please can you explain the Palamon Case, Palamon Caputal Partners/Teamsystem S.P.A

PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. We want to make money by investing in change. -Louis Elson, Managing Partner, Palamon In February 2000, Louis Elson looked over the London skyline and reflected on the international private equity industry and the investment processes that would be necessary for success in this increasingly competitive field. Elson, a managing partner of the U.K.-based private equity firm Palamon Capital Partners, was specifically considering an investment in TeamSystem S.p.A., an Italian software company. Palamon was interested in TeamSystem for the growth opportunity that it represented in a fast-changing market. Palamon had an opportunity to purchase a 51% stake in TeamSystem for (euro) EUR 25.9 million. In preparing a recommendation to his colleagues at Palamon, Elson planned to assess TeamSystem's strategy, value the firm, identify important risks, evaluate proposed terms of the investment, and consider alternative exit strategies. International Private Equity Industry The international private equity industry was segmented into three sectors. Venture capital funds made high-risk early-stage investments in startup companies. Generalist private equity funds provided expansionary funding or transitional funding that allowed small companies to grow and eventually go public. And leveraged buyout funds financed the acquisitions (often by management) of pre-existing companies that had the capacity to take on debt and make radical improvements in operations. Private equity funds raised capital primarily from individual investors, pension funds, and endowments that were interested in more attractive risk/return investment propositions than the public capital markets offered. Funds existed all over the world, but, not surprisingly, North America had the largest number of funds and largest dollar value of capital invested as of 1999. Europe and Asia had the next largest private equity industries. Exhibit 1 presents the number and dollar values of private equity funds by global geographic region. Most private equity markets saw rapid growth in the 1990s. In Europe, the amount of new capital raised grew from EUR4.4 billion in 1994 to EUR25.4 billion in 1999. Correspondingly, the amount of capital invested by the funds more than quadrupled from EUR5.5 billion to EUR25.1 billion over the same period. Exhibit 2 summarizes the amount of new capital raised and the amount invested through the 1990s. Some key players in the mid- market sector in Europe included Duke Street Capital (EUR650 million fund based in the United Kingdom), Mercapital (EUR600 million fund based in Spain), and Nordic Capital (EUR760 million fund based in Sweden). Large investment banks such as Dresdner, Deutsche Bank, and Banca de Roma also had notable private equity presences. Louis Elson and Palamon Capital Partners 1 Louis Elson began working in private equity in 1990, when he joined E.M. Warburg, Pincus & Co. Soon after joining the firm, he began focusing on European transactions and, in 1992, decided to relocate permanently to Europe. Elson became a partner of Warburg, Pincus in 1995 and was an integral part of a team that built a US$1.3 billion portfolio of equity investments for the firm. The portfolio contained more than 40 investments in seven different European countries. In late 1998, Elson and another of his partners, Michael Hoffman, saw a unique window of opportunity in the European private equity industry. They believed that the European economic landscape was changing in a way that benefited smaller, middle-market companies. Therefore, Elson and Hoffman recruited two additional partners and began laying the foundation for what would eventually become Palamon Capital Partners. By August 1999, Elson and Hoffman had raised a fund of EUR440 million. They accomplished that despite macroeconomic obstacles like the Russian debt default by marketing their unique pan-European private equity experience. With the fund closed, Elson and Hoffman grew the Palamon team to nine professionals. They hired people with experience in private equity, investment banking, corporate finance, and management consulting. Consistent with Elson and Hoffman's original vision, the Palamon team used their breadth of experience to build a portfolio of investments that would provide investors with a unique risk profile and substantial monernlist nrivata ant find that contadtha on European transactions and, in 1992, decided to relocate permanently to Europe. Elson became a partner of Warburg, Pincus in 1995 and was an integral part of a team that built a US$1.3 billion portfolio of equity investments for the firm. The portfolio contained more than 40 investments in seven different European countries. In late 1998, Elson and another of his partners, Michael Hoffman, saw a unique window of opportunity in the European private equity industry. They believed that the European economic landscape was changing in a way that benefited smaller, middle-market companies. Therefore, Elson and Hoffman recruited two additional partners and began laying the foundation for what would eventually become Palamon Capital Partners. By August 1999, Elson and Hoffman had raised a fund of EUR440 million. They accomplished that despite macroeconomic obstacles like the Russian debt default by marketing their unique pan-European private equity experience. With the fund closed, Elson and Hoffman grew the Palamon team to nine professionals. They hired people with experience in private equity, investment banking, corporate finance, and management consulting. Consistent with Elson and Hoffman's original vision, the Palamon team used their breadth of experience to build a portfolio of investments that would provide investors with a unique risk profile and substantial long-term returns. Essentially, Palamon was a generalist private equity fund that served the segment of investor that was interested in less risk than venture capital, but more risk than the leveraged buyout funds. Accordingly, Palamon targeted a 35% return on a single portfolio investment, and 20% to 25% blended net return on a portfolio, with an investment horizon of approximately six years. Louis Elson said: Our investors include large American public sector pension funds, corporate pension funds, major financial institutions, and large endowment funds. They look for us to beat the return on the S&P Index by 500 basis points per year on average. We have the best chance of getting funded again if we can beat this target, adjusting of course for risk. We look to pick up good businesses at attractive prices, and then add value through active involvement with them. Like other generalist funds, Palamon's investment strategy was to make "bridge" investments in companies that wanted to move from small, private ownership to the public capital markets. Unlike many private equity funds, however, Palamon did not restrict itself to one specific European country, nor did it limit its scope to one industry. Instead, Palamon focused more broadly on small to mid-sized European companies in which it could acquire a controlling stake for between EUR 10 million and EUR50 million. For companies that fit Palamon's profile, the transition from private to public ownership required both funding and management ability. Palamon, therefore, complemented its