Different strokes

Jim Davidson isn’t exactly a media darling. The 28-year Silicon Valley veteran is fiercely protective of his privacy and rarely agrees to press engagements, preferring instead to immerse himself in the intricacies of global technology investing and business building well out of the public spotlight.

It is clear from the outset of our meeting at Silver Lake’s Menlo Park headquarters that Davidson is slightly uncomfortable being the sole subject of an interview. He stresses repeatedly – in the same calm, humble manner that characterises his tone throughout the conversation – that his firm transcends any one individual.

Davidson talks to PEI about technology investing

But as the discussion progresses and Davidson somewhat lets down his guard, he makes no secret of his passionate belief that technology has the potential to improve industries and lives, and that private equity has the ability to better technology companies.

This is perhaps not a surprising admission to anyone who’s been keeping tabs on Silver Lake lately. The niche mega-firm was behind one of the largest and most closely watched LBOs last year, the purchase of VOIP company Skype, as well as what PEI readers voted to award as the best North American exit of 2009, the IPO of semiconductor company Avago Technologies. It has also been notably absent from the headline news plaguing many other large buyout firms’ portfolios, having never had a portfolio company default on loan obligations nor file for bankruptcy.

Davidson’s belief in mature technology’s potential has only expanded as technology businesses have further globalised (and become less understood), prompting Silver Lake to both expand its business lines and ramp up its activities outside of the US, primarily in Asia.

“The United States is the biggest technology market in the world and Western Europe ranks second. Yet there are also growth economies globally where technology is a strategic industry,” says Davidson, who before Silver Lake led the technology investment banking business for Hambrecht & Quist. “Technology is strategic for many reasons – not only in terms of economic development and job creation, but also for the improvement of educational standards, consumer consumption and overall efficiency.”

It would be arrogant to assume that the US and Western Europe will continue to dominate all these sectors, he continues, in light of the increase of emerging market government sponsorship of domestic technology industries. “Our belief is that technology leadership can emerge anywhere and our goal is to know where it is emerging and to be part of it – and not at the venture level, but where companies have proven technologies.”

This focus on “proven” technology, say several market insiders, is thoroughly shared by fellow co-founders Glenn Hutchins, whose background includes senior roles at The Blackstone Group and Thomas H Lee Partners, and Dave Roux, a veteran tech industry entrepreneur who was formerly chairman and chief executive of Liberate Technologies, executive vice president at Oracle and senior vice president at Lotus Development. Roger McNamee was also originally part of the founding partners; he later went on to establish Elevation Partners.

Effectively launched from the floor of Davidson’s living room in 1999, Silver Lake’s strategy – to apply LBO techniques to mature technology companies – sparked the interest of some of the world’s most notable individual and institutional investors, including Bill Gates, Larry Ellison and Michael Dell. In a short time period, the firm rounded up an eye-popping $2.3 billion for its debut fund – an offering so hot that one LP was reportedly clamouring for access while climbing Mount Everest.

“Before they came along, there was a very widespread belief that you couldn’t do typical private equity LBO-type deals in the large technology space,” recalls Dan Burstein, co-founder of direct venture secondaries firm Millennium Technology Value Partners and a former colleague of Hutchins’ at Blackstone. Many industry participants believed there was something unique about technology company executives and intellectual property that defied later-stage, often leveraged, investment. “Their vision that you could do this was really a breakthrough and their track record has been good,” says Burstein. “Today, when people think about large scale technology buyouts or private equity deals for technology companies, a ‘Silver Lake deal’ is almost a noun.”

THE LEVERAGE OPTION

Despite its ability to apply leverage to technology companies, Silver Lake shrugs off the “LBO shop” label that

'We are looking for good businesses
that grow.'

is often applied to it. Davidson argues that Silver Lake has never really led with deal structures.“We use deal structure to add incremental return but it is usually not part of the fundamental thesis of the deals we do,” says Davidson. Some of that stems from exclusively focusing on technology, “or parts of the economy that are enabled by innovation”, he says. “We are looking for good businesses that grow and most of the economic returns from our investments come from the growth of the businesses and improving the business models themselves. We are not afraid to use leverage if it improves return on equity, and surely that is part of what drives our investors to invest with us, but it is not how we lead.”

