As busy as I have been lately, I have tried to keep up on the various analyses of Blackboard’s acquisition by Providence Equity Partners, Inc. There seem to be two schools of thought. The first school, which seems to be getting the most play, is moderately negative for higher education. The second school, which I’ve seen gestured to in a few places here and there but never fully and clearly articulated, is neutral to positive for education.
I honestly don’t know which of these analyses is more accurate. Both are grounded in the known behaviors and motivations of private equity firms like Providence. Neither is supported by a lot of publicly available information specific to this deal. But the facts will come. My goal with this post is to provide a framework through which the facts we learn in the future can be interpreted by comparing them to one hypothesis or the other.
The Basics of Private Equity
The most fundamental fact you need to know about companies like Providence is that they use large amounts of debt to purchase other companies. Blackboard, as a publicly traded company, has lots of people who own little pieces of it in the form of stock shares. Some of those stock shares have been purchased with borrowed money, but a lot of them have been purchased with cash. It’s the stock market’s system of aggregating a large number of buyers with smaller amounts of cash that enables companies to get the cash they need to grow big quickly. When a private equity firm like Providence purchases a publicly traded company like Blackboard, they do so by essentially taking out a giant mortgage to buy up all the shares that are floating around in the market.
Why does this matter? It matters because giant mortgages come with giant mortgage payments. Private equity firms are able to get very good interest rates, but even a low interest rate on the purchase of a $1.5 billion company adds up to something substantial. There is a cost structure that is inherent in these deals, and that structure puts some constraints on what the new owners can do with the company. As a result, there are a couple of different relatively standard strategies that private equity companies take to get a return on their investments. The two most prominent strategies correspond to the two most prevalent analyses that we’re seeing of the Blackboard deal.
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Possibility #1: Providence is a Landlord
One way that private equity companies make money on their investments is to use them as cash cows. This is very similar to a real estate owner buying an apartment complex and collecting rent. Naturally, the landlord’s goal is to collect as much rent as possible while putting only enough money into the building to keep the tenants in it.
On the surface, Blackboard appears to have all the characteristics that would make it a good rental property. The building managers have done a superb job of keeping the quarterly income rock-steady predictable. It’s hard for renters to move, so the new landlord is not likely to suffer mass vacancies very quickly. And rental prices have been going up steadily over the years.
But scratch the surface and there are problems with this approach. To begin with, there are signs that rents in the LMS market have peaked and there is downward pressure on prices. Part of that comes from the fact that competitors have improved the housing stock in the neighborhood, so there is more competition. Also, Blackboard already has significant debt, which means that the mortgage on the new building will have to be even larger and the mortgage payments will therefore be proportionally larger. If rents are going down, tenants are leaving, and the mortgage is massive, then the investment value of the property starts to look less attractive. Landlords in this situation are forced to make some hard choices that are often not so good for the tenants. This is essentially some of the logic behind Jim Farmer’s first post, and I have heard similar arguments from other people whose financial analysis I trust. However, many of these same people were surprised that the deal happened in the first place, precisely because it looks like a bad deal for the new landlord.
It could be that Providence took this deal because they are either they know more than everybody else or because they were in a hurry and cut some corners. Either possibility is at least mildly plausible. On the one hand, Providence has a strong reputation in the financial markets for being a canny investor. It’s possible that they went through Blackboard’s books (and remember, they would have had access to information that is not publicly available) and saw a better situation than is apparent to outside observers. On the other hand, the deal appeared to happen pretty quickly, and I’m told that the conditions in the bond market are such that private equity firms are under a lot of pressure to close deals now. This could have been a rush job.
Either of these possibilities is plausible, but neither is supported by significant publicly available evidence. For now, it’s probably best to assume that both are unlikely. Which brings us back to the point that the landlord investment thesis is not without its problems. Let’s look at the other thesis now.
