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An early assessment of the Ultimate acquisition

Brian Sommer Profile picture for user brianssommer February 10, 2019
Ultimate, a major HR vendor, is going private and many are speculating about how the deal will affect employees, customers and top executives. But shouldn’t we be discussing other factors, too (e.g., how the private-equity deal financing will affect things)?

Last week, Ultimate (NASDAQ: ULTI) announced that is would be taken private at a price of $331.50 per share. The deal is backed by Hellman & Friedman, Blackstone, GIC, Canada Pension Plan Investment Board (CPPIB), JMI Equity and other investors.

Ultimate is a key player in the HR/HCM/Payroll processing world. It competes with Ceridian, Workday, ADP, SAP, Oracle and many others.

Early coverage of the announcement was positive with many people parroting the comments within the press release/announcement. Those sentiments included:

“Ultimate will continue to operate under the leadership of CEO Scott Scherr and the existing senior management team.”

“This change will bring meaningful benefits to our employees and customers—both in the long and short terms. Since all of our employees are given equity in Ultimate when they join us, as stockholders, this transaction will result in immediate financial upside for them. Today’s announcement will also allow us to make additional, prudent investments in our products and services to better serve our customers”

“Our customers will benefit from our ability to bring new features and services to market more quickly, while still enjoying the same high level of service they have with Ultimate today, or better, with new innovations to our offerings. Hellman & Friedman is in full alignment with our vision to serve the global HR market, while preserving our unique company culture and mission”

“After the transaction is complete, Ultimate will continue to develop, market, deliver, and service its suite of human capital management and employee experience solutions globally—including HR, payroll, benefits management, talent acquisition, talent management, workforce management, employee sentiment analysis, and HR service delivery—with no changes to the markets Ultimate serves and no changes to its mission: put “People First.””

”We are excited to partner with Ultimate and this investor group to support the strong growth and culture of this exceptional company.”

Let’s take a deeper look at these statements and what people aren’t talking about.

The money

This deal is valued at $11 billion for a company that has just broken through the $1 billion revenue level (ULTI ended 2018 with $1.1 billion of revenue). While a 10X valuation is very good, what we should be looking at is how much of the $11 billion will be financed and how the new, privately held ULTI will service that debt.

Private equity deal financing often gets priced at junk status – ie: the interest rate will be high to offset the increased risk of default. Should ULTI have to assume $5.5 billion of the acquisition cost via debt, it could also have to accept a cost of capital of 7-10% or more. Ten percent of $5.5 billion is $550 million or half of ULTI’s annual revenue.

Servicing debt and paying private equity firms their management fees post-acquisition are often a huge financial headache for the leadership of the acquired firm. To meet the debt obligations, significant cuts in spending may be needed. Areas like R&D and Marketing are often hit the hardest. Customers could see price increase and aggressive audit activity, too.

So, before customers and employees start thinking this is a good deal, I would want to know what the new debt load on the firm will be.

According to a recent ULTI earnings announcement, the company has cash of approximately $162 million. They’ll likely need most of that for normal business operations. This money won’t make a dent in the $11 billion acquisition price tag. So, if the new owners don’t want to risk a lot of their own money on this deal, they’ll have to acquire debt financing. (Remember, private equity firms love leverage. They’d rather risk other people’s money and skim as much of the upside for themselves. So, a betting person would bet that ULTI will have to assume a fair bit of debt as part of this deal).

The players

The key players in this, as mentioned previously, are Hellman & Friedman, Blackstone, GIC, Canada Pension Plan Investment Board (CPPIB), JMI Equity and other investors. While much has been noted about Hellman’s other investment in Kronos, JMI is the more interesting participant.

Before we get to JMI, let’s explore the Kronos angle. I seriously doubt this deal was done as part of a larger rollup strategy. Kronos has products that complement and compete with Ultimate. Moreover, I’m not sure which investment fund the Kronos deal was in but I suspect it isn’t the same one this ULTI deal is in. A better rollup plan would be to acquire tuck-in products and more complementary solutions. Granted, I like both ULTI’s HCM and Kronos’ products, it’s just that a rollup seems doubtful. Also, the Kronos/SAP relationship would also need to be sorted out before a more substantial linkup between Kronos and Ultimate could occur.

JMI is the equity investment entity that was principally funded years ago by John Moores. John Moores, founder of BMC software (and maybe one of their best executives), is a key person and really knows the software space. JMI, like Hellman, also has money invested in Kronos but over the years has done deals involving several other HR firms including Halogen, WorkFront, ServiceNow and other HR solutions. See their portfolio here: JMI also had an investment in Adaptive Insights (now owned by Workday), BigMachines and Eloqua (now owned by Oracle).

