During the week, ASX software stock ReadyTech (ASX: RDY) announced a capital raising, a potential share purchase plan, and the proposed acquisition of a (presumably) declining software business.
To be more specific, Readytech will issue shares at $1.88 to fund the cash acquisition of Open Office and McGirr from Pemba Capital to Readytech (which was also floated by Pemba Capital). Note that for Pemba Capital “the primary goal in planning an exit strategy is to maximize the value for all shareholders. Having been on the journey to an exit event many times, we are there to help the Board and shareholders carefully select the timing and method of sale. Our sale experience has included share market listings, trade sales, asset sales and sales to larger private equity groups.”
The fact that Pemba is selling its software business in an all cash transaction at approximately 3.2x FY21 forecast revenue and
approximately 8.7x FY21 forecast EBITDA should tell us that Readytech has accumulated yet another reasonably unimpressive low growth, but high customer retention software package. It also makes clear that Pemba Capital has no hesitation with using the listed Readytech entity for its own purposes, so we as minority shareholders should feel suitable chastened.
Now, I could spent time analysing and explaining why I think that McGirr is a decent but unimpressive business and Open Office is completely unimpressive, but the more important thing is the bigger picture. The bigger picture is that Readytech is just a roll-up of random half-decent software businesses and this acquisition is another step on that journey.
When I bought Readytech I thought that they would use their existing cash or a combination of that and debt to make further acquisitions. This could have been a value generating strategy but unfortunately what I did count on was that Pemba capital would be using Readytech as their exit strategy for whatever software companies they don’t want to own any more. Presumably, they will hold on to the better ones until they get the numbers looking good, and then offer them to Readytech shareholders, who are apparently happy to take them.
So, the bad news is…
Ultimately, I think there is no way that Readytech is going to be a high quality business if one of their major shareholders is treating the listed entity as an exit strategy. The whole thing just looks like a random collection of unimpressive to decent software businesses. However, to me the potential upside is severely limited because the I think that management is too close to Pemba and that the businesses they are buying are completely unrelated businesses that have no synergy with Readytech’s other businesses. I find it hard to believe that out of all the possible software businesses in the whole world, the best ones to buy just happen to be owned by the private equity company that has a partner on the board of Readytech.
As a result, I find it hard to believe the software businesses will receive the care and attention needed to make them flourish. Rather, the thesis looks more like a public/private arbitrage play, and nothing more.
What is acquisition arbitrage?
Public/private arbitrage occurs when someone owns a private asset and they want cash for it. In that scenario, they need to find a buyer. Companies like Readytech are set up (in this case, by Pemba) to buy such companies (in this case, from Pemba) for a set multiple that is less than the company’s current multiple, thus creating a bridge between public ASX listed valuations and the private market valuations (usually lower).
Basically, because public markets are generally more liquid, companies trade for higher multiples (which makes sense, since people can access their money more easily if they want it). In Readytech’s case it was trading at around 10x EBITDA before this acquisition. Therefore, RDY can issue shares at 10x EBITDA to buy a business on 9x EBITDA (or in this case, 8.7x forecast EBITDA). This works for the acquirer because they are essentially lowering their own EBITDA multiple, all else being equal. Of course, who it really works for is Pemba capital, who get to exit their investments at far closer to public market multiples than they would otherwise. Very clever.
What to do now?
Personally, I think Readytech shares will probably perform decently well from here, but there’s no way I want to be part of the story long term. The reason for this is that public/private arbitrage companies can rarely rocket unless they use cashflows to grow, rather than issuing shares. When they constantly dilute, there is always an opportunity for funds to buy in at the next (discounted) raising, so its rare to see any fomo to buy shares on market.
I can see now that Readytech will be doing deals with Pemba Capital. Pemba says its job is to “maximize the value for all shareholders serve Pemba capital”, and one of their partners is on the board of readytech. Even though that board memeber would presumably have no say in the acquisition decision, I am not comfortable with this kind of corporate governance.
I have confidence in the clever fellows at Pemba that they will capture most of the value of the businesses for themselves. After all, maximising exit valuations is their publicly stated goal; which should put Readytech in an oppositional (other side of the trade) position, rather than a cooperative one. I would feel more positive about the company if Pemba did not have a representative on the board of directors.
As a result, once shares start trading again I’ll look to slowly exit my position. In my opinion, Readytech stock will still perform decently well over the long term. The reason for this is that buying resilient software businesses is a good game to be in, even if you have a CEO focussed on eagerly buying the next business from the very people who made him CEO. To their credit Readytech is being very open about what is happening.
I find it hard to believe that RDY shares are not actually genuinely worth around $2 per share or more. Of course, the big unknown here is how much management energy is going into the businesses themselves, versus just the never-ending task of raising capital, acquiring, and integrating acquisitions. It’s anyone’s guess where that will lead (and it could work well, genuinely) but I’d prefer back management that are focussed on improving existing businesses, rather than constantly issuing shares to buy new ones.
At the price of $1.88 I could consider buying more Readytech shares, but I probably won’t. Still, I don’t think I could bring myself to sell under about $2 and even at $2.10 I’m in no hurry to sell my shares.
But ultimately, I think I will sell my shares. The speed at which I sell may be impacted by other opportunities I see. This acquisition is just too big — and too unrelated to Readytech’s existing businesses — to leave me with the confidence in management I generally require.
The author owns shares at the time of publication. This post is not financial advice, and you should click here to read our detailed disclaimer.