Private equity and venture capital tend to stay out of each other's way.
The former turns a buck from injecting a mix of financial engineering and operational smarts to rejuvenate and grow a business, the latter by aggressively funding an ambitious new business from disruption through to total domination, whatever the cost.
In this context, the Australasian accounting software market has thrown up a fascinating clash between the two related but ultimately divergent paths to value maximisation.
The ultimate winner, if there even is one, will be as much about who can create the best software to help the millions of Australia's small enterprises "keep their books" as it will be about profitability and ubiquity.
What makes the situation even more fascinating is that even though these rivals, MYOB and Xero, are being guided by private capital they both find themselves quoted on listed exchanges. And this situation has attracted the attention of opportunistic speculators, institutions and short sellers.
With regard to MYOB, which has long been Australia's favoured accounting software package, opinions could not be more divided.
The business was bought from Archer Capital by esteemed private equity house Bain Capital in 2011 for $1.3 billion – and re-listed in 2015. Bain, of course, is well known for its association with 2012 Republican presidential candidate Mitt Romney.
At present MYOB's enterprise value is $2.5 billion. That's roughly the same size of rival Xero, the New Zealand-based, dual-listed cloud computing juggernaut that is backed by venture capitalist all-stars such as Accel Partners and Donald Trump's Silicon Valley booster Peter Thiel.
Sharemarket investors wary
For MYOB, much has been made of the fact that Bain still holds about 57 per cent of the company which at some stage it will have to sell – as is the nature of private equity. Management incentives are structured so that the higher the share price in the 20 days leading into the end of September of this year, the more of outstanding performance shares will be granted.
That has some convinced that this is Bain's desired exit timetable, and that the short-term share price matters.
But others point out that Bain, which could have sold out by now, as its shares are out of escrow, is not under any great time pressure to sell. And when it does sell, it may well attract investors who desire greater liquidity.
Australian sharemarket investors, who have found themselves on the wrong side of a private equity sale a few too many times, are justifiably wary.
But anticipating a PE "hospital pass" has also been a winning strategy for short-sellers that are lining up to bet against MYOB.
The most recent ASIC data ranks MYOB among the top 15 highest short positions on the ASX, with 8 per cent of all shares loaned out to speculators. But when you look at the short position as a percentage of the free float, it's over 20 per cent.
There have been few such high conviction short bets in the market, especially for what appears a strong, profitable and growing business.
Investment gap
It's no surprise that much of the short case centres around the private equity overhang, which has weighed on the stock. The shorts also hold the view that to maximise the market value of the business heading into the float, and the sell-down, MYOB has used its market domination to increase prices – which has helped grow its earnings and support its valuation.
But MYOB, the shorts say, will face a difficult balancing act in sustaining price increases and growing users amid tougher competition. MYOB must balance the need to deliver earnings growth to support its valuation with the need to develop and market its product.
Xero is rapidly gaining market share as more small businesses migrate to the cloud – where customers pay a monthly fee to access accounts online from just about anywhere.
The cloud has dramatically changed the industry and while Xero led the revolution, MYOB, to its credit, has followed fast.
In the race to own the cloud, MYOB is spending about $60 million per annum on research and development – a ratio that analysts say is in line with global peers. It's also not shirking on sales and marketing, which accounts for 20 per cent of revenues.
But Xero is spending more – by a factor of 2.5 to 3 times. An "investment gap" is opening up, say the bears.
Stereotyping dangerous
This apparent investment gap is where the divergent approaches of PE and VC matter. MYOB has debt to service, dividends to pay and earnings to produce, all of which constrain from investing as much as it needs to do to keep up with aggressive competitors such as Xero and Intuit.
Xero's uber growth-oriented shareholders are being rewarded not on profits or PE ratios (which don't exist, as in Xero's case, when the "E" is negative and the company is posting losses) but on market share gain. This is seen as a measure of pace in the race towards the eventual dominance of the sector, which Xero investors believe will ultimately maximise the value of their investment.
As one analyst put it, in MYOB "you are buying from a top tier PE firm at a valuation that is more than twice what they paid another PE firm, both of whom have taken a lot of cash along the way".
But with Xero "you're investing alongside a top tier VC firm at a valuation below the price they have injected growth capital into the business – which you are a beneficiary of".
The shorts are clearly of the view that any efforts at MYOB to maximise point-in-time valuation – for example, to time with Bain's potential exit in September – will come at a cost to the long-term value of the business, and it's a matter of time before this becomes apparent.
But could they be wrong? Absolutely.
Stereotyping can sometimes be dangerous. PE exits aren't always executed at the expense of buyers and venture capital doesn't always succeed.
Not a 'winner takes all market'
It's worth pointing out that as much as high short interest is a sign of scepticism in a company's valuation, it also means that just a hint of good news could trigger a parabolic rally, as the shorters are sent scrambling to buy back shares.
The assertion that Xero is out-investing MYOB by three times may also be exaggerated, some have suggested.
MYOB management make the point that when it comes to accounting software there are no truly global players. Every state, city and country has its own tax and administration codes, so outright dollars don't imply the same factor of spending in a particular market. Xero may be outspending MYOB, but not at the pace suggested.
There's also fair point to be made that being profitable, as MYOB is, may be more sustainable than a red ink fuelled quest for market share. Time will tell.
With regard to the sustainability of price increases, it's worth noting the utility of the product relative to the cost. The accounting software being developed by MYOB and Xero saves hours but costs less than what a small business would spend each year on coffee, paper and other sundry items.
CEO Tim Reed says customer surveys shows their bank feed function saves customers 10 hours, so an additional $3 to $4 per month is a value increase exchange. And as they develop new tools he envisages more functions that will increase efficiency will create more value, and lead to higher revenues.
The relatively low cost of accounting systems that getting better admin and accounting functions is central to the bull case for MYOB.
Reed's message, and that of some shareholders, is that this isn't a "winner takes all market".
Undervalued or overvalued?
The move to online means the customer value increases while the servicing costs decline, and with only 20 per cent of businesses migrated to the cloud, the revenue for the whole sector will increase. That's before the well recognised "churn" as small businesses constantly close and form.
So is MYOB undervalued or overvalued? At over 20 times forward earnings, few would regard it as cheap, but neither is it grossly out of whack with peers.
More bullish analysts argue that MYOB's discount to peers such as Intuit (which is ramping up its presence in Australia) isn't justified given the growth it is likely to generate as more users convert to the cloud.
We may know more on February 23 when MYOB reports its full year earnings. It's a set of numbers that shareholders, short-sellers and competitors are eager to see.
But in truth, we will have to wait much longer to know for sure whether MYOB did enough to hold off the threat of Xero and win enough of the market to justify a higher valuation.
Until then, all sides will be minding their own business, watching and waiting for attractive entry and, more importantly, exit points.