Part of the reason leverage has never been the key to a Silver Lake deal, adds Davidson, is that the firm entered the market at a time when the growth of technology was 1.5 to 3 times the global economy’s overall GDP growth. “Leverage is always considered, but is not a requirement for many of our deals,” he says.

Presently investing its third buyout fund, which closed on $9.3 billion in 2007 and is about 40 percent deployed, Silver Lake’s current portfolio of 12 companies has a range of leverage levels associated with each investment.

“We have investments with zero net debt, and we have investments with eight times debt to equity where we have taken the institutional opinion that the company is more of an infrastructure type of a play,” Davidson says. The latter company he referenced is satellite operator Intelsat, which Silver Lake purchased with BC Partners in 2007 in a secondary buyout valued at $16.4 billion, including about $11.4 billion in assumed debt. “When you have 15-year contracts or 12-year contracts with governments, with the largest broadcasters in the world, we are willing to lever against that. But in other cases we are much, much more conservative and instead aggressively invest in the business operationally.”

The firm grabbed headlines last year when it led the $2.7 billion purchase of a 65 percent stake in Skype from eBay, the online auction giant. That portfolio company was levered three times, Davidson says, but added that Skype is growing quickly and he expects March numbers to reflect a less aggressive debt level.

The deal – which stood out as one of the few large buyouts agreed in 2009 – is an exemplar in terms of Silver Lake’s thematic approach to tech investing. Its partners, whose diverse backgrounds combine financial acumen with hands-on operating expertise, spend a great deal of time thinking through the macro trends on technology spending and business model innovation enabled by technology deployment.

The firm had been on the lookout for potential portfolio companies that fit into these macro views. As Davidson says: “We believe in globalisation, we believe in communications, and we believe in internet technologies affecting a lot of traditional types of businesses.”

Enter Skype with its 500 million users, which eBay had written down significantly and deemed non-core as it focused its attention more fully on other business divisions.“We thought Skype had greater opportunities for growth as a standalone business,” Davidson says.“There was tremendous potential both as a disruptive technology but also as a mainstream technology in improving the way people communicate.”

The way in which the deal came together was also typical of how Davidson says Silver Lake likes to operate, in that the firm shares its visions with the selling party and often invites it to come along for the ride. “We basically painted the picture of why we believed, in this case, an independent Skype would not only be successful but also thrive as an independent company,” says Davidson. eBay, which originally planned to sell the business outright, opted to retain a 30 percent stake because it saw merit in Silver Lake’s plans for the company.

“Over the course of the transaction, we had the opportunity to bring together all of the disparate interests and unify them to create a new Skype, which, for the first time in the company’s history, had everyone focused on the success of the company without different economic interests and competing agendas,” Davidson says.

Soon after the deal was agreed, Skype co-founders Janus Friis and Niklas Zennstrom came back on board and outstanding litigation regarding Skype’s intellectual property between the founders and eBay was worked out. “There is a renewed excitement, the camaraderie is great, the working relationships among the different parties are fantastic,” Davidson says.

PROVING CRITICS WRONG

Silver Lake likes technologies that fit its macro view of the world, which explains some of its attraction to Avago Technologies, a semiconductor company whose some 6,500 products include items like optical touch sensors, cameras and Wimax technologies used in mobile phones and other applications.

Avago generated a lot of attention last year because Silver Lake – along with Avago’s co-sponsor, Kohlberg Kravis Roberts – effectively renewed the hopes of many a GP that the IPO market was thawing when it successfully floated the company. Listed in August on the Nasdaq exchange, the IPO was one of the largest recorded in the US last year; it priced at the top of its range, selling 43.2 million shares to raise a total of $648 million, and valuing the company at $3.5 billion. The stock closed up nearly 8 percent on its first day of trading, pushing the company’s valuation to $3.8 billion.

The investor group, which bought Avago in 2005 for a reported $2.7 billion, sold nearly 22 million shares worth a total of about $326 million in the IPO. In early 2010, the group further exited the company by selling $435 million-worth of shares in a secondary offering.

Asked if the sponsors were nervous to test the choppy equity markets, Davidson indicates the sponsors were confident the company was ready to go public but that it didn’t have to go public. “I think the challenge for us is that we try not to drive any of our liquidity events around what we want to do – instead, we try to be fiduciaries for what is best for the business of each portfolio company, which, we believe, ultimately benefits our investors.” 