financial investments with advisory services to increase the probability that the portfolio companies would successfully make it to the public markets. Elson was optimistic about Palamon's investment strategy. As Elson sat in his office, Palamon was finalizing its first investment, a Spanish Internet content company, Lanetro, S.A., and had three other investments (including TeamSystem) in the pipeline. Investment Process I Palamon's investment process began with the development of an investment thesis that would typically involve a market undergoing significant change, which might be driven by deregulation, trade liberalization, new technology, demographic shifts, and so on. Within the chosen market, Palamon looked for attractive investment opportunities, using investment banks, industry resources, and personal contacts. The search process was time-consuming, with only 1% of the opportunities making it through to the next phase, due diligence, which involved thorough research into the history, performance, and competitive advantages of the investment candidate. Typically, only one company made it through that final screen to provide Palamon with a viable investment alternative. Investment Process Palamon's investment process began with the development of an investment thesis that would typically involve a market undergoing significant change, which might be driven by deregulation, trade liberalization, new technology, demographic shifts, and so on. Within the chosen market, Palamon looked for attractive investment opportunities, using investment banks, industry resources, and personal contacts. The search process was time-consuming, with only 1% of the opportunities making it through to the next phase, due diligence, which involved thorough research into the history, performance, and competitive advantages of the investment candidate. Typically, only one company made it through that final screen to provide Palamon with a viable investment alternative. Palamon brought its deal-making experience to bear in shaping the specific terms of investment. Carefully tailored agreements could increase the likelihood of a successful outcome, both by creating the right incentives for operating managers to achieve targets, and by timing the delivery of cash returns to investors in ways consistent with the operating strategy of the target. Deal negotiations covered many issues including price, executive leadership, and board composition. Once a deal had been completed, Palamon then offered value-added support to management To close the process, Palamon searched for the best exit alternative, one that would help them fully realize a return on the fund's investment. Classic exit alternatives included sale of the firm through an initial public offering in a stock market, and sale of the firm to a strategic buyer. Exhibit 3 provides more detail about Palamon's process and the firm's investment screening criteria. TeamSystem, S.p.A. Palamon's theme-based search generated the opportunity to invest in TeamSystem, S.p.A. In early 1999, even before Palamon's fund had been closed, Elson had concluded that the payroll servicing industry in Italy could provide a good investment opportunity because of the industry's extreme fragmentation and constantly changing regulations. History had shown that governments in Italy adjusted their policies as often as four times a year. For Palamon, the space represented a ripe opportunity to invest in a company that would capitalize on the need of small companies to respond to this legislative volatility. With the help of a boutique investment bank and industry contacts, Palamon approached two leading players in the market. Neither company was suitable to Palamon, but both identified their most respected competitor as TeamSystem. Palamon approached TeamSystem directly and found a good fit. Due diligence was done and, by the end of the year, a specific investment proposal had taken shape. It was the one Elson now considered. TeamSystem was founded in 1979 in Pesaro, Italy. Since its founding, the company had grown to become one of Italy's leading providers of accounting, tax, and payroll management software for small-to-medium-size enterprises (SMEs). Led by cofounder and CEO Giovanni Ranocchi, TeamSystem had built up a customer base of 28,000 firms, representing a 14% share of the Italian market. TeamSystem was founded in 1979 in Pesaro, Italy. Since its founding, the company had grown to become one of Italy's leading providers of accounting, tax, and payroll management software for small-to-medium-size enterprises (SMEs). Led by cofounder and CEO Giovanni Ranocchi, TeamSystem had built up a customer base of 28,000 firms, representing a 14% share of the Italian market. TeamSystem offered its customers a compelling value proposition. The company's software integrated a business's financial information and automated tedious and complex administrative functions. The software also enabled SMEs and their financial advisors to stay on top of the frequently changing regulatory environment. To that end, TeamSystem continually invested in development to keep its software current. Customers were given access to product upgrades in exchange for a yearly maintenance fee that the company collected in addition to the initial purchase price of the software). TeamSystem had excelled in customer service and developed loyal customers. Nearly 95% of its customers renewed their maintenance contracts every year. 1 In 1999, TeamSystem generated sales of (lira) ITL60.5 billion (EUR31.3 million) and EBIT (earnings before interest and taxes) of ITL18.5 billion (EUR9.5 million). Those results continued a strong pattern of growth for TeamSystem. Since 1996, sales had grown at an annualized rate of 15% and operating margins improved. As a result, EBIT had grown at an annualized rate of 31.6% over the same period. Exhibit 4 provides additional detail on TeamSystem's historical sales and profitability from 1996 through 1999. Exhibit 5 contains balance sheet information for the same period. As Elson looked through the numbers, he noted the current lack of debt on TeamSystem's balance sheet. In his opinion, that represented an opportunity to bring TeamSystem to a more effective capital structure that might lower the company's cost of capital. Elson also noted the "pro forma" label on both financial statements. TeamSystem, given its private ownership and multicompany structure, did not have audited consolidated financial information for the previous five years. Industry Profile The Italian accounting, tax, and payroll management software industry in which TeamSystem operated was highly fragmented. More than 30 software providers vied for the business of 200,000 SMEs with the largest having a 15% share of the market (TeamSystem ranked number two with its 14% share.) All of the significant players in the industry were family-owned companies that did not have access to international capital markets. Exhibit 6 shows 1998 revenues for the nine largest players. Analysts predicted that two things would characterize the future of the industry- consolidation and growth. Consolidation would occur because few of the smaller companies would be able to keep up with the research and development demands of a changing industry. Analysts pointed to three acquisitions in 1998-99 as the start of that trend. As for growth, experts predicted 9% annual growth over the period 