Everyone knows about the rapid consolidation going on in the enterprise software market. CIOs are now accustomed to frequent ownership changes among their application vendors, but most assume it simply signifies a maturing industry in which larger vendors buy up smaller ones to fill holes in their product lines, gain entry to new markets or build critical mass. But something more is happening — something that may have very different implications for application buyers: Private equity firms have been spending billions to buy up software companies and combine them into very large portfolio businesses.

Nearly every one of these acquisitions is positioned as one software company buying another, but it may not be that simple. If the acquiring company is owned or controlled by a private equity firm, there is a good chance that the transaction has more to do with investment strategy than application synergy. Should that make a difference to the customer?

Here’s the good news:

• Your vendor becomes part of a larger company with more resources.

• The private equity backers are financially savvy and have deep pockets.

• The new owner is likely to be more financially viable, and may have broader geographic coverage.

• The new owner is very interested in the installed base maintenance stream, and will focus on keeping existing customers happy.

• Private equity firms are often very good at trimming costs and improving operations.

And here’s the bad news:

• The real owners are financial investors with little interest in software products.

• Private equity firms typically do not want to hold an investment for more than five to seven years.

• Employee, product or customer loyalty is unlikely to influence business strategy.

• Debt reduction is a much higher priority than long-term product investments.

Software buyers need to understand who really owns their vendors. They should determine whether those owners are motivated to build a world-class software company with long-term customer relationships, or if they are simply focused on exiting within a few years with a good financial return.

The players

Throughout the 1980s and 1990s, most software companies were started and nurtured on venture capital. While venture capital firms (VCs) are still funding software start-ups, a set of private equity investors has joined them, buying up mature software companies or taking public companies private.

In some cases, these firms manage a portfolio of independent software companies much as the VCs have done, but a small group of private equity firms – notably, Golden Gate Capital, Francisco Partners, and Thoma Cressey Equity Partners – have taken a much more aggressive approach. They select one of their portfolio companies to use as an aggregator, and then acquire companies at a brisk pace to create new mega-vendors with financial resources, customer bases, and product footprints on par with some of the biggest traditional enterprise application companies.

Perhaps the best example of this technique is Infor Global Solutions (which has become the home for SSA, BAAN, Mercia, D&B Software, JBA, Marcam, Mapics and Systems Union, among others) but Attachmate, Made2Manage, GXS and JDA are also further instances.

This type of consolidation comes at a price that, unfortunately, customers must pay. Because it is very expensive for customers to switch their enterprise applications, most companies have little choice but to stay put, pay maintenance and hope for the best.

Money makes the whole thing work. Aggregators must find a way to pay the debts they acquired to finance their expansion and generating cash flow to service their debt is essential. Cutting costs and focusing investments on only the most productive sectors and maintenance revenue help to generate that cash flow, but it can come at the expense of customer service and product enhancements. Golden Gate paid approximately $130,000 per customer in order to merge SSA Global with Infor. This might seem expensive, but we estimate that SSA was generating between $40,000 and $50,000 in annual revenue per customer.

The private equity firms could easily be portrayed as a cynical bunch of financial guys. But the fact is that the enterprise applications market was filled with companies that couldn’t grow, yet had enough of a recurring revenue streamto ensure they wouldn’t die. We believe private equity investors have also recognised a fundamental truth: ultimately, customers are far more valuable than code.