Recent reports indicate the Hewlett-Packard Enterprise Co. may be talking to private equity groups about selling its software business or even, if one report is to be believed, the entire company.

Although the latter seems a remote possibility, it might just be the right one for HPE, according to several private equity experts and companies that have gone private. Slow-growing companies such as HPE find it difficult to make big changes in the glare of quarterly scrutiny, so going private may give it the breathing room it needs.

BMC Software Inc. CEO Robert Beauchamp, for example, has said there’s no way his company could have made the investments it needed to make to reinvent itself if it had to worry about quarterly accountability. “We spent nine figures on R&D to create a new strategy,” he said in a recent interview with SiliconANGLE. “I don’t think the company could have made as much progress as we have in the past two years if we weren’t private.”

But going private also carries a lot of risks for tech companies looking to stay on the cutting edge, not least because private equity firms are usually looking to cut costs, with long-term investments like research and development in their crosshairs. “Private equity investments usually focus on short-term results, and short-term results are usually the enemy of innovation,” said Ken Doctor (@kdoctor), an analyst and author who specializes in the economics of media.

There’s no question that a trend is building toward tech companies opting for private ownership rather than submitting themselves to the tumult of the public market. Among the prominent once-public companies that have gone private in recent years are BMC Software Inc., Compuware Corp., Dell Inc., Riverbed Technology Inc., SolarWinds Inc., Informatica Corp. and Tibco Software Inc. With its pending purchase by Dell, EMC effectively is being taken private. Another venerable software company, Syncsort Inc., never went public, but sold to a private equity firm late last year.

What is private equity?

Private equity firms raise capital from private investors who seek better returns than they can get with “safe” investments like Treasury bonds and money market funds without the volatility of the public markets. The private equity industry is lightly regulated and publicity-averse. Hedge funds, which invest money on behalf of wealthy investors, are one type of private equity firm.

Being a target of a private equity acquisition says something about your company. “Private equity firms are notorious for scooping up beleaguered businesses, attempting to turn those companies around and then selling them,” wrote Geri Terzo in an explainer on Chron.com. At their worst, the new owners chop up companies into pieces and sell them off, as was a favored tactic of Albert J. “Chainsaw Al” Dunlap.

More commonly, though, private equity firms invest in mature businesses with the idea of reinvigorating them for an eventual public offering. In almost all cases, they cut costs at the acquired company in order to maximize cash flow to pay off the debt that was taken on to fund the buyout.

“They’re generally seeking companies whose best growth days are behind them,” said David Readerman (@dreaderman, left), managing member at Endurance Capital Partners LLC. “Revenue growth at the acquired company is usually decelerating and investors are looking for the part of the business that’s mature but producing stable cash flows. They use those cash flows to pay down the debt and improve the balance sheet.”

If all goes well, the company may attempt another initial public offering, creating the potential for a big payday for the investors. Or the company to continue as a privately held concern indefinitely. Either way, profitability is paramount. “The bankers have to get paid,” Readerman said. “You can pay that loan annually or get a terminal payment in the form of an IPO.”

Best-case scenario

The success of a private equity buyout depends a lot upon the investors. Patient ones will give the company leeway to make long-term investments that can return the company to growth without sacrificing profitability. That’s what BMC is betting on as it attempts to make itself over into an enabler of digital business while reducing its dependence on legacy mainframe software sales.

With high margins and reliable maintenance revenues, mainframe software companies like BMC are considered ideal targets for private equity firms. So are companies with big legacy customer bases and high switching costs, like HPE.

Removing the harsh light of quarterly investor accountability enables business leaders to move more quickly and set long-term goals. “One of the biggest advantages to working for a smaller private equity-owned firm is the ability to have more control of your day-to-day decision-making and destiny,” wrote Chris Davis, executive human resources leader at WestRock Co. in a LinkedIn post. He added that employees at privately held companies are able to make a bigger impact on the business and often better salaries because stock options aren’t available as compensation. That can improve retention and morale.

On the other hand…

Taking a company private isn’t all sunshine and flowers, however. Because of the ever-present need to service the debt burden, unprofitable lines of business are usually on the chopping block. Volatile or marginally profitable businesses, like commodity hardware, may be considered unattractive.

The same goes for long-term projects with questionable returns. For example, HPE’s The Machine, a futuristic computing architecture with a questionable commercial availability date, could be at risk. And forget about the kind of multi-year-loss business plans that fueled legendary startups like Amazon.com Inc. Anything that doesn’t produce profits in the near term is expendable. “It’s all about cash flows,” Readerman said.

For innovation-driven tech companies, a bottom-line focus can be a disaster. A private equity firm’s “usual modus operandi is to find companies that are ‘undervalued,’ meaning that they can wring more profit over a two- to four-year time span by deeply cutting costs and keeping a company’s product ‘good enough,'” Doctor (right) said. “Unfortunately, ‘good enough’ becomes the enemy of a long-term sustainable and profitable future.”

High-priced talent may be dismissed for the sake of maximizing profits which damages morale and saps the company of the skills it needs to compete, particularly in high tech. Or the acquirers may lack the expertise to lead the firm in a competitive business.

That’s what happened to Prime Computer Inc. after its purchase by private equity firm J.H. Whitney & Co. in 1989. Whitney was a “white knight” that rescued Prime from a hostile takeover bid, but it knew precious little about IT or Prime’s market. In the end, Whitney lost nearly its entire investment and Prime was never heard from again.

“Rich and powerful but inexperienced investors and invasive venture capital companies can force a company down a path to failure,” wrote Rob Enderle, president and principal analyst of the Enderle Group, in a post on CIO.com.

So what’s the bottom line? Readerman said private equity investments are usually a bad idea for tech companies. “Technology is a very competitive industry,” he said. “It requires a high level of reinvestment in R&D as well as service, sales and support models. Private equity bankers, by definition, have to find areas to cut.”

On the other hand, companies that seek steady, profitable growth can benefit from patient management and a long-term perspective. “We set a profit target and we maximize our growth at that profit target, and we believe that’s the best way to build a great company,” said Kevin Thompson, CEO of SolarWinds, in a Network World interview. “The public markets don’t reward that very well.  They just want you to grow fast at all costs.”

Which means that for a mature, slow-growth company like HPE, private equity may be just the ticket.

Photo by IamNigelMorris via Flickr CC