Francisco Partners’ CEO on complexity arbitrage

‘Our strategy is to buy confusion and sell clarity,’ says Francisco Partners chief executive and founding partner Dipanjan ‘DJ’ Deb.

This article is sponsored by Francisco Partners.

Dipanjan ‘DJ’ Deb

Dipanjan ‘DJ’ Deb is founding partner and chief executive of tech-focused private equity firm Francisco Partners. The firm manages more than $25 billion and has invested in over 300 technology companies in the last two decades, making it one of the longest-standing and most active technology investors in the industry. He tells Private Equity International what the firm’s investment strategy entails and talks through the trends driving opportunities in tech.

How has the technology investment opportunity evolved over the past two decades?

When we started the firm in 1999, technology investment was restricted to Western Europe and North America, and to the three Cs of computing, communications and consumer. Today, technology is ubiquitous. It exists in every part of society, every industry, every geography and every end market. As an example, I grew up in India and even in poor villages there, where people may not have very much, they have cell phones and TVs. Technology is driving every aspect of the world in which we live.

What is unique about Francisco Partners’ approach to investing in technology?

What differentiates Francisco Partners from many of our private equity peers is that, while we are 100 percent focused on technology, we are not just solely focused on software. We specialise in a number of markets within technology and pursue investment opportunities within each of them. Our team has the intellectual interest and expertise in every sub-sector that we invest in – and when you combine that with our firm’s tenure investing in technology companies, it positions us competitively as a partner to management teams and companies that are looking to grow.

What sub-sectors does the firm specialise in and why?

Beyond infrastructure and application software, we specialise in several other markets, including healthcare IT; security, both networking security and cybersecurity; communications; consumer internet; educational technology; semiconductors and hardware; and financial technology.

Not only do we believe in tech specialisation, but we also believe that in order to outperform over the long term, you need sub-sector specialisation. For us, that approach has certainly worked – we recently received an award for having the best returns in the industry [the firm ranked first in the 2020 HEC-Dow Jones Private Equity Performance Ranking]. We were 2.4 standard deviations away from the median over a 10-year period.

Furthermore, the difference in performance score between us and the firm ranked second was greater than the difference between the firms ranked second and 10th. Since that data was published, we have achieved 11 different exits to date and have also been very active on the new investment front.

What do you look for in companies within those investment themes?

When we look at a company, we are looking for a great customer base and good technology that can be optimised in ways it historically has not been. Our strategy is called complexity arbitrage, we look for companies that have great potential that has yet to be unlocked. Essentially, this means we buy confusion and sell clarity. We provide companies with flexible capital and the strategic and operational support to help them drive growth and scale their business. Our view is typically that if you have sticky customers and good technology then most everything else can be sorted out. Ultimately, that is the way to generate returns and to create long-term value.

What skills and resources are required to execute on that kind of strategy?

First, I would point to our long history of investing in the sector. We have seen a vast number of assets so can now spot patterns and try to repeat them. Second, we have a huge operating group, Francisco Partners Consulting, which is made up of 35 people who can parachute in and out of situations to provide invaluable counsel and operating expertise to our companies. Our Francisco Partners Consulting team includes former CEOs, CFOs, CMOs, CSOs, and HR and procurement experts who bring first-hand experience leading technology companies to our management teams.

Third is our sourcing process. Each of our partners creates a business plan for their vertical every year based on five different ways of sourcing. They call up the conglomerates in their space, they identify themes and then discover who the beneficiaries of those themes are. They have huge networks of executives to turn to. In addition, we also screen the ecosystem so that when a new company hits a certain size, we know it and can go and see them.

Finally, there is the flywheel. We are one of the pre-eminent technology firms, so a lot of deals come our way. From there, it becomes a question of sifting through those opportunities to figure out which assets we want to pursue so we can then utilise our operational team to help optimise those businesses.

How is the generalist versus sector specialist debate playing out?