The company initially filed to go public in 2008, found the market less than receptive at the time, and held off until the aforementioned blockbuster IPO in August 2009.

Avago, originally the semiconductor business of Hewlett Packard, is an interesting case study for the firm, in part because many industry observers expected the deal to fail when the investment was made near the end of 2005. It demonstrates that Silver Lake’s “expertise around technology allows us to differentiate between perceived risk and real risk”, Davidson says.

While part of HP, and later Agilent, the semiconductor business had sunk hundreds of millions into R&D and had invented an array of very advanced technologies, but the business had continually been questioned by its corporate parent because it was deemed too cash-intensive and was not reporting large profits.

“That did not mean it was a bad business, it just meant that it was a business in the wrong place,” Davidson says.

'Coming out of this economic cycle … I think every one of our
companies took market share.'

When Silver Lake purchased the company, it had trouble raising the bond segment of its financing for the deal. A group of potential bond purchasers approached Silver Lake under an NDA and standstill agreement to hold a conference call, during which the firm explained that Avago, under private equity ownership, was really a portfolio of assets.

Six hours later, the bond deal was done, with 70 percent of the purchases made by individuals participating on the call, Davidson recalls. Within three months, Avago went on to sell several of its businesses, which had been generating around $18 million to $20 million in EBITDA, to strategic buyers. “Four months later Avago had no bank debt. The bonds were now the most senior debt in the company and the strategic sales netted about $730 million in cash. But what was most important about restructuring Avago’s business lines was that we had a much more focused company.”

That focus intensified, with improvement in the business’ growth, balance sheet and business processes up until the IPO, which Davidson notes, crucially, was an IPO in which stock investors could make money. At press time, Avago shares were trading at $21.90, up roughly 46 percent from their offering price.

“I hope that is what we are known for, because we like to be affiliated with high quality companies that are still growing,” Davidson says.“We are fiduciaries for our limited partners’ capital but we are also trying to be stewards of the companies themselves as they continue to perform well even after capital has been returned to our investor base.”

PLEASING THE PARTNERS

During 2006 and 2007, Silver Lake invested around $2.2 billion and returned about $3.4 billion to investors. This net return of capital is a subject Davidson raises when asked if the firm has encountered any liquidity issues among its LP base in the past two years (he says it hasn’t).

Until last year, he says, Silver Lake’s peak year of investing was 2005. “As the private equity industry was deploying tens of billions of dollars in 2006 and 2007, we actually saw a decline in our pace of investment. This was not some big strategic decision, it was simply that we saw valuations reach such high levels that we were unwilling to be a competitive bidder for certain assets. As a fundamental value investor, our strategy holds that when valuations go up, we tend to become less aggressive and when valuations go down, we tend to become more aggressive. Again, that is not some big strategic insight, it is being disciplined.”

Davidson also stressed how seriously it takes its relationship with LPs and notes that it works hard to be respectful of investors’ needs.“When we do our marks and valuations, similar to when we negotiate a purchase with a seller of a business, we show our limited partners everything. We give them the financial results and show them the multiples and valuation metrics.We tell people exactly what we think and where we believe the business will go over the coming year or two or longer.”

A key LP in the firm’s buyout funds confirmed that Silver Lake’s communications on investments are frank, timely and informative. “When it comes to reporting, they are best in class,” the LP said. “I think also very important is if they have a problem, they tell you and they tell you what they’re doing about it. There’s no hiding any information.”

NOT IN DISTRESS

Asked if there have been particular difficulties in the portfolio over the past two years, Davidson responds that the firm began to think the economy was weakening several years ago and held a meeting with portfolio companies in early 2007 that stressed the need for cash and liquidity. “As a result, we went into the downturn focused, with the full cooperation and support of the management teams of our portfolio companies, on managing cash and liquidity and being prepared for a disruption in the economic cycle. Our intent was to be prepared to invest during the downturn, allowing us to take market share from competitors and strengthen ourselves for when the cycle recovered.”

By and large that strategy has indeed played out, he says. “Coming out of this economic cycle, I can maybe think of one company that’s still got some work to do, but I think every one of our companies took market share and is continuing to take market share.”