1999-2002. That growth would come primarily from increased PC penetration among SMEs, greater end-user sophistication, and continued computerization of administrative functions. The Transaction After reviewing TeamSystem's past performance and the state of the industry, Elson returned his attention to the specifics of the TeamSystem investment. The most recent proposal had offered EUR 25.9 million for 51% of the common (or ordinary) shares in a multipart structure that also included a recapitalization to put debt on the balance sheet: . . Palamon would invest ITL50.235 billion (EUR25.9 million) in the ordinary shares (i.e., common equity) of TeamSystem S.p.A. Those shares would be purchased from existing shareholders of TeamSystem. Giovanni Rannochi would maintain a 20% shareholding, while noncore employees would be diluted from holdings ranging from 3% to 8% to just 1% each after completion. I More than half of TeamSystem's ITL28.5 billion of cash was to be distributed to existing shareholders via two dividend payments before Palamon's investment: an ITL8.5 billion dividend to existing TeamSystem shareholders in April 2000, and a ITL6.5 billion dividend to be paid at time of closing. A cash balance of ITL13.5 billion would remain. With Palamon's assistance, TeamSystem would borrow ITL46 billion from Deutsche Bank, in a seven-year loan, offering a three-year principal repayment holiday and an initial cost of 1.0% over base rates (Italian government bonds). Shareholders would receive the proceeds of the debt at time of closing in another special dividend. Excess real estate would be sold by TeamSystem, thus removing the distraction of unrelated property investments. A group of existing shareholders had made an offer to purchase ITL2.1 billion of real estate at book value if the transaction closed. The sources and uses of funds in the transaction are summarized in Exhibit 7. An income statement and balance sheet for TeamSystem, pro forma the transaction, are given in Exhibits 8 and 9. Palamon, as a majority shareholder, would have full effective control of TeamSystem, although the existing shareholders would have a number of minority protection rights. For example, Palamon would be unable to dismiss Ranocchi for a two-year period. But Palamon would have the ability to deliver 100% of the shares of the company to a trade buyer should that be the appropriate exit. Furthermore, more than 40% of the cash to be paid to the departing shareholders would be held in escrow for a period of at least two years, under Palamon's control Excess real estate would be sold by TeamSystem, thus removing the distraction of unrelated property investments. A group of existing shareholders had made an offer to purchase ITL2.1 billion of real estate at book value if the transaction closed. The sources and uses of funds in the transaction are summarized in Exhibit 7. An income statement and balance sheet for TeamSystem, pro forma the transaction, are given in Exhibits 8 and 9. Palamon, as a majority shareholder, would have full effective control of TeamSystem, although the existing shareholders would have a number of minority protection rights. For example, Palamon would be unable to dismiss Ranocchi for a two-year period. But Palamon would have the ability to deliver 100% of the shares of the company to a trade buyer should that be the appropriate exit. Furthermore, more than 40% of the cash to be paid to the departing shareholders would be held in escrow for a period of at least two years, under Palamon's control. Valuation To properly evaluate the deal, Elson had to develop a view about the value of TeamSystem. He faced some challenges in that task, however. First, TeamSystem had no strategic plan or future forecast of profitability. Elson only had four years of historical information. If Elson were to do a proper valuation, he would need to estimate the future cash flows that TeamSystem would generate given market trends and the value that Palamon could add. His best guess was that TeamSystem could grow revenues at 15% per year for the next few years, a pace above the expected market growth rate of 9%, followed by a 6% growth rate in perpetuity. He also thought that Palamon's professionals could help Ranocchi improve operating margins slightly. Lastly, Elson believed that a 14% discount rate would appropriately capture the risk of the cash flows. That rate reflected three software companies' trading on the Milan stock exchange, whose betas averaged 1.44 and unlevered betas averaged 1.00. The second challenge Elson faced was the lack of comparable valuations in the Italian market. Because most competitors were family-owned, there was very little market transparency. The nearest matches he could find were other European and U.S. enterprise resource planning (ERP)' companies and accounting software companies. The financial profiles of those comparable firms are contained in Exhibits 10 and 11. Looking through the data, Elson noticed the high growth expectations (greater than 20%) for the software firms and correspondingly high valuation multiples 1 Risks Elson was concerned about more than just the valuation, however. He wanted to carefully evaluate the risks associated with the deal, specifically: TeamSystem's management team might not be able to make the change to a more professionally run company. The investment in TeamSystem was a bet on a small private company that Elson hoped would become a dominant, larger player. The CEO, Ranocchi, had successfully navigated the last five years of growth, but had, by his own admission, created a management group that relied on him for almost every decision. From conversations and interviews, Elson concluded that Ranocchi could take the company forward, but he had concerns about the ability of the supporting cast to deliver in a period of continued growth TeamSystem was facing an inspection by the Italian tax authorities. The inspection posed a financial risk, and therefore could serve as a significant distraction for management. Further, because it was "open-ended," the inspection might delay the company's ability to go public. Elson had quantified the risk, however, through sensitivity and scenario analysis, and believed that the expected monetary impact of the inspection was low. The company might not be able to keep up with technological change. While the company had begun to adapt to technological changes such as new programming languages, it still had some products on older platforms that would require significant reprogramming. In addition, the Internet posed an immediate threat if TeamSystem's competitors adapted to it more quickly than TeamSystem did. . I . Finally, Elson wanted to make sure that he could capture the value that TeamSystem might be able to create in the next few years. Exit options were, therefore, also an important consideration. Conclusion Elson looked at all the information that covered his desk and pondered the recommendation he should make to his partners. How much was a 51% stake really worth? What might explain the valuation results? What nonprice considerations should he make part of the deal? How might Palamon feasibly capture the value from the investment? Were the risks serious enough to compromise the value of the investment? Exhibit 1 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Size of Regional Private Equity Markets, 1999 Region North America Europe Asia Middle East