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Despite Public Drop, Tech M&A in Private Markets At Record Highs

Danielle Fugazy | November 28, 2018

Tech stocks have dropped in the public markets, leading some to wonder whether the same will happen in the private markets. However, M&A activity in private sector tech is busier than ever, and high valuations and competitive processes to win deals are expected to remain the norm.

The plunge in the public markets might give “private buyers a justification for offering a lower price, so it might make buyers feel better about losing the deal in a competitive sale process, but public markets are still at historically high revenue multiples for software companies, so there is a long way to come down before I would consider the valuations reasonable,” says Devin Mathews, co-founder of ParkerGale, a Chicago-based middle market private equity firm that invests in technology companies. “I don’t think private equity buyers look too closely at the public markets for what they should pay for a company. I think most of them look at what they can build over time as the owner, what that might be worth to the next owner, and whether that hits their target return.”

Jeff Bistrong, a managing director with Harris Williams, says that the volatility in public markets has to date had no real impact on how the private market has valued tech companies. “One of the reasons the broader public market has pulled back is because interest rates are going up. Marginal increases in interest rates aren’t a key driver for private equity valuations,” says Bistrong. “Modest increases in rates may impact credit structures and bank debt multiples, but a significant influx of private capital in the tech space should keep private market valuations strong”

The numbers certainly prove that out. M&A activity in the tech sector has not so much as paused. In fact, according to Preqin, private equity funds are set to make more buyout investments in the technology sector in 2018 than any other previous year. As of November 2018, there had been 1,079 buyout-backed technology deals announced globally, worth $71 billion, approaching the record of 1,096 set in 2017. What’s more, the number of deals has steadily risen each year since 2009.

Technology-focused private equity is a major industry, with funds holding more than half a trillion dollars in assets under management at the end of March 2018. The sector has almost doubled in size in the last five years, according to Preqin.

From January through mid November 2019, 286 tech-focused private equity funds have raised a total of $68 billion. This brings the average fund size to $238 million, the largest ever for tech-focused PE funds, according to Preqin.

Non-Traditional Tech Investors Join the Fray

As if there isn’t already enough competition in the sector, non-traditional tech investors are getting involved more frequently as well. “There is a maturation of software as a sector and you have non-tech private equity investors as well as sovereign wealth funds and family offices investing in mature, but still high-growth, tech companies that play in verticals where they have expertise,” says Bistrong. “Non-traditional investors who used to be scared of technology investments are now attracted to their highly recurring cash flows. Traditional tech investors might be surprised to learn these entrants are likely here to stay.”

These non-traditional tech investors usually have expertise in a particular vertical and understand how a particular software solution adds value in that end market so they are making the leap and buying tech companies. “This is adding increased competition and raising valuations,” says Bistrong.

Mathews agrees the tech industry is garnering widespread interest from different investor types. “We are entering the ‘tourist’ phase of tech M&A in private equity. Funds who have never invested in tech before, who aren’t experts in building or valuing software companies, are buying software companies that serve industries they know well,” says Mathews. “Lenders are eager to load up the debt on predictable, recurring revenue businesses and some private equity buyers are more than willing to take the maximum leverage to pay the price required to win the auction. We’ve seen this before and we’ll see it again. It won’t end well for some and others will just learn their lesson and stick to businesses they know well next time.”

Outlook for 2019

Deal professionals are expecting more of the same in 2019 for the most part. While earlier in the cycle the risk of a downturn was really an academic question, it is now part of investors’ lexicon and private equity firms are modeling investments for a possible downturn scenario — but that is not cooling the hot M&A environment. “The only real change is that, for investments in certain cyclical end markets such as energy or manufacturing, private equity firm are modeling a downturn earlier in their hold periods, which obviously impacts valuations,” says Bistrong, “but overall software valuations remain strong.”

Additionally, software-as-a-service—subscription-based companies—are expected to remain in vogue. “More public software companies are paying very high prices for SaaS companies to increase their recurring revenue and that will continue,” says Mathews.

Look no further than SAP’s (NYSE: SAP) acquisition of Qualtrics Internationals Inc. SAP agreed to pay $8 billion for the company as proof. The deal is SAP’s second largest acquisition ever, following its $8.3 billion purchase of expense software company Concur. Qualtric is a software data company that competes with SurveyMonkey. Along the same lines, in October, Microsoft-owned LinkedIn acquired Glint, a Redwood City, California company that helps organization get feedback from employees.

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