growth and this is mainly because we managed to develop very advanced high tech industries and very strong exports.”

Technology Capital

The stock market in Israel, whose population of 7.8 million is similar to Switzerland's, was upgraded to developed-market status by MSCI Inc. in May 2010, the same month the 63-year-old country was accepted into the Paris-based Organization for Economic Cooperation and Development. The country has about 60 companies traded on the Nasdaq Stock Market, the most of any nation outside North America after China and is also home to the largest number of startup companies per capita in the world.

Israel ranks third in terms of projected growth this year among MSCI's list of 24 developed economies, after 6 percent for Hong Kong and 5.3 percent for Singapore, according to the IMF.

“Israel's exports are high-added value exports like informatics and technology,” said Jean-Dominique Butikofer, a fund manager who helps oversee about $1 billion of emerging- market debt at Union Bancaire Privee in Zurich, including quasi- sovereign Israeli bonds. “They're not exporting Gucci bags. If there's a slowdown, these are the kind of assets that are good to have.”

Talent Pool

Venture-capital backed Israeli technology companies raised $364 million in the second quarter of this year, a 77 percent jump from the $206 million raised in the year-earlier period, according to PricewaterhouseCoopers LLP Moneytree report. Seventy-six companies raised funding in the three-month period, compared with only 60 last year, the report said.

“One reason that the economy continues to do well is the component of innovation and ability to adapt to a changing environment,” Citigroup Israel Managing Director Ralph Shaaya said in explaining the New York-based bank's decision to locate a research center in Israel. ‘There is a rich pool of talent in the high tech sector. The propensity for innovation is high.”

For Mellanox, orders are persisting even as global growth falters.

“In these situations people tend to look for products that do more with less,” Chief Executive Officer Eyal Waldman said in an interview on Aug. 29. “We still see the orders going in so we don't feel the macro waves coming.”

Shares of Mellanox have jumped about 28 percent in Tel Aviv trading this year, compared with a 21 percent drop on the benchmark TA-25 index. In New York, shares gained about 23 percent, compared with a drop of about 4 percent in the Nasdaq composite index.

Political and Economic

The good times may not last. After withstanding a Palestinian uprising in 2000 that frightened away tourists and deterred foreign investment and a credit crisis in 2008, Israel now faces troubles both political and economic.

Palestinian Authority President Mahmoud Abbas plans as early as tomorrow to ask the Security Council to recommend that Palestine become the world body's 194th member. The U.S. has threatened to veto any resolution in the Security Council.

Bank of Israel Governor Stanley Fischer, whose actions in 2008 helped the economy recover from the global financial crisis, this week voiced concern about the possible effects a prolonged global slump and geopolitical friction could have in coming months. His worry was reflected in the IMF forecast for 2012, which predicts a slowing to 3.6 percent.

Lowest Jobless Rate

Israel has emerged from economic turmoil before. In 2000, as peace with the Palestinians looked possible following the 1993 Oslo accords and the Israeli technology industry took off, growth was at 9.1 percent. Then, in December, the second intifada, or Palestinian uprising, broke out, just as the technology bubble burst on world stock markets. In 2001, Israel contracted by 0.1 percent and in 2002, by 0.6 percent.

By 2004, growth had returned to 5.1 percent; it reached 5.7 percent in 2006. Israel's unemployment rate declined to 5.5 percent in the second quarter of this year, the lowest level since at least 1985.

Still, next year's IMF outlook of 1.8 percent growth for the U.S. and 1.1 percent growth for the euro area, Israel's two main markets, is likely to moderate demand for the country's exports, one of the main growth engines of the $217 billion economy. The Palestinian statehood bid could give the new entity more legal clout or raise nationalism pressure should the Security Council vote to reject it.

Turkey Expulsion

Israel is also facing security threats as the so-called Arab Spring creates turmoil in its Middle Eastern neighbors. In Egypt, the pipeline that carries gas to Israel has been bombed four times since the January uprising against former President Hosni Mubarak. A cross-border attack by terrorists who came from the Sinai peninsula killed eight people near the resort city of Eilat in August.