Australia/Oceania Central/South America Africa Number of Funds 8,376 2,556 1,360 130 155 42 13 Total Value of Funds (in U.S.S millions) 892,598 160,749 60,582 1 6,469 5,741 5,044 1,711 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Historical Data on European Private Equity Market New Funds Raised per Year (EUR millions) 30,000 (EUR millions) 25,000 20,000 15,000 10,000 5,000 1989 1991 1993 1995 1997 1999 Funds Invested per Year Funds Invested per Year (EUR millions) 30,000 25,000 20,000 I (EUR millions) 15,000 10,000 5.000 1 1989 1991 1993 1995 1997 1999 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Screening Criteria and Investment Process Investment Process Palamon utilizes an investment process that has been proven over the past decade through economic cycles and across geographic regions. The process is underpinned by a core set of investment principles, which can be summarized by stage of the investment process. Determination of Investment Focus-Identify sectors undergoing significant changes, develop industry knowledge, and take a contrarian stance when appropriate. Pro-Active Deal Sourcing - Proactively pursue investment opportunities within identified sectors. Rigorous Due Diligence-Execute comprehensive yet focused company due diligence; concentrate on "deal breakers" early on. Sophisticated Deal Structuring-Base structuring on a sound knowledge of local practices without relying necessarily on ineffective customs: align objectives with the entrepreneur; avoid excess leverage Value Added Support-Provide strategic direction to portfolio companies; make international network of advisors and expertise available to management teams; commit to longer time horizons sufficient to ensure scope for company growth. Proven Realization Strategies Prepare for liquidity events; utilize in-house expertise to access public market capital or organize trade sales, creating exit options for all shareholders. Investment Screening Criteria 1 The partners of Palamon are especially rigorous in their investment selection criteria, identifying those characteristics that will foster high growth combined with manageable risk. The following key elements are sought in each investment made: Superior management with unique capabilities and experience Leadership in core markets which are either expanding robustly or are experiencing dislocation due to technological, regulatory, or competitive changes High potential for operating leverage Opportunity to access alternative markets . Access to undervalued assets Source: http://www.palamon.com, (accessed 19 December 2005), PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. TeamSystem S.p.A. Pro Forma Historical Income Statement (values in ITL millions) 1996 1997 1998 1999 Total sales 39,665 42,922 50,694 60,499 Cost of materials Cost of service Rents and leasing Total operating cost (9,979) (9,380) (328) (19,687) (11,430) (8,692) (394) (20,516) (12,258) (10,889) (1,493) (24,640) (15,179) (12,389) (1,553) (29,121) I Salaries Social contributions Other personnel costs Total personnel costs (4,875) (1.855) (456) (7,186) (5,382) (2,047) (481) (7,910) (6,282) (1,917) (572) (8,771) (7.151) (2,011) (753) (9,915) Other operating costs (2,793) (3,052) (3,133) (1,339) EBITDA Depreciation & amortization 9,999 (1,052) 11,444 (1,427) 14,150 (1,355) 20,124 (1,636) |EBIT Interest expense Non-op income 8,947 (185) 1,800 10,017 (144) 1,305 12,795 (154) 1,132 18,488 (210) 1,283 Other operating costs (2,793) (3,052) (3,133) (1,339) EBITDA Depreciation & amortization 9,999 (1,052) 11,444 (1,427) 14,150 (1,355) 20,124 (1,636) EBIT Interest expense 8,947 (185) 1,800 10,017 (144) 1,305 18,488 (210) 1,283 Non-op income 12,795 (154) 1,132 I 13,773 (6,437) Pretax profit Taxes 10,563 (5,870) 11,178 (6,699) 19,562 (9,525) Earnings before minorities Elimination of intercompany invest 4,693 (30) 4,479 (13) 7,336 (139) 10,036 (287) Net income 4,663 4,466 7,197 9,749 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. TeamSystem S.p.A. Pro Forma Historical Balance Sheet (values in ITL millions) 1996 1997 1998 1999 13,092 19,134 21,144 28,513 ASSETS Cash Marketable securities Receivables Inventory Total current assets 13,257 1,333 27,682 14,957 1,087 35,178 16,328 1,195 38,667 19,443 1.235 49,191 Intangible assets Land, PP&E Other tangible assets Deferred costs Securities and other Total assets 14 4,962 729 327 1,434 35,148 22 2,080 668 1,947 1,173 41,068 18 2,489 1,140 1,738 1.229 45,281 21 3,681 2,055 1.865 1,236 58.039 LIABILITIES Accounts payable Tax and other payables Deferred income and accruals Long-term liabilities Total liabilities 7,661 6,796 1,200 2,688 18,345 8,932 9,827 1,127 2,094 21,980 8,969 8,660 1,257 2,235 21.121 9,669 9,956 4,156 3,055 26,836 LIABILITIES Accounts payable Tax and other payables Deferred income and accruals Long-term liabilities Total liabilities 7,661 6,796 1,200 2.688 18,345 8,932 9,827 1,127 2,094 21,980 8,969 8,660 1,257 2.235 21,121 9,669 9,956 4.156 3.055 26,836 4,580 6,636 4,584 4,580 9,442 4,405 4,580 11,662 7,132 4,580 15,884 9,660 SHAREHOLDERS' EQUITY AND MINORITY INTEREST Capital Reserves Operating income (Less special dividend) Total shareholders' equity Minority interest Total shareholders' equity and minority interest 15,800 1,003 18,427 661 23,374 786 30,124 1,079 16,803 19,088 24.160 31,203 35,148 41,068 45,281 58,039 Total shareholders' equity and liabilities Source: Palamon memorandum. Exhibit 6 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Revenues for Top Companies in Italian Payroll Software Industry, 1998 Company TeamSystem Inaz Paghe Osra Sistemi Zuchetti Esa Software Omega Data Axioma Dylog Italia Revenues (ITL billions) 50.7 47.0 38.0 37.0 36.0 35.0 34.4 26.0 25.0 Exhibit 7 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Sources/Uses of Cash in Proposed Leveraged Restructuring (values in ITL millions) Sources: Debt Excess cash 46,000 15,000 61,000 I Uses: Special dividend-April 2000 Special dividend closing 8,500 52,500 61,000 Note: This table refers strictly to the leveraged recapitalization of TeamSystem. Ignored in this table are (1) the ITL 50.235 billion purchase of shares by Palamon from investors in TeamSystem and (2) a purchase of TeamSystem real estate for ITL 2.1 billion by investors. Palamon would not receive any of the special dividends. PALAMON CAPITAL PAR TeamSystem S.p.A. PI (values ir 2 2 1999 1998 1996 1997 691 60,499 50,694 39,665 42,922 Total sales Cost of materials Cost of service Rents and leasing Total operating cost (9,979) (11,430) (12,258) (9,380) (8,692) (10,889) (328) (394) (1,493) (19,687) (20,516) (24,640) (15,179) (12,389) (1,553) (29,121) (31. Salaries Social contributions Other personnel costs Total personnel costs (4,875) (1,855) (456) (7,186) (5,382) (2,047) (481) (7.910) (6,282) (1,917) (572) (8,771) (7.151) (2,011) (753) (9,915) (1C (2.793) (3.052) (3.133) (1,339) Other operating costs 2 9,999 (1.052) EBITDA Depreciation & amortization 11,444 (1.427) 20.124 (1.636) 14,150 (1,355) EBIT Interest expense Non-op income 8,947 (185) 1.800 10.017 (144) 1,305 12,795 (154) 1.132 18,488 (210) 1.283 Pretax profit Taxes 10,563 (5.870) 11,178 (6,699) 13,773 (6,437) 19,562 (9,525) Earnings before minorities Elimination of intercompany invest 4,693 (30) 4,479 (13) 7,336 (139) 10,036 (287) Net income 4,663 4,466 7,197 9,749 2002 2004 2003 2001 1999 2000 15% 69,573 2007 6% growth 123.131 15% 2005 6% 109,586 2006 6% 116,162 6% 97,532 