Technofile Europe

Wolters Kluwer catches compliance wave with FRSglobal acquisition

Today we’re very pleased to announce the sale of our portfolio company FRSglobal to Wolters Kluwer.  

Coming on the heels of the new Basel III accord, this deal is a small but significant milestone in the evolution of banking compliance following years of regulatory upheaval.  FRS and Wolters Kluwer's Financial Services unit will have their work cut out in providing solutions to help bank CFOs manage the welter of new regulations coming out of Basel III, Solvency II, the Dodd-Frank Act, MifiD and other regimes.

The financial crisis highlighted the importance of really understanding risk, not just managing it to regulatory requirements.  Wolters Kluwer -– an established purveyor of content to the legal, health and financial verticals – long ago started investing in bringing true analytics to senior decision-makers.  In fact, by 2009, software and online revenue represented more than 50% of Wolters Kluwer’s business, while books were less than 10%.

Like the acquisition by Thomson Reuters of Complinet, this deal also confirms the entrance of a new competitor group into the enterprise solutions markets previously dominated by IBM, Oracle and Microsoft.  Analytics (fka decision support) is the new battleground. The competition is likely to heat up, with IBM also announcing an acquisition last week in the risk management space.

When we acquired FRSglobal together with Carlyle’s European Technology Fund in 2006, we were tracking several trends: 

1. Need for centralised risk management. Banks had disparate, disconnected systems to manage compliance in each product group and geography.  This led to textbook-compliance only –- eg box-ticking exercises to please local regulators -– and deprived CFOs and risk managers of a single view of risk across the bank’s product silos.  This lack of risk oversight would have disastrous consequences in 2008.  FRS was and remains the only provider of a unified regulatory reporting platform that can address this issue for large banks.  Too late for some; in time for many. 
2. Convergence of content and software. The first wave of SaaS companies moved traditional enterprise applications (eg CRM) onto a hosted platform.  The next generation combines delivery of software functions with proprietary content -– eg domain databases, analytics, benchmarking data.  Without unique content, most SaaS businesses will be commoditised away.  FRS had worked out how to codify statutory regulations in 40+ countries into useable, actionable templates that banks could use to manage compliance.  Most important, however, FRS’s domain experts around the world continually maintain this content, effectively providing ongoing ‘compliance insurance’ to customers.
3. Shift from perpetual software licences to subscriptions.  In the 1990s investors and the public markets loved the spectacular growth rates of software companies flogging perpetual licences.  Big deals, high-flying sales people, and double/triple-digit growth drove valuations of 5x revenues and more.  But in recent years the markets have developed a total aversion to the volatility implicit in that model, so that now the highest valuations are reserved for companies with recurring revenues, strong cash flows and low churn.  When we bought FRS the idea of shifting to a recurring revenue model was a glint in the management team’s eye.  Today the majority of FRS revenues are recurring on long-term contracts, and –- thanks to its clients’ reliance on FRS to remain compliant with regulations -– customer churn is virtually nil.

We couldn't predict the financial crisis and the wave of interest in compliance that followed.  That was a spot of luck.  But the team we recruited into FRS, led by Steve Husk and Serge Minne, understood how to shepherd banks up the curve of the software and risk management trends above.  

FRS is an operational success story among European software companies, like Cramer Systems, Business Objects or StepStone.   It shows that there are top-notch management teams in Europe with whom we can build market-leading businesses given a modest amount of capital and a touch of vision.

Congratulations to Steve, Serge, Jeroen and the rest of the team.

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Stop this AIFM disaster

If ever the UK body politic needed reminding why European institutions make terrible -- even dangerous -- legislation, surely the imminent 'hedge fund bill' is the last straw.  As early as Monday the new Con-Lib government's George Osbourne will fight passage of this legislation in the European parliament, with nary a chance of defeating it.  

(Fred was admirably early on the ball, rallying European entrepreneurs against the bill.)

Officially known as the Directive on Alternative Investment Fund Managers (AIFM), this misguided reaction to the financial crisis by the EU's demagogues risks doing more long-term damage to the European economy than the Greek financial crisis. 

The nub of it is this: 

In their populist hunt for a bogeyman, the Eurocrats have latched onto hedge funds, blaming them for various aspects of the financial crisis (CDO trading, shorting bank stocks, etc), and even for the Greek debt crisis.  In spite of scant evidence, Brussels declared these funds to pose a 'systemic risk' to the financial sector, and drafted new rules to curtail and control them.