While it’s easy for a press release to contain phrases like “we look forward to continuing the growth”, it’s another matter altogether to see private equity firms waive their considerable management fees, deal origination fees, etc. It’s also interesting to see them not load up a company with debt. Call me skeptical but I need to see more of how the future will be financed before blindly accepting statements like these.

But as to the specific firms in this deal, if Hellman and JMI can structure ULTI for true long-term success, that would be great. However, if this is a smashup that leads to an IPO in a couple of years, I wouldn’t be impressed.

Overseas growth

Overseas growth for Ultimate is important and has been something that Ultimate tried to do in tiny steps for a long time. One time, I quizzed Ultimate CEO Scott Scherr about overseas expansion and what I learned after a spirited exchange was that:

  • Overseas expansion is very expensive from setting up offices, hiring sales and support staff, etc.
  • The costs to make the products functionally viable in each country is substantial given the wide variety and number of regulatory, compliance and labor management issues in each country
  • It is far less expensive for Ultimate to hire more sales and marketing professionals in its main markets (ie: the United States and Canada) than to open up new markets in all-new countries
  • To support large multi-national firms, Ultimate did an alliance deal with Celergo that helped them provide payroll services in approximately 100 countries. (Last year, Celergo was acquired by Ultimate’s competitor ADP.)
  • Scherr understood the Rule of 40 (although we didn’t use that term then). He wanted to deliver 20+% top line growth annually and the same for their profit margins. It’s what, he explained, his investors and Wall Street expected of Ultimate. So, he tempered his expensive global expansion plans accordingly.

I remember this conversation well as it was in contrast to so many grow-at-all-costs discussions I usually got from Silicon Valley CEOs.

The deal is not a done deal

This deal could vaporize in the next 50 days. If you read the deal announcement, there’s this tidbit:

The definitive agreement for the transaction includes a 50-day “go-shop” period which permits Ultimate’s Board of Directors and financial advisor to actively initiate, solicit, and encourage alternative acquisition proposals, and potentially enter negotiations with other parties that make alternative acquisition proposals.

A go-shop provision means some other player could come into the picture. Another firm might offer a better price but they might also have very different ideas of the post-acquisition ULTI firm. They could smash it into their own firm, jettison the existing management, layoff redundant staff, etc. For all of the pronouncements about employees loving this deal, they might not love an alternative. Or, maybe there is a white knight deal out there that could be even better for employees and management.

Let’s wait until the go-shop period expires before anyone goes out spending their stock option money.

Why this deal and why now?

The answer to this question has eluded me.

Some pundits have posited some ideas, but I don’t think the real answers have surfaced yet.

On the macro-economic front, some people believe that the economy will flatten out and the numbers of people requiring paychecks is at an upper limit. That may curtail organic growth for Ultimate and its competitors.

Increased competition could be in the offing as ADP has scheduled a global payroll engine for this summer that will support approximately 50 country payrolls. Workday continues to take market share away from its competitors. If Ultimate wanted to sell in the near-term, this may be a good time to do so right after it finished a solid 2018.

Some think ULTI did the deal to get more capital and less interference from Wall Street so that it could expand its offerings and/or re-platform some of its product line. It would be hard to meet Rule of 40 targets while spending a lot on either R&D or global growth.

Some think that top executives wanted to cash out. The press release is implies that this isn’t the case but more on that below.

But, none of us really know the true motivation for this deal and why now. Maybe this will come in time.

Will employees stay?

No buyer of another company wants to see mass defections especially of the most valuable people. That’s why the acquirers quickly identify which employees they want to stay and put together stay-pay packages to keep them in the fold. Less valuable employees won’t get anything.

So, what should we see with Ultimate? Much has been written that this deal will trigger a lot of employees exercising their stock options and getting wealthy. Well, that might happen IF these employees had material change of control clauses in their agreements that trigger rapid vesting (or additional vesting or full vesting) of these options. If that language exists, then, yes, employees stand to do well. Given how generous Ultimate has been with stock options in the past, I suspect many employees will be happy. That’s in the short-term though!

Longer-term, the new owners will be challenged to come up with another incentive program that keeps the best and brightest at Ultimate. The difficulty for them is that there will be no liquidity for any ‘shares’ or ‘tracking shares’ that they could offer employees as Ultimate will be privately held. I’ve seen this unfold in other firms that have been taken private and, contrary to the assurances and pie-in-the-sky projections from the private equity owners, I know of no one that’s ever benefited from these plans.