6% 103,383 15% 80,009 0,499 92,011 5.179) 2.389) 1.553) 121) (31,308) (36,004) (41,405) (43,889) (46,523) (49,314) (52,273) (55,409) 45.00% of sales ",151) ,011) 753) -915) (10,784) (12,401) (14,262) (15,117) (16,024) (16,986) (18,005) (19,085) 15.50% of sales -339) (3,200) (3.680) (2.783) (3,901) (4.135) (4.925) 4.00% of sales (4.646) (4,383) 124 636) 24,699 (835) 28,403 (900) 32,664 (975) 34,624 (1.010) 36,701 (1.046) 38,903 (1,085) 41,237 (1.126) 43,712 (1.170) 25.00% of PP&E and Intang 42,542 488 2101 283 23,863 (3.160) 561 27,503 (3,160) 1,157 31,689 (3.160) 1.855 33,614 (2,765) 2.091 35,655 (1,975) 2,408 37.818 (1.185) 2.813 40,111 (395) 3,310 6,87% interest 5.00% retum on mkt secur 4,507 562 525) 21.265 25,500 30,383 32,939 36,088 39,446 43,026 47,049 (10,207) (12,240) (14,584) (15,811) (17,322) (18,934) (20,652) (22,584) 48.00% of pre-tax profit 36 87) 49 11,058 13,260 15,799 17.129 18.766 20,512 22,373 24,465 PALAMON CAPI TeamSystem S.p.A. Pro (values in IT 1998 1999 1996 1997 21,144 28,513 13.092 19,134 ASSETS Cash Marketable securities Receivables Inventory Total current assets 13.257 1.333 27,682 14,957 1,087 35,178 16.328 1,195 38,667 19.443 1,235 49,191 14 4,962 729 22 2,080 668 Intangible assets Land, PP&E Other tangible assets Deferred costs Securities and other Total assets 18 2,489 1.140 1.738 1.229 45.281 21 3,681 2.055 1.865 1.226 58,039 327 1.434 35.148 1.947 1,173 41,068 LIABILITIES Accounts payable Tax and other payables Deferred income and accruals Long term liabilities Total liabilities 7,661 6,796 1.200 2.688 18.345 8,932 9,827 1,127 2,094 21,980 8,969 8,660 1.257 2.235 21.121 9.669 9.956 4.156 3.055 26.836 4.580 6,636 4,584 4.580 9,442 4,405 4.580 11,662 7,132 4,580 15,884 9,660 SHAREHOLDERS' EQUITY AND MINORITY INTEREST Capital Reserves Operating income (Less special dividend) Total shareholders' equity Minority interest Total shareholders' equity and minority interest 15,800 1,003 18,427 661 23,374 786 30,124 1,079 16,803 19.088 24,160 31,203 Total shareholders' equity and liabilities 35,148 41,068 45,281 58,039 DEBT REPAYMENT Starting balance Principal due Payment Source: Case writer's analysis. Exhibit 9 APITAL PARTNERS/TEAMSYSTEM S.P.A. System S.p.A. Pro Forma Balance Sheet (values in ITL millions) 2007 2006 2003 2004 2005 2001 2002 1999 2000 1998 21.144 28,513 15,202 23.143 24,003 1,600 63.948 13,500 11,224 20,872 1,391 46,988 17,482 37,096 27,603 1,840 84,021 18,531 41,816 29,259 1,951 91,557 19.643 48,165 31,015 2.068 100,891 23.395 19.0% of sales 90,144 PLUG 36.939 30.0% of sales 2.463 2.0% of sales 152,941 22,071 66.196 34,848 2,323 125,438 20.821 56,253 32.876 2.192 112.142 19.443 1.235 49.191 16,328 1.195 38,667 18 2.489 1.140 1.738 1.229 45.281 21 3,681 2,055 1.865 1.226 $8.039 20 1,581 2.000 2,400 1.600 71.549 20 1,581 1,739 2,087 1,391 53,807 20 1,581 2.300 2,760 1.840 92.523 20 1,581 2,438 2,926 1.951 100,473 20 1.581 2,585 3,102 2.068 110.245 20 1.581 2,740 3.288 2.192 121.962 25% of sales 3.0% of sales 20% of sales 20 1.581 2,904 3,485 2.323 135.751 20 1.581 3,078 3.694 2,463 163.776 18,586 18 586 5.808 19,701 | 16.0% of sales 19,701 | 16.0% of sales 6,157 5.0% of sales 11.132 11,132 3,479 8.969 8,660 1.257 2.235 21.121 9,669 9.956 4.156 3,055 26,836 12,802 12,802 4,000 46,000 75,604 14,722 14,722 4,601 46,000 80,044 17,534 17.534 5.479 11,500 52,047 15.605 15.605 4,877 34,500 70.587 16.541 16,541 5.169 23,000 61.252 45,559 46,000 42.980 71,742 4.580 4,580 (24.398) (11,138) 13,260 15.799 4.580 15.884 9,660 4.580 11,662 7,132 4.580 4,661 17,129 4.580 21.789 18,766 4.580 40,553 20,512 4.580 61.067 22.373 4.580 83,440 24.463 4,580 25,544 11,058 (61.000) (19,818) 1,883 9,241 3.238 26,369 3,517 65,647 4,269 (6,558) 2.504 23,374 112.486 5,732 45.135 3.859 88,020 4,751 30,124 1,079 3.5% of equity 786 48,994 69,915 92.771 118.218 29.886 12,479 24,160 (4,054) 31,203 (17,935) 110.245 100.473 121.962 135.751 163.776 92,523 71,549 45.281 53,807 58,039 DEBT REPAYMENT Starting balance Principal due Payment 46,000 0% 0% 0% 25% 25% 25% 259 (11.500) (11.500) (11,500) (11.300) Exhibit 10 Vita PALAMON CAPITAL PARTNERS/TEAMSYSTE Valuation Measures for Publicly Traded Enterprise Resource Planning Adjusted Market Value as a Multiple of Equity Market Value as a Multiple of: Cal 1999 Cal. 2000 Cal. 2001 EPS EPS EPS Est. Est. Long-term Projected EPS Growth Long-term Op. Inc EPS Est. 26% 27% NM 37.9+ 47.81 Long-term Revenues Tier 1-Large ERP Players Baan 4.0 JD Edwards 1.6 x Oracle 6.8 Peoplesoft 2.3 SAP 8.31 Low 1.61 Mean 4.62 High 24% NM 26.2 x 32.0 23.6% 42.12 23.6 % 310 x 42.11 NM 74.94 27.8 x 44.3 36.62 NM NM 42.12 NM 61.91 42.12 52.0 61.91 NM 95.0 34.4 54.8 45.8 34.41 57.52 95.01 NM 75.21 379 53.61 75.21 27.8 x 24% 25% 24% 25% 27% 45.9 x 74.9 83 28.01 37.8 x 52.42 18.1 Tier 2Middle Market Accounting Software Companies Great Plains Software Inc. 4.8 x 8.1 x Intuit Inc. 5.8 x 42.8 Epicor Software 1.5 NM 16.0 x 58.5 x Sage Group PLC 0.7 x Symix 8.2 x 0.7 8.1 x Low Mean 5.8 x 29.4 High 16.0* 58.5 x 56.12 43.6 x NA 8431 12.61 126 1 49.21 84.31 48.22 62.42 54.2 71.1 13.51 13.51 49.9 71.12 58.22 12.1 43.2 142 43.0 9.4 9.41 27.6 43.2 35% 21% 28% 35% 28% 21% 29% 35% 12.1 x 35.7 58.22 Tier 3_Others Agresso 0.8% 1.6 x 40.2 x -69.2x 79.6 x 42.01 NM Intentia Navision 1219 N 15.6 62.12 41.6 72.72 7.7% 29.5 32.0 31.8 x 3.5 x NA NA Z Z 17.6 x 126.92 NM Brain International Low Mean High 3.1 x 0.8 x 5.8 x 17.6 x NM -69.2x 16.9 x 42.0 84.5 126.93 15.6 480 72.7 x 7.71 25.3 32.0 % NA 3.5 % 3.5 3.5 N 121 12 12 79.6 x Based on adjusted market capitalization, which is defined as equity market value + long-term debt - "Based on 1/B/E/S estimates. Source of: Thomson Financial's Datastream Advance. Exhibit 10 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. ures for Publicly Traded Enterprise Resource Planning (ERP) Software Companies ket Value ple of Equity Market Value as a Multiple of Cal. 1999 Cal. 2000 Cal. 2001 EPS EPS EPS Est Long-term Long-term Projected EPS Growth CY 1999 P/E to Long-term Margins Growth Rates 1 Year Op. Inc. EPS Est Est. LTGR Rev. EBIT EBIT Net NM NM NM 26% 8.2% 37.9 x 47.8 74.9 27% NM 26.2 x 32.0 23.61 42.1 23.6 31.0 42.1 24% NM 95.0 x 34.42 54.8 x NM 42.1 x NM 61.9 X 42.12 NM 75.2 37.9 53.6 x 75.2 x 44.2% 23.6% 61.1% 41.9% 27.8 44.3 X 36.6 x 27.8 x 45.9 74.9 x 45.82 NM NM 143% 231% 182% 143% 185% 231% 24% 25% 24% 25% 27% NM 77.0% 32.7% 41.7% 17.4% 17.4% 42.2% 77.0% -38.0% 6.2% 21.2% 9.9% 19.794 -38.0% 40.2% 5.0% 14.6% 2.1% 11.1% -40.2% -1.5% 14.6% 8.2% 34,4 % 57.5+ 95.0 x 52.0 61.9 35.8% 3.8% 61.1% 21.2% re Companies 8.1 56.1 x 28.02 590.5% 42.8 43.6 x 43.2 x 35% 21% 108% 247% 57.5% 12.8% 40.1% NA 28% NM 58.5 821 8.1 29.4 58.5 14.2 x 43.0 x 48.22 62.42 54.2 71.1 x 13.5 13.51 49.9 71.1 84.3 12.6 x 12.6 x 49.24 843 x 37.81 52.4x 18.1 x 58.2 12.1 x 12.1 x 35.7% 58.2 9.4 x 35% 28% 21% 29% 35% 66% 165% 43% 43% 126% 247% 9.4 27.6 x 43.2 NA 25.9% 48.4% 12.8% 36.2% 57.5% 58.9% 13.6% - 10.0% 27.4% 8.4% - 10.0% 19.7% 58.9% NA 26.6% 68.0% 26.6% 181.3% 590.5% 9.5% 16.3% -10.2% 17.7% 5.1% -10.2% 7.796 17.7% 42.0 x 40.22 -69.24 15.6 NM 3.5 x NA NA 121% NA 126.9 NA NM 79.6 NM -69.2x 16.9 79.6 NA 7.7 x 29.52 32.0 x 31.8 7.7 x 25.3 32.0 62.1 x 41.6% 72.72 15.6 48.0 72.72 6% NA NA NA 6% 6% 6% 266.4% 51.7% 91.5% 23.1% 23.1% 108.2% 266.4% NA 121% 121% 121% 42.0 x 3209.1% 115,6% 137.9% -66.0% -66.0% 849.2% 3209.1% 1.8% -5.5% 14.0% 1.1% -5.5% 2.1% -2.4% 22.1% -0.2% -2.4% 5.4% 22.1% 3.5 x 3.5 3.5 x 84.5 x 126.9 2.9% 