Turkey, one of Israel's largest regional trading partners, expelled the Israeli ambassador and halted defense purchases after Israel refused to apologize for a commando raid last year on a Turkish vessel attempting to breach the blockade of the Hamas-controlled Gaza Strip that left nine dead.

Israeli five-year credit-default swaps, or the cost of protecting government debt against non-payment for the period, are at 190, the highest level in more than two years, according to data provider CMA. It is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

The shekel has weakened more than 5 percent this year, headed for its biggest annual drop against the dollar since 2005 when it fell 6.1 percent.

Investment Grade

“We weren't Switzerland to begin with,” said Yaniv Pagot, chief strategist for the Ayalon Group, a holding company with interests in insurance, the capital market, and real estate. “We've had the Lebanon War, the Cast Lead military operation in the Gaza Strip, and the economy has dealt with temporary situations. If the situation lasts longer, if it becomes permanent, that could have an impact.”

The economy may already be feeling the bite. Exports, excluding ships, aircrafts, and diamonds, declined for the fourth month out of five in August to their lowest since January, according to seasonally adjusted figures.

This didn't deter Standard & Poor's from raising Israel's credit rating earlier this month to A+, its fifth-highest investment-grade rating, just a few weeks after cutting the U.S. and before cutting Italy. S&P cited the two gas fields, Tamar and Leviathan, off its Mediterranean coast.

“You have a situation where the global economy is clearly running into a roadblock and having a tough time while the Israeli economy is going to bend but it isn't going to break,” said Daniel Hewitt, senior emerging-market economist at Barclays Capital in London. “We think Israel can maintain positive growth. Israel has a strong economy with a strong base.”

--With assistance from Louis Meixler and Jonathan Ferziger in Tel Aviv and Tal Barak Harif in New York. Editors: Anne Swardson, Andrew J. Barden

Its party time!!!

Since I last blogged, the market has been "mildly interesting", to put it mildly!!!

Last weeks rally was the first positive week in a month, and it continued yesterday with an impressive party in stocks all round. And yes, a rally was to have been expected, coming from horrendously oversold levels, at least in the short term, though its very interesting to see the relative winners and losers. And I'm not talking about the reward for lending money to various sovereign Governments around the world based on the risk you are taking on. Whether it’s the mouthwatering 44% on offer for lending to Greece, which has one foot in the grave. Or the 0.0000 miniscule number that you'd be getting for lending to the Japanese with its 200+% debt/GDP. Or to Europe, which arguably may or may not be around in its current states for much longer. Granted, the European balance sheet may look slightly more enticing now that the ECB have moved on from buying the worthless Greek debt to the dubious Spanish and Italian debt!!! Or the US with its $14 trillion and rising deficit? At some point, we'll learn the hard way that "safety" promised by the Governments, is a nonstarter.

Anyway. I'm not talking about all that- that’s the subject of a different post! Back to todays post! It was interesting to see the relative winners and losers. Despite the oversold conditions, and an expected rally, the outlook is not all that rosy. Turbulence continued in Libya, violence worsened in Syria, Israel/Arab tensions, hurricane in the US, plus the eagerly awaited Bernanke speech at Jackson hole (whose remarks were initially perceived as negative, but then markets recovered to finish strongly higher). With hindsight, come September, its possible that the post Bernanke rally was based on "hope". This time last year, when Bernanke spoke, he PLEDGED QE to combat deflationary pressures. This time around, he spoke about fiscal policy and gave his usual "range of tools that could be deployed", but there was very little talk about monetary policy per se. Nevertheless, markets rallied, on what? Hope? There was also the small matter of the first revision to Q2 GDP, which dropped from a preliminary 1.3% to a meager 1%.

However, the market more or less ignored all this, and rallied. And what rallied the hardest? Small cap growth. At least if you're going to party/rally, a rational market would presumably rally in the "safer" asset classes? Small Cap growth, the antithesis of a flight to safety, was up 6.7% for the week, whereas the large cap growth, the epitome of a flight to safety (within the equity space), was the worst performer at 4%. Further, the Utilities and health care stocks, the "boring defensives", performed almost as badly (relatively speaking), whereas the Industrials, the cyclicals, outperformed. However, it is also imperative to point out that the rally was noteworthy for its lack of leadership- the leaders are thinly traded. Additionally, unlike last year when QE2 sparked a massive move out of bonds and into equities with a huge rise in yield as investors sold bonds, this time round, the 10 year hardly moved. And generally, the bonds lead the equity market, and a sub 1% yield on the 5 year speaks volumes for the signal for the economic outlook.

