For decades, the software and technology industries have been under the exclusive jurisdiction of the venture capital community. As tech continues to disrupt basically every industry that PE has traditionally played in, the opportunity has simply become too large to ignore. This has led to a noticeable uptick in PE activity in the tech and software space over the last few years. There are several key factors driving this trend, and it’s creating opportunities and competitive disruptions in the world of PE.
PE & Tech Meet in the Middle
As the software industry continues to mature, private equity firms have continued to evolve, bringing the two closer together. Growth forecasting, previously outlandish valuations, and wide margins were all familiar territory for venture funds, but those characteristics so common in tech were difficult to reconcile with the cash flow analysis making up the backbone of PE methodology. That experience gap has been closing.
Large cap shops that first waded into enterprise software have now had well over a decade to master the intricacies of the space, producing a large number of experienced professionals & advisors that spread these capabilities across the industry. These days, it’s more common for incoming young professionals and MBA grads to have computer science degrees and tech backgrounds. Ongoing digital transformation at the portfolio level and the fund level also make it easier for firms to get their arms around the most valuable services and strategies. Software is now a more familiar beast.
The tech world is also changing to be more palatable for a wider array of investors. An increasing number of tech darlings are software-enabled companies that don’t actually generate their revenues from licensing or SaaS models. Google, Amazon, Netflix, Uber, and many more have built transformative businesses that derive competitive advantages from software, but they owe sales to some other service. Prior to the rise of this business, most powerful software players were core enterprise tech companies that were less aligned with PE diligence and analysis. Most funds simply would not be involved in those sorts of deals. However, these software-enabled companies offer an easier entry point for PE firms, because these business models and operational norms are more familiar.
All the while, the high-growth software companies of old are maturing into the characteristics that have traditionally driven PE firms. Models with high recurring revenue, sticky services with high switching costs and retention, and predictable cash flows are common in the sector.
The Changing Competitive Landscape
Tech’s soaring exit multiples and hyper growth are hard to replicate in most other sectors, so PE firms with competence in tech are more appealing to many prospective LPs.
Teams with in-house technology experience can differentiate themselves from lagging competitors. Firms that lack that internal competency must lean more on consultants and advisors, who will enjoy their own value rising. Tech-specific firms will tout their advantage as specialists, which will be attractive to some portfolio companies and LPs who demand partners with that deep experience. Conversely, generalist firms can lean on the presence of potential partners and customers within their portfolio, which some tech companies will really value in an acquirer.
The middle market is less suited for some of the core enterprise tech plays out there, but the aforementioned growing number of software-enabled companies is a ripe area for smaller funds. There are more opportunities for those sorts of deals than ever before, so the evolving landscape isn’t reserved for big firms with more resources. Longer-term, middle market firms can use footholds established in the software-enabled space to build the experience necessary to grow into enterprise tech where applicable, which provides access to less volatile businesses than in the B2C world.
All of this necessitates altered due diligence and investment analysis processes. TAM needs to be thought about very differently, because disruptive services create a more complicated set of novel solutions that are addressing problems in very different ways. Expense structures and growth profiles must be approached differently as well. Software companies usually enjoy excellent direct margins, but R&D spending needs to be prioritized. Software products are never “complete”, and resources must be continually dedicated to the improvements to remain competitive. Finally, PE firms must develop expertise in assessing technical debt, which is an off-balance-sheet obligation for the future development costs required to avoid obsolescence – a crucial step in any successful software deal.
PE’s Role in the Software Sector Moving Forward
Private equity will need to distance itself from the stereotypical role (fair or not) of acquiring, leveraging, and slashing expense structure to be successful in the new tech market. Long-term stewardship should become more popular out of necessity. A short term model isn’t compatible with the requirement to manage technical debt. If a software company must be groomed for longer-term operational success to retain its value, it will require attention to items outside of financial statements. This approach can be totally congruent with the PE mission. Software can provide a combination of healthy cash flows and growth that is uncommon elsewhere in the current economy, which should be appealing to any investor.
Indeed, VC and public markets are becoming less aligned with many tech leaders as they grow and mature. Publicly traded companies are beholden to quarterly reporting, which necessarily shifts some focus to short-term results at the expense of long-term growth. PE funds can also offer liquidity that’s not accessed as easily by other ownership structures. This makes them an attractive ally for tech companies who are navigating transformational periods such as cloud migration or transition to a SaaS model, which can require capital injections to unlock operational opportunities and incite expanding valuation multiples. This is an exciting time full of opportunity in private equity, which is only enhanced by historic levels of dry powder. We are seeing more interest in alternative deal types as well, with minority holdings and PIPEs becoming more popular. Firms would be well served to monitor their place in the evolving competitive landscape and opportunistically position themselves to benefit from these emerging software trends that will shape the global economy for the next few decades.