14.0% which is defined as equity market value + long-term debt - cash & equivalents. eam Advance PALAMON CAPITAL PARTNERS/TEAMS Financial Data for Selected Enterprise Resource Planning (values in USD thousands, except per-sha Long Term Debt Cash & Equiv. Adjusted Market Value (a) Revenues Op. Inc. 200,546 Equity Market Value Tier 1 - Large ERP Players Baan 2,637,618 JD Edwards 1,829,385 Oracle 62,282,746 Peoplesoft 3,611,452 SAP 41,907,460 121,697 211,782 2,562,764 498,155 693,411 2,716,467 1,617,603 60,021,122 3,113,297 41,932,907 674,664 1,001,263 8,827,252 1,333,095 5,052,321 (256,440 61,842 1,872,88 131,97: 995,53 301,140 718,858 Tier 2 - Middle Market Accounting Software Companies Great Plains Software 767,893 123,683 Intuit Inc. 6,476,010 36,043 1,761,200 Epicor Software 154,977 47,304 Sage Group 5,997,648 136,046 78,171 Symix 84,421 4,109 3,261 644,210 4,750,853 107,673 6,055,523 85,269 134,907 814,889 73,688 377,477 123,010 79,48 111,00 (7,33 103,59 10,31 Tier 3 - Others Agresso Intentia Navision Brain International 1,398 36,833 88,554 557,217 655,707 256,499 18,680 12,655 6,285 39,283 71,272 581,395 649,422 237,207 85,973 352,988 36,875 76,686 1,7 (8,4 8,1 (1 19,991 (a) Based on adjusted market capitalization, which is defined as equity market value + long-term (b) Based on I/B/E/S estimates. Source of data: Datastream. UVA-F-1331 -18- Exhibit 11 CAPITAL PARTNERS/TEAMSYSTEM S.P.A. cted Enterprise Resource Planning (ERP) Software Companies es in USD thousands, except per-share data) Cal. 2001 EPS Book Cal. 2000 EPS Est. (b) Total Assets Adjusted Market Value (a) Est. (b) Value EPS Revenues Op. Inc. 7 2 2,716,467 1,617,603 60,021,122 3,113,297 41,932,907 674,664 1,001,263 8,827,252 1.333,095 5,052,321 (256,446) S (1.35) S 0.08 61,842 $ 0.45 s 0.18 1,872,881 $ 0.87 S 1.21 131,978 S 0.05 0.26 995,535 $ 5.33 S 8.76 s 0.10 S 0.23 S 1.50 S 0.32 S 10.96 112,821 583,996 3,695,267 664,292 2,096,138 696,510 950,473 7,259,654 1,440,605 4,083,069 5 644,210 4,750,853 107,673 6,055,523 85.269 134,907 814,889 73.688 377,477 123,010 79,489 $ 0.86 S 1.28 $ 1.72 111,009 S 2.15 S 1.79 $ 2.17 (7,333) NA S 0.21 S 0.27 103,595 $ 0.58 $ 0.83 S 1.13 10,374 $ 0.91 $ 0.95 $1.22 133,193 1,673,405 122,196 11,187 36,749 180,252 2,469,865 199,735 650,375 73,346 71,272 581,395 649,422 237,207 85,973 352,988 36,875 76,686 1,771 S 0.04 $ 0.24 (8,400) S (0.72) $ 0.74 8,155 $ 0.20 $ 0.80 (164) $ 0.13 $ 1.26 S 0.53 NA NA NA 40,804 104,085 9,540 65,365 89,789 275,714 25,127 107,844 ed as equity market value + long-term debt - cash & equivalents. PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Recent ITL/EUR Exchange Rates On January 1, 1999, the European Community fixed the ITL/EUR conversion rate at LIT 1,936.27. The exchange rates that follow were estimated through euro vs. dollar exchange rates,' and are proxies for open market rates of exchange. Date September 1999 October 1999 November 1999 December 1999 January 2000 ITL/EUR 1696.3 1740.1 1901.8 1912.6 2055.0 ITL/EUR I 2100.0 2000.0 1900.0 1800.0 1700.0 1600.0 1500.0 Sep-99 Oct.99 Nov-99 Dec-99 Jan-00 Exhibit 13 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Capital-Market Conditions, February 2000 Yield Instrument EUIBOR 90-day 6-month 3.41% 3.78% 4.11% I 1-year Government Bonds (euro-denominated) Italy, April 2004 Italy, July 2007 Italy, March 2011 Euro Area, 5 years Euro Area, 7 years Euro Area, 10 years 6.00% 5.87% 9.25% 5.16% 5.45% 5.61% Price/Earnings Multiple Equity Market Index Milan MIB30 Index FTSE 100 Index (London) DAX Index (Frankfurt) 37.87 28.75 57.47 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. We want to make money by investing in change. -Louis Elson, Managing Partner, Palamon In February 2000, Louis Elson looked over the London skyline and reflected on the international private equity industry and the investment processes that would be necessary for success in this increasingly competitive field. Elson, a managing partner of the U.K.-based private equity firm Palamon Capital Partners, was specifically considering an investment in TeamSystem S.p.A., an Italian software company. Palamon was interested in TeamSystem for the growth opportunity that it represented in a fast-changing market. Palamon had an opportunity to purchase a 51% stake in TeamSystem for (euro) EUR 25.9 million. In preparing a recommendation to his colleagues at Palamon, Elson planned to assess TeamSystem's strategy, value the firm, identify important risks, evaluate proposed terms of the investment, and consider alternative exit strategies. International Private Equity Industry The international private equity industry was segmented into three sectors. Venture capital funds made high-risk early-stage investments in startup companies. Generalist private equity funds provided expansionary funding or transitional funding that allowed small companies to grow and eventually go public. And leveraged buyout funds financed the acquisitions (often by management) of pre-existing companies that had the capacity to take on debt and make radical improvements in operations. Private equity funds raised capital primarily from individual investors, pension funds, and endowments that were interested in more attractive risk/return investment propositions than the public capital markets offered. Funds existed all over the world, but, not surprisingly, North America had the largest number of funds and largest dollar value of capital invested as of 1999. Europe and Asia had the next largest private equity industries. Exhibit 1 presents the number and dollar values of private equity funds by global geographic region. Most private equity markets saw rapid growth in the 1990s. In Europe, the amount of new capital raised grew from EUR4.4 billion in 1994 to EUR25.4 billion in 1999. Correspondingly, the amount of capital invested by the funds more than quadrupled from EUR5.5 billion to EUR25.1 billion over the same period. Exhibit 2 summarizes the amount of new capital raised and the amount invested through the 1990s. Some key players in the mid- market sector in Europe included Duke Street Capital (EUR650 million fund based in the United Kingdom), Mercapital (EUR600 million fund based in Spain), and Nordic Capital (EUR760 million fund based in Sweden). Large investment banks such as Dresdner, Deutsche Bank, and Banca de Roma also had notable private equity presences. Louis Elson and Palamon Capital Partners 1 Louis Elson began working in private equity in 1990, when he joined E.M. Warburg, Pincus & Co. Soon after joining the firm, he began focusing on European transactions and, in 1992, decided to relocate permanently to Europe. Elson became a partner of Warburg, Pincus in 1995 and was an integral part of a team that built a US$1.3 billion portfolio of equity investments for the firm. The portfolio contained more than 40 investments in seven different European countries. In late 1998, Elson and another of his partners, Michael Hoffman, saw a unique window of opportunity in the European private equity industry. They believed that the European economic landscape was changing in a way that benefited smaller, middle-market companies. Therefore, Elson and Hoffman recruited two additional partners and began laying the foundation for what would eventually become Palamon Capital Partners. By August 1999, Elson and Hoffman had raised a fund of EUR440 million. They accomplished that despite macroeconomic obstacles like the Russian