So far, so mediocre.  But the real disaster is that the politicians have failed to understand the structure of the equity financing markets, and have lumped into this legislation not only hedge funds, but also private equity firms, real estate funds and hundreds of venture capital firms.

Not only does this directive do nothing to address systemic risk (neither PE-backed nor VC-backed companies pose any, and arguably hedge funds don't either), it threatens to throttle the one potential engine of growth in Europe: entrepreneurship.

If passed in its current form, the AIFM directive will: 

• require VC-backed companies with 50 or more employees to disclose their financial performance, capital structure, divestment plans, research spending and strategy;  
• increase the compliance burden on venture funds and (probably) require them to hold additional regulatory capital; and,  
• discriminate against non-EU investors in European funds, making it more difficult to raise new funds.  This is likely to lead to retaliatory action from the US, further reducing the flow of capital to innovation.

It is estimated that the cost of complying will set portfolio companies back €30k or more per year.  But more insidious is the loss of competitiveness that results from revealing so much to the market.  Many growth companies will be required to disclose more confidential information than divisions of large public companies or foreign companies with which they compete!  Score one for big business against the little guy...

European venture capital is still a relatively young industry, and one that is going through tumultuous times.  But the growing number of high-growth technology and Internet ventures, and the development of a real class of repeat entrepreneurs, remains one of the few bright spots.  And they arguably represent one of the few export industries that can help pull this continent out of the doldrums. 

This legislation has too much political momentum to be stopped, although there is some hope of it being watered down as it goes through the approval process.  If only the Eurocrats invested as much time in thinking about the real systemic risks to the economy, like the structure of the banking industry or the lack of control over national budgets... and left the innovation sector alone. 

I used to be a real Europhile and advocate of the UK joining the Euro.  But if this kind of legislation is the best our 'European government' can do, then we had better steer well clear. 

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Death, taxes and financial regulation

As the global banking sector convulses with the most comprehensive restructuring in memory, voices on both sides of the Atlantic are calling for tighter banking regulation in order to prevent a future meltdown.  Heads had to roll and a number of senior executives have lost their jobs, while others find themselves inadvertently turned into civil servants operating state-owned banks. 

Relatively speaking, that was the easy part.  The question now is: how to regulate the industry better without stifling financial innovation?

There is no shortage of ideas coming from European and US regulators, many bad (executive pay caps, short sale bans), some good (clearinghouses for private financial contracts).  The only thing we can say for certain is that there will be amendments to existing Basel II and Mifid regulations, as well as new initiatives to increase disclosure and fiddle with capital adequacy rules.

As a participant on the margins of financial markets, I hope regulators err on the side of improving the transparency and liquidity of existing financial innovations, rather than try to constrain the complex financial products whose reckless distribution got us into this mess.  

The fact is that every link in the chain of this financial crisis -- subprime mortgages, credit default swaps, counterparty defaults, off-balance sheet investment vehicles -- was beset by the same fundamental problem:

insufficient information to
(a) gauge value, and
(b) understand dependencies.

This was an information crisis.  The new financial instruments and their markets simply got ahead of risk managers', CEOs' and regulators' ability to keep track of them.  And this is in spite of all the technical tools to manage this information being readily available.

We have a vested interest in this problem, through our investment in FRSglobal.  Until this year, FRS provided necessary but unexciting solutions to banks to calculate risk and to automate regulatory reporting.  Today, FRS is talking to regulators all over the world about how to improve everyone's visibility of risks and interdependencies among banks.  FRS CEO Steve Husk blogs about these issues here. 

The crisis is the catalyst that is finally bringing together risk management, business analytics and reporting -- a 3-way marriage software vendors and consultants have talked about for a decade, but which no one has yet consummated.  It's time for CFOs to have a single view of risk exposure, and to report on that view to both their boards and the regulators. 

To this end, FRS has made two acquisitions in the past 3 months: Swiss-based vendor of integrated risk management solutions IRIS (see Gartner's take here), and SAP/Business Objects subsidiary SECAM+, a specialist in regulatory reporting for the UK securities industry. 

Traditional ERP and even banking systems vendors acknowledge that the new paradigm of risk management and reporting is a highly specialised activity, requiring purpose-built analytical tools and extensive banking domain knowledge.  For this reason, incumbents like SAP and Temenos are partnering with FRS to deliver unified risk management to their clients.

It's only the beginning of the consolidation in this market and a lot of uncertainty remains.  But to death and taxes, we can undoubtedly add 'more regulation' to the list of certainties.

What does the crisis mean for growth capital and VC?

A lot of people have been asking me what impact the global financial crisis has on the business of venture capital and growth equity.  The short answer to this question is: not much.  The slightly longer answer is: not much, yet.