Posssibility #2: Providence is a House Flipper
Another way that private equity firms make money off their investments is to buy properties that they think they can improve relatively quickly, invest in some changes that give them more curb appeal, and then sell them off again relatively quickly at a higher price. One way that private equity has been known to spruce up the property is, again, to lower costs. Keep in mind that Blackboard has significant cost cutting already built into their road map. We know that WebCT and ANGEL will both be gone by 2014. Each of these systems has development and support costs for Blackboard. We also know that the company plans to merge Elluminate and Wimba into a single next-generation platform that they have code named “Gemeni.” Again, one less platform means less cost. I don’t know how much these cost savings will add up to. They are likely to be significant, though maybe not enough to fundamentally change company valuation.
But there may also be another game afoot. So far, most of the public analysis of this acquisition assumes that Blackboard is at best a solid, reliable earner whose days of explosive growth are essentially over. Certainly, the stock market seems to have valued Blackboard mainly for its reliability rather than its growth potential. But what if Providence thinks that assumption is wrong? Blackboard was able to grow to a $1.5 billion company because of the massive adoption wave of institution-wide LMS installations in the first half of the last decade. What if Providence thinks the same thing is about to happen in Brazil, Russia, India, China, or other large developing-world countries? If so, and if Blackboard can capitalize on that second wave (which is likely to be a lot larger than the first one was), then the market valuation of the company could be much higher a few years from now.
Taking advantage of new global demand, even if it comes, will not be easy. Open source is much better established in developing countries than it is here, largely because it has been the only affordable alternative. So Blackboard wouldn’t have the same green field that they had in the United States. On the other hand, it takes capital to really reach those markets and sell into them, and that’s one thing Providence can make sure that Blackboard has. In contrast to the stock markets, which only think three months out (at most) and would not tolerate any major dips in Blackboard’s quarterly revenue and profit growth, private equity can afford to take a longer view. They could tolerate a few weak quarters in the interest of long-term growth, as long as they’re able to make their mortgage payments. Private equity firms as house flippers can potentially be net positive for education if they enable the companies they acquire to make strategic investments that otherwise would have been difficult or impossible. This appears to be the opinion of Lou Pugliese, the current CEO of Moodlerooms, former CEO of Blackboard, and a guy with a lot of experience in the financial markets. He wrote in a recent blog post responding to the Blackboard news,
Throughout my career, I have been a staunch supporter of private equity investment in education. I applaud those forward thinking, sometimes visionary firms who have managed to strike a balance between the emphasis on “patient capital”, and the strong motivation for serving the best interests of technology innovation in education. Private equity can indeed be a strong ally in public education to the extent that the financial over-engineering and the drive for earnings does not jeopardize long term value creation for institutions, which is often the original, but overlooked intent in financial transactions.
In this scenario, the Providence purchase might enable Blackboard make the investments it needs to make in order to catch the second wave overseas while actually moderating the amount of cost cutting they need to do by relaxing the quarter-to-quarter demands that the public markets have put on the company.
There may be a second play along similar lines but domestically focused. It’s starting to look more and more like American colleges are going to need to make substantial investments in ensuring and documenting better learning outcomes, through analytics, higher touch student counseling, and other methods. Nobody knows how big this wave could be, but Blackboard has made some acquisitions that begin to position it for the possibility that the wave will be pretty big. At the extreme end of this line of speculation, it is conceivable that Providence could seek a merger between Blackboard and SunGard. Such a deal would be complex to pull off, since Providence only owns 10% of SunGard and would have to convince the other investors to go for the deal, but it is not completely outside the realm of possibility. In any case, merger or no merger, having companies focused on providing a portfolio of products and services for improving student outcomes could be a net positive for education.
I Don't Know. Really and Truly.
Right now, we just don’t have the data we need to know which of these possibilities is closer to the way that Providence sees the world. Going forward, both company statements and company actions will provide evidence that can be used to sort out the truth. Do they make increasingly high profile press releases about their efforts to grow their overseas business? Do they sell off parts of the business or start laying off employees? All of these actions will be visible, and all can be fitted to one or the other of the hypotheses above and will tell us what Providence's true investment thesis is. And, of course, there's the separate question of whether that thesis turns out to be correct.
In other words, it's going to be another interesting year.