Going back to the GDP report, as well as the downward revision, there is also the statistic that the real GDP year over year change has now fallen to 1.5%. And as can be seen from the following chart, courtesy of Bloomberg, since 1948, each time the real y/y change in GDP has fallen below 2%, the economy has subsequently entered into a recession.

In an uncertain, volatile environment, the one certainty, is that we are in for an interesting, volatile ride!!!

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Is Sage a Listed Private Equity Firm?

I was wondering what the implication was for Sage having being beaten by Bain to the MYOB deal. MYOB (for those unfamiliar) is the equivalent of Sage in Australia.

Accepted wisdom among Sage watchers is that they are a very disciplined buyer and therefore tend not to get into bidding wars with private equity firms.

We have seen examples of this previously when they missed out on Visma (acquired by KKR from Hg Capital et al), and TeamSystems (acquired by Hg Capital, sold by Bain).

The problem with my opening axiomatic comparison between Sage and PE as buyers, is that in my experience the opposite is generally the case. We normally expect that strategic acquirers (Sage, Cisco, Oracle, SAP etc) tend to be able to justify a higher price than PE firms (Hg, Bain, KKR etc).

The reasons for this are fairly simple and boil down to the ability of strategic acquirers, particularly if they are global companies, to gain significant strategic synergy, rather than the pure financial synergy and financial engineering that you would expect from the private equity firms. These synergies might include consolidation of sales, products, core technology which cannot be achieved by a pure financial acquirer.

Perhaps then we need to rethink the category that we place Sage into. They are clearly a global player in the SME software market with important share in all of the key markets (excluding Asia). However when we look under the bonnet what we find is that the federated nature of the set-up gives it some of the characteristics of a more "financial" player. Without going into detail it is clear that relative to other global tech players Sage is really a collection of leading domestic businesses. There is little or no genuine global product range (Sage ERP X3 is a recent attempt) and certainly no integrated global sales and marketing operation.

I want to make clear that this is by no means a criticism. This federated view of the world has long been a pillar of the Sage strategy, mainly resulting from an early realisation that in the realm of small business accounts and business software, local knowledge, tax and regulation is absolutely crucial and has lead to a strategy of acquiring local market leaders and implanting to the extent possible the Sage model of high recurring revenues. The main synergy arising is based on the success of increasing the percentage of acquired customers to long term maintenance contracts, somewhat different to the story you will see when an IBM, Oracle or SAP carries out an acquisition.

On the flip side this is also the main reason why Sage has only on a very limited basis made "technology" acquisitions. Again in the IBM/Oracle/SAP world acquiring technology is done on the basis of the leverage they can achieve by taking a proven technology and using the global sales distribution to greatly accelerate the growth in the acquired company. On the basis that Sage does not have a globally managed sales and marketing operation, there is little point in paying inflated prices for technology, as they have almost no way of leveraging the acquired technology. Given that a high percentage of these acquisitions do NOT yield the expected strategic returns, it follows that this is not necessarily a bad thing for Sage and its shareholders.

There is some chatter in the financial markets that Sage's institutional shareholders showed cool interest in the MYOB deal, notwithstanding that management had not had a chance to present the pro's and con's. If true, then this in itself is a little disappointing and suggests that the company and the new management leading it have some work to do to establish confidence in their ability to execute the type of deal that MYOB offered. (Some 21st century investor relations might help!)

If we are to follow the thesis that Sage is a private equity firm, then I would suggest that they do what the great PE investors do, which is to sell assets as well as acquire them (well over 100 since the IPO in 1989). I am sure that there are a couple of operating companies that could be identified for sale without wishing to state the obvious and this would go some way to showing that Sage understands that value creation can be achieved by realising assets as well as acquiring them.

