Darktrace (OTCPK:DRKTF) is set to leave the public markets with an acquisition offering from Thoma Bravo. Of course, there are theoretically deal risks that could come into play, and therefore some amount of deal spread remains on the stock which is slated to be taken off markets at $7.75 per share or 605 GBX at today’s exchange rates. The deal spread is around 3.2% with closure expected towards the end of the year, so less than 6 months. Therefore, the spread annualised is more than 6.4% and maximum 12.8% assuming a sooner third quarter close, which is only somewhat higher than Treasuries over the same horizon. Typically, deal risk will be associated with the possibilities of the transaction being blocked by antitrust concerns. Darktrace is a relatively small player and a competitive industry, so that risk is highly limited. We don’t expect any financing risks either, especially given improvements in the funding environment lately and the relatively conservative use of leverage nowadays by P/E. The due diligence was probably carefully done as well, considering the extra attention after the short seller reports which we discussed briefly in our previous coverage, so idiosyncratic unforeseeables, while being the principal risk, also don’t seem very likely. The deal spread reflects quite high confidence that the deal will go through, which while reasonable, offers no extraordinary upside.

Darktrace Acquisition

Thoma Bravo is acquiring Darktrace in an all cash deal that converts, as of today, from the $7.75 dollar amount to 605 pence sterling. That means the headline deal spread is just over 3.2%. Depending on when the market expects the deal to close, at this point it either annualises at 6.4% assuming half a year, or if in one quarter at closer to 12%. 6% would be at almost no risk-premium at all. Something between 6-12% makes sense, as it would incorporate some space in return to compensate investors from some possibility of the failure of the deal.

If you go through the comprehensive documentation, it would seem that the only ways the deal could get derailed are the typical ones. If in some of the geographies the governments step in to prevent monopolising of the market, that would tank the deal. The competitive landscape is wide where Darktrace operates, which is in threat detection systems now also with some machine learning elements, has plenty of other competitors including major companies like Palo Alto Networks (PANW) and Arista Networks (ANET). The services are often interchangeable enough where they can be mixed and matched, and some brands like recently Carbon Black routinely donate business to other companies when they drop the ball for things like endpoint threat detection, being one of the markets Darktrace operates in. Darktrace is also small in absolute terms. Darktrace was acquired at a $5.3 billion EV, which is diminutive compared to most other cybersec picks in the US. We wouldn’t expect the acquisition to enable undue control over the detection and response software and services market.

Also, while Thoma Bravo has a portfolio of cybersec companies, they are all quite small and the market is already plenty decentralised. In fact, Thoma Bravo may be getting its hands on Darktrace just to create a more attractive overall offering for system integrators (MSSPs) to include smaller properties. We really don’t expect antitrust issues.

Quite a lot of the verbiage in the deal is dedicated to uncovered or unforeseen information that substantially changes the nature of the deal. This could be the presence of newly triggered liabilities from the acquisition, or an exhaustive host of other factors. Darktrace was the subject of a short attack that made some claims about their accounting and other businesses practices. The short seller report came out well before any announced acquisition. While not specifically drafted for Darktrace’s short attack situation, these terms would cover Thoma Bravo on that front, and any profound issues with the accounting could cause the deal to be derailed if Thoma Bravo doesn’t waive any of the conditions. Darktrace has long since made efforts to put those accusations to bed, including commissioning an independent audit of its books without the need to restate accounts of them. In terms of the reported trading update financials, trends are basically just continuing from before as secular demand for cybersec continues to grow, including from its newly released AI-based product. ARR growth is expected to continue to be at around 25% for the remainder of the year and also for the next year, in line with the growing industry, which means any major adverse financial changes that would meet conditions for termination of the transaction, including a consent of the court panel, shouldn’t become a factor either.

Thoma Bravo’s own financial risks could also tank the deal to the detriment of Darktrace holders. However, leverage accounts for a little under half of the EV of the company, so leverage is by no means overwhelming, which is the new normal and the obvious response of P/E to the higher interest rate environment. The debt is already secured for the purpose of purchasing Darktrace and a major macroeconomic crack that could prevent agreed upon financing is unlikely. In general, not even just for financial sponsors, there is a lot of supply and demand for credit, and the markets don’t seem to be at major risks of locking up especially as regulatory scrutiny comes down on financial institutions to be even better shored up. We don’t see disclosure of a break fee, either.

Bottom Line

The expectation is meeting the outstanding conditions by Q3 or Q4 of this year, mainly antitrust approvals, at which point the positive vote from Darktrace shareholders on accepting the acquisition price will come into effect and the company will begin to delist and integrate as an element of Thoma Bravo’s P/E portfolio.

If it happens on the longer end of the timeline, the annualised return is only a little over 6% which is not competitive and offers no risk-adjusted upside. Only if the transaction closes very quickly, within the next 3 months, is there somewhat of a compelling case of annualised return at around 12%.

They will give ample notice of at least 10 business days before the court hearing that sanctions the deal happens, which will be after the conditions like antitrust approval are met. The vote just happened on the 18th of June. It will be at least a month until regulatory approvals are done, probably more, and then courts will need to have the hearing. As said, they expect the deciding dates to be in Q3 or Q4 of the 2024 calendar year. A couple of days after that day there will be the removal of the listing and the shares will be transferred from Darktrace shareholders to the holders in the new cap table after being taken private.

Even at 12% return, it’s at a normal equity risk premium. We’d rather go with something that doesn’t have a binary profile and offers some downside protection. If the deal were to fail for whatever reason, we aren’t comfortable with Darktrace valuations for our risk appetite. While it’s quite cheap on a relative basis compared to peers, with EV/EBITDA around 27.8x on a forward basis compared to well over 40x with PANW, CrowdStrike (CRWD) and SentinelOne (S), it’s still a lofty multiple that we’d rather not get involved with, even if it’s being supported by 25% underlying growth in ARR and profits for now.

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