He also notes that to date, the firm has never had a portfolio company default, experience covenant problems or file bankruptcy.

One has to go back nearly 10 years to find documentation of any Silver Lake deals that didn’t pan out – an example being its growth capital injection in SubmitOrder, an e-order fulfilment company that catered to retailers and reportedly went out of business in 2002 after its largest customer, Kmart, went bankrupt. Silver Lake, which media reports have estimated invested around $200 million in SubmitOrder, wasn’t the only firm to get burned; other investors in the company included Partners Group, Oracle Venture Fund, Amadeus Capital, Integral Capital Partners, Merrill Lynch, NCT Ventures,The Barksdale Group, GE Capital, Imperial Bank, Pino Ventures, PNC Bank and Morgan Stanley.

“We have lost money on deals before, but we currently have no distressed situations in our existing portfolio,” Davidson says.“That does not mean we have not had volatility in our portfolio, but that the businesses have all performed well.”

The firm, which is known to mark its portfolio very conservatively, declined to provide any specific information on portfolio valuations or fund returns. According to public documents from the California Public Employees’ Retirement System, which invests in Silver Lake funds and also owns a stake in its management company, the firm’s first fund provided LPs a 2.3x return multiple on investment and booked a 25.2 percent net internal rate of return. The firm’s second fund, a 2004 vintage that raised $3.6 billion, had a 1.1x multiple and 4.4 percent net IRR as of 30 September 2009.

EVOLVING STRATEGIES

Silver Lake’s franchise has grown in recent years to include two other separate business lines: Silver Lake Sumeru, a mid-market private equity arm that raised a $1.1 billion debut fund in 2008, as well as a distressed technology credit-focused arm, Silver Lake Financial.

“We actually thought that the technology credit markets and the credit markets in general were getting a little weird,” Davidson explains, when asked why the firm launched an investment management fund focused on technology credits. “When we started Silver Lake in 1999, there was very little debt financing available to technology businesses. In 2006 and 2007 there were a lot of deals initiated by investment bankers walking in to private equity offices and saying, ‘We would like you to look at buying this technology business, and here is stapled financing for six times.’ It was rather anecdotally humorous to us because, in some cases, it looked to us like the stapled financing was worth more than the business itself.”

Many good companies were being given balance sheets that unless various assumptions played out perfectly, would create distressed situations, Davidson says. “And as more and more debt got issued and the liquidity, depth of the market, and breadth of the technology credit market got big enough, we believed that there would be an opportunity to spot mispriced instruments.”

Silver Lake is not simply a firm full of “equity people”, Davidson stresses. “We look at technology businesses and we try to understand the true franchise value and then we back into the optimal capital structure that preserves all of the operating flexibility that we might want to invest in the business, grow the business, and make the business better. And then – perhaps – add some debt to optimise ROE without surrendering the operating flexibility.”

HEIRS APPARENT

When Davidson hands over his business card, he points out the card looks no different from that of his assistant – neither card features a job title.“The theory has always been either you are good enough to work at Silver Lake or you are not. And if you are good enough to work at Silver Lake all you need is your name and Silver Lake. And if you are not good enough, you will not be here very long.”

In terms of the firm itself sticking around for a while, Davidson is confident that Silver Lake will avoid the succession issues that many private equity firms have encountered and transition well from being managed by its founders to the next generation.

“From day one, that has been a goal of ours,” he says. “Whether it is Egon Durban in London, Ken Hao in Asia, or Greg Mondre, Mike Bingle and Joe Osnoss in New York, the next generation is just as capable, and probably more talented, than the founding partners.” he says.

The professionals the 50-year-old Davidson mentions – all in their late 30s or early 40s – have worked for the firm more or less since inception and have regularly featured on various industry “rising star”-type lists in the past few years.

Davidson adds that the firm has lived through the Y2K bubble, the dotcom crash, 9/11 and the recent financial crisis, and still its returns have been “quite good”.

“Our portfolio companies are strong businesses that truly stand for leadership in the tech space and, I think, coming out of this downturn, most of them will have taken market share,” he says. “So if you agree that technology has a future in the global economy, Silver Lake seems to be reasonably well positioned for what is going to happen in the next five or 10 years. And if the young guys are as good as I think they are, we are pretty well positioned for the next 20 years.”