Let me explain.

If you are currently raising a venture capital or growth capital fund, the paralysis of investors worldwide means slower decision-making and a longer fund-raising cycle.  You may even lose some previously committed investors who are now conserving cash to cover losses in other asset classes.  If you have recently raised a fund then you are in good shape.  As banks, non-bank companies and consumers are rapidly finding out, when credit is tight cash is king.

But what about the impact on our business of investing in businesses?  Our existing portfolio companies will feel the crisis on two fronts: commercial performance and exit horizon. 

First, a prolonged recession will make it harder to land customers and grow revenues.  This means that business plans will take longer to achieve.  The exception may be in countercyclical or recession-proof segments, such low-priced entertainment (eg, games), discount retail (eCommerce), cost-reduction tools (eSourcing, supply chain optimisation), and products that address the current crisis directly (like compliance software, or trading platforms for previously 'hidden' financial assets). More on the latter category in a future post.

Second, as the IPO window remains shut for longer and M&A activity slows, there will be fewer buyers for companies and acquisition prices will be depressed.  We already saw throughout 2008 a flight to quality: companies with strong topline growth and high profitability are still being acquired and achieving good valuations.  The companies best able to survive this environment are those with strong 'operating leverage' -- that's VC-speak for high gross margins.  High margins reduce the effect of slower revenue growth and give companies more flexibility to reduce their cost structure as the market slows.

For investors, the key is to be able to wait for the right time to sell a company. This means both the internal timing (strong operations, good growth, a clean balance sheet) and external timing (market interest).  Companies that are profitable or close to profitability have a huge advantage in this market.

The impact on the private equity industry will vary drastically.  At the top end, LBO funds have already seen a huge increase in their equity cost as they refinance debt packages with equity, while their companies' earnings decline.  This is a continuation of the shake-out that started a year ago.

The second most affected category will be early-stage VC.  Most VC-backed companies are loss-making and were valued at the time of investment on the basis of aggressive growth forecasts, or expected strategic value on exit, or both.   Slower growth and a longer-time-to-exit means they will need to raise more capital, probably on worse terms.  This increases the equity cost of their investors and extends their investment horizon, depressing rates of return. 

Already we are seeing VC firms increase the follow-on reserves for existing portfolio companies, which will mean less capital available for new investments.  In the last downturn, many shifted their focus to later-stage investments, leading to a funding drought for pre-revenue companies.  More on the dilemma for early-stage companies on Fred Wilson's blog here, and Jason Calacanis' here.

The least affected, in my view, will be growth equity and midmarket buyout firms.  Growth equity portfolio companies typically have little or no debt financing and are cash-generative (or can get there quickly).  This means they can adapt their operations to slower market conditions, invest in discrete growth opportunities, and wait for the right time to exit.  The best ones will be acquired for the quality of their earnings by savvy buyers even during the downturn.  Growth equity investors can focus these businesses on improving the quality of the business and finding pockets of higher growth while positioning the business with potential acquirers.

Lastly, the more unpredictable effect is on the making of new investments in the technology markets.  In the 2001-2003 downturn (which was heavily weighted toward the technology industry) few entrepreneurs felt confident enough to write aggressive growth plans, and as a result it was difficult to find quality companies to invest in.  But I think this one is going to be different.  Here's why:

First, this recession is going to be more generalised, similar to the banking-led industrial downturn of 1980-82, with a correspondingly smaller effect on the technology industry itself. 

Second, the European investment eco-system is far deeper and more mature than it was in 2001.  Back then, a nascent VC and entrepreneurship market was nearly wiped out by the collapse in stock market values.  Today, we are tracking thousands of European technology companies that have shown more than 5 years of continuous growth, are profitable and in many cases geographically diversified.  This represents a very deep pool of potential investments, which are supported by a broad universe of specialised lawyers, bankers, recruiters, and angel investors.  So, I think that for investors with funds, good research capability and a broad network of sources for dealflow, there will be no shortage of investment opportunities.  Equally, for entrepreneurs with capital-efficient businesses, that have demonstrated an ability to prosper in good times and bad, there will be no shortage of investment capital.

Let's see how it plays out.

FRSGlobal acquires IRIS

Among the few segments of the technology industry actually benefiting from the crisis roiling the financial markets are risk management and compliance.  As shareholders scrutinise banks' risk management practices and regulators debate new reporting requirements, financial institutions of all sizes are having to review how they assess and report on risk. 