debt default by marketing their unique pan-European private equity experience. With the fund closed, Elson and Hoffman grew the Palamon team to nine professionals. They hired people with experience in private equity, investment banking, corporate finance, and management consulting. Consistent with Elson and Hoffman's original vision, the Palamon team used their breadth of experience to build a portfolio of investments that would provide investors with a unique risk profile and substantial monernlist nrivata ant find that contadtha on European transactions and, in 1992, decided to relocate permanently to Europe. Elson became a partner of Warburg, Pincus in 1995 and was an integral part of a team that built a US$1.3 billion portfolio of equity investments for the firm. The portfolio contained more than 40 investments in seven different European countries. In late 1998, Elson and another of his partners, Michael Hoffman, saw a unique window of opportunity in the European private equity industry. They believed that the European economic landscape was changing in a way that benefited smaller, middle-market companies. Therefore, Elson and Hoffman recruited two additional partners and began laying the foundation for what would eventually become Palamon Capital Partners. By August 1999, Elson and Hoffman had raised a fund of EUR440 million. They accomplished that despite macroeconomic obstacles like the Russian debt default by marketing their unique pan-European private equity experience. With the fund closed, Elson and Hoffman grew the Palamon team to nine professionals. They hired people with experience in private equity, investment banking, corporate finance, and management consulting. Consistent with Elson and Hoffman's original vision, the Palamon team used their breadth of experience to build a portfolio of investments that would provide investors with a unique risk profile and substantial long-term returns. Essentially, Palamon was a generalist private equity fund that served the segment of investor that was interested in less risk than venture capital, but more risk than the leveraged buyout funds. Accordingly, Palamon targeted a 35% return on a single portfolio investment, and 20% to 25% blended net return on a portfolio, with an investment horizon of approximately six years. Louis Elson said: Our investors include large American public sector pension funds, corporate pension funds, major financial institutions, and large endowment funds. They look for us to beat the return on the S&P Index by 500 basis points per year on average. We have the best chance of getting funded again if we can beat this target, adjusting of course for risk. We look to pick up good businesses at attractive prices, and then add value through active involvement with them. Like other generalist funds, Palamon's investment strategy was to make "bridge" investments in companies that wanted to move from small, private ownership to the public capital markets. Unlike many private equity funds, however, Palamon did not restrict itself to one specific European country, nor did it limit its scope to one industry. Instead, Palamon focused more broadly on small to mid-sized European companies in which it could acquire a controlling stake for between EUR 10 million and EUR50 million. For companies that fit Palamon's profile, the transition from private to public ownership required both funding and management ability. Palamon, therefore, complemented its financial investments with advisory services to increase the probability that the portfolio companies would successfully make it to the public markets. Elson was optimistic about Palamon's investment strategy. As Elson sat in his office, Palamon was finalizing its first investment, a Spanish Internet content company, Lanetro, S.A., and had three other investments (including TeamSystem) in the pipeline. Investment Process I Palamon's investment process began with the development of an investment thesis that would typically involve a market undergoing significant change, which might be driven by deregulation, trade liberalization, new technology, demographic shifts, and so on. Within the chosen market, Palamon looked for attractive investment opportunities, using investment banks, industry resources, and personal contacts. The search process was time-consuming, with only 1% of the opportunities making it through to the next phase, due diligence, which involved thorough research into the history, performance, and competitive advantages of the investment candidate. Typically, only one company made it through that final screen to provide Palamon with a viable investment alternative. Investment Process Palamon's investment process began with the development of an investment thesis that would typically involve a market undergoing significant change, which might be driven by deregulation, trade liberalization, new technology, demographic shifts, and so on. Within the chosen market, Palamon looked for attractive investment opportunities, using investment banks, industry resources, and personal contacts. The search process was time-consuming, with only 1% of the opportunities making it through to the next phase, due diligence, which involved thorough research into the history, performance, and competitive advantages of the investment candidate. Typically, only one company made it through that final screen to provide Palamon with a viable investment alternative. Palamon brought its deal-making experience to bear in shaping the specific terms of investment. Carefully tailored agreements could increase the likelihood of a successful outcome, both by creating the right incentives for operating managers to achieve targets, and by timing the delivery of cash returns to investors in ways consistent with the operating strategy of the target. Deal negotiations covered many issues including price, executive leadership, and board composition. Once a deal had been completed, Palamon then offered value-added support to management To close the process, Palamon searched for the best exit alternative, one that would help them fully realize a return on the fund's investment. Classic exit alternatives included sale of the firm through an initial public offering in a stock market, and sale of the firm to a strategic buyer. Exhibit 3 provides more detail about Palamon's process and the firm's investment screening criteria. TeamSystem, S.p.A. Palamon's theme-based search generated the opportunity to invest in TeamSystem, S.p.A. In early 1999, even before Palamon's fund had been closed, Elson had concluded that the payroll servicing industry in Italy could provide a good investment opportunity because of the industry's extreme fragmentation and constantly changing regulations. History had shown that governments in Italy adjusted their policies as often as four times a year. For Palamon, the space represented a ripe opportunity to invest in a company that would capitalize on the need of small companies to respond to this legislative volatility. With the help of a boutique investment bank and industry contacts, Palamon approached two leading players in the market. Neither company was suitable to Palamon, but both identified their most respected competitor as TeamSystem. Palamon approached TeamSystem directly and found a good fit. Due diligence was done and, by the end of the year, a specific investment proposal had taken shape. It was the one Elson