So, will people leave? Yes. Some will want to do their own software thing. Some will retire. Some will seek true love in a smaller startup. Some won’t want to work for a private equity backed firm. So, yes, there will be departures. The quantity and timing of these is largely a result of how hard the new owners try to retain people.

For more on this angle, check out this TechTarget piece discussing the potential for people departures from Ultimate. Author Patrick Thibodeaux reports:

Employee financial windfalls, along with the potential for a startup-corporate culture clash, may lead to the "loss of the very talent that got you to where you are," said Ruben Moreno, who heads the HR executive search practice at Blue Rock Search, a national recruiting firm in Sarasota, Fla., that works with private equity investing groups in deals.

I concur.

Customer impact

Will customers see any benefit from this deal? I believe it will be mixed.

On the plus side, Ultimate could get funding to expand globally, re-platform products and possibly acquire complementary technologies. A stronger, more modern and more global solution would make Ultimate’s products more attractive to current and future customers.

Again, TechTarget reports:

Ian Campbell, CEO of Nucleus Research, based in Boston, said the Ultimate Software acquisition is "fantastic news" for customers. He said he believes it will improve the firm's technology investments and is not expecting a private equity takeover that results in major cutbacks.

However, if the debt servicing and management fees become a financial challenge, then customers will see a marked slowdown in innovation.

Likewise, if enough of the current employees reap a material financial windfall from this transaction, then employee attrition could adversely impact critical customer-facing positions like support, implementation, etc.

No matter what transpires, Ultimate customers would be wise to revisit their licenses/subscription agreements to see:

  • Did you have any material change of control language that could be relevant?
  • Is your pricing protected (including renewals) from changes introduced by the new owners?

Here are three relevant articles that customers might want to peruse:

Big changes like this often trigger changes in the vendor/customer relationship. Maybe the changes will be small or they could be big. We’ll need to learn more on the deal specifics to make a better assessment.

Will the Ultimate Executives Stay?

In an interesting piece in Workforce, we read:

He (George LaRocque) also doesn’t anticipate much attrition. The leadership team will almost certainly be required to stick around at least for the short term as part of the deal.

We may see changes in leadership in a year or two, but it is safe to say nothing big will happen in the short term,” LaRocque said.

The new owners are likely developing new employment contracts for the top Ultimate executives right now. Some might be more like 1-2 year consulting gigs and others will be full blown employment deals. Either way, the smart executives are already calling their employment contract lawyers to be ready with counter-proposals, golden parachute clauses, etc.

I would bet the new owners are going to push for changes in the executive suite. Maybe not immediately but sooner than some might anticipate.

For example, CEO Scherr might remain for a while to provide stability while a new CEO is either groomed or hired. Scherr is 65 and has been at this a long time (almost 30 years). Was potential retirement a consideration in doing this deal now? His bio is quite revealing. Equilar[1] tells us that:

Scott Scherr has served as President and a director of Ultimate since its inception in April 1996 and has been Chairman of the Board and Chief Executive Officer of Ultimate since September 1996. Mr. Scherr is also a member of the Executive Committee of the Board. In 1990, Mr. Scherr founded The Ultimate Software Group, Ltd. (the "Partnership"), the business and operations of which were assumed by Ultimate in 1998. Mr. Scherr served as President of the Partnership's general partner from the inception of the Partnership until its dissolution in March 1998. From 1979 until 1990, he held various positions at Automatic Data Processing, Inc. ("ADP"), a payroll services company, where his titles included Vice President of Operations and Sales Executive. Prior to joining ADP, Mr. Scherr operated Management Statistics, Inc., a data processing service bureau founded by his late father, Reuben Scherr, in 1959.

Other executives could get transitioned out, too, in time. Equilar also notes:

He (Scott Scherr) is the brother of Marc Scherr, the Vice Chairman of the Board and Chief Operating Officer of Ultimate, and the father-in-law of Adam Rogers, Senior Vice President and Chief Technology Officer. Mr. Scherr shares a household with Vivian Maza, our Chief People Officer and Secretary.

There’s no denying that family members are in the executive roles at Ultimate. When private equity buyers took over a family run firm that I was close to, they moved out some family members immediately, phased out a few more after a year or so and only kept one of the family in the business long-term. In that firm, the private equity owners believed two things: they could find stronger people for those roles; and, they needed a different kind of leader to take the company to the next level.

ServiceNow’s former CEO and I once spoke of the need for a company to have one set of executives to take it from startup to $100 million in revenue. It would need a different team once it crossed $1 billion in revenue and another still at the $4 billion threshold. Given that Ultimate just crossed the $1 billion mark, it could be time for new executives.

My take 

Let’s wait for the 50 day go-shop period to end before getting really worked up. It could be interesting….

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