Earlier this year I wrote about the need for a more comprehensive approach to risk management to take account of off-balance sheet assets and more correlated financial markets.  In particular, I made the point that the bank CFO needs to have a holistic view of risk that is independent from the risk management systems used by individual trading desks. 

In response to increasing demand for end-to-end risk systems under the CFO's control, we announced today the acquisition of IRIS Integrated Risk Management by our portfolio company FRSGlobal.  Iris is known for having one of the most sophisticated platforms for managing complex risks in a single, integrated application.  About 230 financial institutions worldwide use its products. 

FRSGlobal will combine Iris' financial analysis capabilty with its ability to generate regulatory reports in over 30 countries to become the world's only one-stop shop for risk management and regulatory reporting for banks.

As you can tell, I'm pretty excited about this deal, because it (a) makes a lot of strategic sense and has a the support of FRSGlobal's and Iris's existing customers; and (b) it's always satisfying to find a market segment that is counter-cyclical as we head into uncertain economic waters.

Picture credit: Van Gelder Insurance.

What's in a name?

If nothing else the Carlyle Capital debacle is a good lesson in where to draw the line in extending your brand.  The Carlyle Group's partners owned only 15% of the fund, and yet they had lent it their prestigious name.  As a result the hedge fund's collapse has become a PR nightmare for Carlyle, when it could have been the disappearance of just another over-leveraged hedge fund, and little more than a (painful) personal investment loss for Carlyle's partners.  A lesson to remember for the next cycle.

Time for risk management 2.0

The unrelenting waves of bad news coming out of the financial services industry these days all seem to wash ashore at the same place -- on the desk of the CFO and his compliance team.  Financial risk management just isn't what it used to be.  Or rather, the risks themselves have moved so significantly in the past 10 years that banks have not managed to keep up (except, perhaps, the whiz kids at Goldman). 

Time for a change, or as Steve Husk of FRSGlobal suggests in his new blog, banks need to decide whether they want to be Southampton FC or Real Madrid (really!).  It's time for a two-dot-oh look at risk management.

In my view 3 main factors have contributed to an exponential increase in the scope and complexity of risk.  First came an acceleration of innovation in financial instruments, with investment banks churning out weekly new spins on the securitisation concept to ensure they had something to sell to clients, something to trade in and out of to generate fees, and -- in many cases -- something for their prop trading desks to buy.  The sophistication of these products have come a long way from Bowie bonds to a finely-graded slice of sub-prime mortgage risk.

Second, the entrance of new market participants, including hedge funds, corporate treasurers and commodities offices, the banks' own SIVs, and -- finally -- consumers egged on by retail bank 'consultants', created greater liquidity but also volatility in the market.  The behaviour of many of these market participants was not predictable and their reaction in a crisis untested.

Third, capital moves at higher speed through many more jurisdictions today than ever before.  There is no such thing as a domestic or European or American capital market today.  The effects of US subprime mortgage defaults are being felt in every corner of the globe, much to the surprise, no doubt, of the poor souls who are actually defaulting.

And yet the risk management approach used by most banks is based on legislative concepts that were  developed decades ago, in a simpler world of capital offsetting measurable liabilities on balance sheets (Basel I, Basel II).  The IT systems on which these risk management processes run tend to be local financial accounting systems, perhaps even instrument- or business line- specific, with little integration with the global exposures of the bank.

Now that banks know their real exposure is much greater than previously thought, and with the threat of increasing regulation if they don't find a way to regulate themselves, it's time to dust off those formerly Utopian plans to develop a single view of risk within the bank.

For both banks and corporates the era of keeping multiple sets of books is drawing to a close.  There is simply too much risk in not having a single, accurate, reportable view of the financial position.  The board will want to see the same report as the regulator is reviewing.  And when the regulator calls, the CFO wants to make sure his reporting is fully transparent and auditable.

It's no longer good enough to delegate local regulatory reporting to country managers. Regulators from different countries are talking to each other and are likely to exchange information and continue to harmonise their requirements.  For a bank operating across the world, this means local financial reporting needs to be in synch.  For the CFO, it means reducing risk of local error, while increasing global visibility of the numbers. 

So while general IT spending by banks will likely tail off this year, spending on compliance processes and risk management will continue, benefting firms like Riskmetrics (which is going public today), Algorithmics, and FRSGlobal (disclosure: Kennet company).  It is likely to take banks years to consolidate their financial systems and arrive at a single, global view of risk and an ability to report on it.  The good news is that this is more a process problem than a technology problem.  Recent technical innovations, including all that Web 2.0 stuff, make it notionally easier than ever.  Time to get started.