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Posted: June 28, 2011

Investing in the cloud

For most private equity firms, pluses outweight the minuses

Carolyn Duffy

As cloud computing storms the business world, it is impossible for private equity firms to ignore it. The real question is whether they should adopt it for their portfolio companies.

This isn't a one size fits all question for PE groups. The cloud computing decision has to take several factors into account, including investment focus, the question of control and the likely acquirers of portfolio companies. However, by and large the cloud presents many of the opportunities for PE firms that it does for everyone else and for those reasons, it rates serious consideration.

Cloud computing - defined loosely as any computing function that occurs using the Internet - has gained in popularity on three levels: general software packages; a platform as a service that is modified for a customer; and infrastructure such as storage and computer servers. As compared to having to buy software, servers, space to house them in and technicians to implement and update them, cloud applications are browser-based. Cloud computing has lower upfront costs, a shorter implementation cycle, and is constantly updated. It also offers access anywhere and transparency into the financial and operational status of a company.

Private equity owned
Some industries don't have many cloud applications to choose from yet. Process manufacturing involving food, beer, wine, dairy or processed foods is one example. The construction industry is beginning to put some of its applications into the cloud - think of field personnel logging progress completion reports into their PDAs - but it brings us to a major point: The first thing you need to do is make sure there are sufficient applications in your industry.

Once you're satisfied there are suitable cloud software applications for your industry, you have to decide who owns the primary license for the cloud software or service. If the PE firm owns and controls the system, it can sublicense the same package to its investment companies. This can be an attraction as many investments don't have more basic financial systems than QuickBooks.

By adopting cloud computing for operational and financial systems of both the PE and portfolio firms, a private equity group maintains control of the flow and quality of information. A PE firm can set up a chart of accounts that corresponds to the kind of reporting it wants, and configure it in a standard way across all investments.

Say, for example, a firm invests in software companies. A cloud system could be implemented in numerous investments because you are comparing apples to apples for operational or financial information. The same is true for manufacturing, even if they are manufacturing different products. Inventory is inventory and the same metrics for analyzing cost of goods sold would apply whether it is jewelry or clothing. These are examples of industries that the cloud can serve because there are robust applications for them.

A basic cloud package can be useful even for a sprawling PE firm with investments across many industries. For example, we recommended a cloud system for an investment firm that owned two client companies, one in building maintenance and another in health services. Because they were both basically selling time and expense, it worked well and both feel they are on a good system despite the fact they are in different industries.

Once a portfolio company is sold, the company's data is easily migrated into most other systems, cloud or on-premise. After the sale, the seller no longer has access to the information.

One aspect to investigate in regards to a PE owned license is linked to the control issue. Legal counsel may have to advise on who owns the information. It may seem fairly simple; if the PE firm owns a controlling share, then it would naturally own the information. But there may be exceptions, and it becomes especially murky where there isn't a majority ownership.

Investment company owned
If the investment company owns the license, it, not the PE group, would have complete control of the data and processes. Having a portfolio of investments each with their own license would cost more, but may also be perceived by a buyer as more valuable. Additionally, a company may find that it can benefit more from a particular cloud application with features endemic to its particular industry, than from a basic package. All of the above may play into a PE's decision for the investment company to own the cloud application license.

The consideration of the buyers of portfolio companies is also important. Let's say you sell one of your portfolio companies to a major conglomerate and the acquirer runs on a major on-premise system and has alternative cloud systems at work in outlying offices. An investment with its own license could be attractive to that conglomerate because they don't want the field operations to run on the on-premise system.

It would be my preference for PE groups to own their own licenses and sub-license to their investments. The world is going to the cloud anyway. Wouldn't it be great to just have consolidated data instead of buying software, hiring engineers and installing upgrades? I look to venture capital groups to be early adapters because of their comfort with technology.

The cost involved with the cloud is so much less and cloud solutions provide solid analytics. I've been horrified at large companies that are run on spreadsheets or QuickBooks. All of a sudden, because you don't have to buy the main frames and hire the engineers, there's no excuse anymore not to have all of the tools that the cloud can bring. PE firms and their portfolio groups are no exception.
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Carolyn Duffy, CPA, is a director of business advisory services for Hein & Associates, a full-service accounting and advisory firm with offices in Denver, Houston, Dallas, and Southern California. She specializes in cloud computing software implementation, as well as designing and implementing methodologies for SOX 404 and IT service lines. Carolyn can be reached at cduffy@heincpa.com or 303-298-9600.

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