now considered. TeamSystem was founded in 1979 in Pesaro, Italy. Since its founding, the company had grown to become one of Italy's leading providers of accounting, tax, and payroll management software for small-to-medium-size enterprises (SMEs). Led by cofounder and CEO Giovanni Ranocchi, TeamSystem had built up a customer base of 28,000 firms, representing a 14% share of the Italian market. TeamSystem was founded in 1979 in Pesaro, Italy. Since its founding, the company had grown to become one of Italy's leading providers of accounting, tax, and payroll management software for small-to-medium-size enterprises (SMEs). Led by cofounder and CEO Giovanni Ranocchi, TeamSystem had built up a customer base of 28,000 firms, representing a 14% share of the Italian market. TeamSystem offered its customers a compelling value proposition. The company's software integrated a business's financial information and automated tedious and complex administrative functions. The software also enabled SMEs and their financial advisors to stay on top of the frequently changing regulatory environment. To that end, TeamSystem continually invested in development to keep its software current. Customers were given access to product upgrades in exchange for a yearly maintenance fee that the company collected in addition to the initial purchase price of the software). TeamSystem had excelled in customer service and developed loyal customers. Nearly 95% of its customers renewed their maintenance contracts every year. 1 In 1999, TeamSystem generated sales of (lira) ITL60.5 billion (EUR31.3 million) and EBIT (earnings before interest and taxes) of ITL18.5 billion (EUR9.5 million). Those results continued a strong pattern of growth for TeamSystem. Since 1996, sales had grown at an annualized rate of 15% and operating margins improved. As a result, EBIT had grown at an annualized rate of 31.6% over the same period. Exhibit 4 provides additional detail on TeamSystem's historical sales and profitability from 1996 through 1999. Exhibit 5 contains balance sheet information for the same period. As Elson looked through the numbers, he noted the current lack of debt on TeamSystem's balance sheet. In his opinion, that represented an opportunity to bring TeamSystem to a more effective capital structure that might lower the company's cost of capital. Elson also noted the "pro forma" label on both financial statements. TeamSystem, given its private ownership and multicompany structure, did not have audited consolidated financial information for the previous five years. Industry Profile The Italian accounting, tax, and payroll management software industry in which TeamSystem operated was highly fragmented. More than 30 software providers vied for the business of 200,000 SMEs with the largest having a 15% share of the market (TeamSystem ranked number two with its 14% share.) All of the significant players in the industry were family-owned companies that did not have access to international capital markets. Exhibit 6 shows 1998 revenues for the nine largest players. Analysts predicted that two things would characterize the future of the industry- consolidation and growth. Consolidation would occur because few of the smaller companies would be able to keep up with the research and development demands of a changing industry. Analysts pointed to three acquisitions in 1998-99 as the start of that trend. As for growth, experts predicted 9% annual growth over the period 1999-2002. That growth would come primarily from increased PC penetration among SMEs, greater end-user sophistication, and continued computerization of administrative functions. The Transaction After reviewing TeamSystem's past performance and the state of the industry, Elson returned his attention to the specifics of the TeamSystem investment. The most recent proposal had offered EUR 25.9 million for 51% of the common (or ordinary) shares in a multipart structure that also included a recapitalization to put debt on the balance sheet: . . Palamon would invest ITL50.235 billion (EUR25.9 million) in the ordinary shares (i.e., common equity) of TeamSystem S.p.A. Those shares would be purchased from existing shareholders of TeamSystem. Giovanni Rannochi would maintain a 20% shareholding, while noncore employees would be diluted from holdings ranging from 3% to 8% to just 1% each after completion. I More than half of TeamSystem's ITL28.5 billion of cash was to be distributed to existing shareholders via two dividend payments before Palamon's investment: an ITL8.5 billion dividend to existing TeamSystem shareholders in April 2000, and a ITL6.5 billion dividend to be paid at time of closing. A cash balance of ITL13.5 billion would remain. With Palamon's assistance, TeamSystem would borrow ITL46 billion from Deutsche Bank, in a seven-year loan, offering a three-year principal repayment holiday and an initial cost of 1.0% over base rates (Italian government bonds). Shareholders would receive the proceeds of the debt at time of closing in another special dividend. Excess real estate would be sold by TeamSystem, thus removing the distraction of unrelated property investments. A group of existing shareholders had made an offer to purchase ITL2.1 billion of real estate at book value if the transaction closed. The sources and uses of funds in the transaction are summarized in Exhibit 7. An income statement and balance sheet for TeamSystem, pro forma the transaction, are given in Exhibits 8 and 9. Palamon, as a majority shareholder, would have full effective control of TeamSystem, although the existing shareholders would have a number of minority protection rights. For example, Palamon would be unable to dismiss Ranocchi for a two-year period. But Palamon would have the ability to deliver 100% of the shares of the company to a trade buyer should that be the appropriate exit. Furthermore, more than 40% of the cash to be paid to the departing shareholders would be held in escrow for a period of at least two years, under Palamon's control Excess real estate would be sold by TeamSystem, thus removing the distraction of unrelated property investments. A group of existing shareholders had made an offer to purchase ITL2.1 billion of real estate at book value if the transaction closed. The sources and uses of funds in the transaction are summarized in Exhibit 7. An income statement and balance sheet for TeamSystem, pro forma the transaction, are given in Exhibits 8 and 9. Palamon, as a majority shareholder, would have full effective control of TeamSystem, although the existing shareholders would have a number of minority protection rights. For example, Palamon would be unable to dismiss Ranocchi for a two-year period. But Palamon would have the ability to deliver 100% of the shares of the company to a trade buyer should that be the appropriate exit. Furthermore, more than 40% of the cash to be paid to the departing shareholders would be held in escrow for a period of at least two years, under Palamon's control. Valuation To properly evaluate the deal, Elson had to develop a view about the value of TeamSystem. He faced some challenges in that task, however. First, TeamSystem had no strategic plan or future forecast of profitability. Elson only had four years of historical information. If Elson were to do a proper valuation, he would need to estimate the future cash flows that TeamSystem would generate given market trends and the value that