There are few companies in the UK tech environment that have managed the type of success that Sage has!! Their discipline has been a great asset and although it means that they will miss out on deals like MYOB, it also means that they have almost never disappointed their shareholders.

The press has quoted numbers for Bain's MYOB offer as 13.5x EV/EBITDA on a trailing basis. Sage currently trades in London at less than 8x EV/EBITDA. What can Sage do to garner something close to that valuation. Holding companies typically trade at a discount. Perhaps Sage needs to find a way to break this image that it has gained over the years.

How then does the group management leverage this asset going forward to keep it growing in the absence of financially attractive acquisitions? Answers on a postcard!

Congratulations to Goldrock Israel Growth on IDIT

Goldrock Israel Growth - our vintage 2009 growth equity fund in Israel - recently experienced its first exit with the sale of IDIT Technologies to Sapiens (Nasdaq: SPNS). Press article on the closing below:

Sapiens Closes Merger with FIS, IDIT

By Anthony O'Donnell       

July 21, 2011

Sapiens International Corp. (Rehovot, Israel) has signed a definitive agreement to merge with Cardiff U.K. life and pensions core system provider FIS Software and Beit Dagan, Israel-based IDIT Technologies, a provider of property/casualty insurance solutions. The deal brings Sapiens' global customer base to over 70 and will result in revenues reaching $100 million in 2012 -- double the company's 2010 revenue -- asserts Sapiens CEO Roni Al-Dor.

The deal brings Sapiens into the ranks of very few vendors with established core systems across the life/annuities/pensions, property/casualty and reinsurance sectors and brings important synergies to the component companies, according to industry analysts.

FIS brings Sapiens what the vendor calls a comprehensive, enterprise-level solution for life, pension and annuity, with a global client base across the U.K., Europe, Asia Pacific and North America. IDIT offers a full suite of solutions, constituting a single, end-to-end component-based, integrated solution for the P&C insurance market, with a focus on Europe, the U.K., Australia and the rest of the Asia Pacific region.

"Sapiens' move shows that it is serious about building a portfolio of insurance core systems offerings, both for the U.S. and internationally, across life and P&C," comments Matthew Josefowitz, principal of New York-based research and advisory firm Novarica. "Sapiens' success following the [2010] acquisition of Harcase, which has good momentum based on a recent implementation [of the vendor's RapidSure solution] at Philadelphia Insurance Companies [Bala Cynwyd, Pa.], indicates that it should be able to leverage these new acquisitions well."

The proof will be in the pudding, as integration of acquired companies can bring unforeseen complexities, notes another industry observer who declines to comment on the record. In a statement Sapiens has characterized the deal as promising that the company will "become a major global insurance solutions provider." The company has struggled in the past to succeed in the insurance software market but is on a comeback trajectory. Sapiens has turned around from operational loss and significant debt to three years of profitability and a positive cash flow.

Sapiens' merger with FIS and IDIT will bring a very positive result to the organization as it is now constituted, says Donald Light, a San Francisco-based senior analyst with Celent (Boston). Light characterizes the deal as positioning Sapiens for significant presence and growth.

"We see IDIT as a very strong solution in the European and Middle Eastern markets, and Sapiens has been taking some good steps forward to gain traction in the North American market with the acquisition of Harcase and its RapidSure [P&C] solution," Light comments. "The larger revenue base will play very well in the North American market."

"From a North American insurance company point of view, an important issue is whether a vendor is going to be around in five or ten years," Light adds. "This new organization will have a very positive answer to those types of questions."

Regarding the question of whether Sapiens would introduce IDIT to North America or whether RapidSure would be the foundation of the vendor's P&C policy administration efforts in that region, Light commented, "That's a big road map question that they need to resolve and communicate."

Sapiens CEO Roni Al-Dor clarified the matter:

"RapidSure is the P&C product we will continue to offer for the NA market," Al-Dor says. "It has been well accepted and has a growing customer base. We will now be able to further enhance it with billing and claims that we will bring from IDIT and adjust to the NA market. For life and pensions, we will continue to further develop and enhance the FIS suite as it has been gaining market awareness and acceptance."