We don’t see technology as an industry or a sector. Technology touches every end market today, so we see it as a horizontal and not a vertical market and we believe that specialisation matters. That is the way we run our business and the approach is backed up by the numbers. Quite simply, tech firms have outperformed non-tech firms – and from an LP perspective, I would say technology has been the best performing sector for the past two decades. Technology is disrupting all other industries and that is what is creating the multiple uplift that you see in the capital markets.

How would you describe the impact of the pandemic on technology opportunities?

The pandemic has accelerated technology in a way that, frankly, none of us thought possible. Remote working is here to stay, at least in a hybrid model, and that has created all sorts of opportunities around video, security and payments, for example. The pandemic has had a horrific human toll, which makes me profoundly sad, but technology trends have been accelerated in a remarkable way.

What particular challenges would you associate with technology investment and how can they be overcome?

First, tech valuations are high, even by historical standards. Second, there is more competition than ever before, which means investors must navigate the market carefully. To put this into context, we see two areas that align with what former Federal Reserve chairman Alan Greenspan referred to as “irrational exuberance”.

One area is late-stage growth equity, where there are unicorns being formed every day. Some of those companies are genuinely changing the world but not all will. Some of today’s unicorns are really opportunities for tomorrow. The other area is large-scale software buyouts, where there is a perception that you cannot lose money on software. That is just not true – if you overpay and over leverage, the bottom line is you can lose money.

Given this huge appetite for tech businesses, where are you seeing most of your exits come from today?

Historically, I would say that 70-80 percent of our exits went to strategics. In recent years, we have sold ClickSoftware to Salesforce, Plex Systems to Rockwell Automation, and Capsule Technologies to Philips. However, sales to other private equity sponsors and IPOs are increasing, by virtue of the fact that firms are raising mega funds and IPO markets are very receptive to technology.

What broader trends do you expect to see driving opportunities in technology?

Everything is becoming disrupted by technology. Over the next 20-30 years, we believe technology is going to be the greatest source of value creation in the world. Valuations are high, so we need to be selective and that is where sub-sector specialisation comes to the fore.

Complexity arbitrage in action

When Francisco Partners took barcode scanning business Metrologic private in 2006, it was not without its problems. The general perception was that barcodes were going to be disrupted by radio frequency identification.

“Metrologic also had a 70-plus year-old founder who was reluctant to retire and who owned half of the stock,” says Francisco Partners’ Dipanjan Deb. “That founder brought in a new head of sales but was unable to let go of the reins. There was a succession issue.”

While Metrologic had historically focused on tier-two and tier-three retailers, working with Tesco and Target meant margins were starting to come down. “Getting those bigger customers seemed to mean sacrificing profits,” Deb explains.

Finally, Metrologic was embroiled in intellectual property litigation with its biggest competitors and had completed an acquisition that had not worked out as expected. “It was a classic Wall Street orphan,” says Deb. So, why was the business a good fit for Francisco Partners?

The firm recognised that, while RFID tags cost 10 cents at the time, a bar code cost a fraction of that price. Francisco Partners therefore gained conviction in the future of the sector. The team got to know the founder well and convinced him that they would take care of the company, drafting in an operating partner to run the business while carrying out a CEO search.

Although the plan was originally to shed the larger customers – shrinking revenues and growing profits – in due diligence, Francisco Partners realised the biggest issue was a sales force incentivised on revenues and not margins. Within 18 months of rectifying this issue, margins grew substantially.

“We also streamlined manufacturing and went to the company’s biggest competitors and negotiated cross licences, to remove the threat of patent litigation,” says Deb. “Finally, we unwound one of the acquisitions.”

These measures resulted in a 50-plus percent increase in EBITDA within the first 18 months and a sale to Honeywell International. “The CEO that we hired to run Metrologic at the outset has since risen through the ranks and is now CEO of the whole of Honeywell, a company with a market capitalisation of over $150 billion,” Deb says. “That is a classic Francisco Partners story.”