Industry Expertise Increasingly Important for Booming Number of PE Software Investments

As software deals garner heightened interest from the private equity world due to their high growth and returns, it’s increasingly important for firms to optimize their investments by developing a deep industry expertise.

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As private equity dealmaking in general rises, with the number of deals increasing from 5,600 in 2007 to 6,200 in 2016, software sector activity is one industry gaining a disproportionate share of activity. The number of software deals at entry jumped from 228 to 481 over the same period, representing 4% and 8% of total PE deals respectively. Software deal exits also increased from 96 in 2007 to 182 in 2016, up from 4% of total deals to 5%.

New research from BCG indicates that expertise in software deals can make a major difference in just how much private equity firms outperform the market. In the sample studied, serial software investors, or those that had made at least ten software deals, such as Carlyle, 3i, Vista Equity and JMI Equity, outperformed the median IRR of other industries by 15%. Experienced investors, or those whose software deals represented at least 20% of their total deals, outperformed by 20%, contrasted to opportunistic investors, who outperformed by just 2%.

As private equity funds sharpen their focus on software companies, they are able to figure out particular ways in which to create value at these companies and thus generate higher returns from their investments. Industry expertise is especially important in the current market, with a weak IPO market and more high growth companies choosing to stay private.

BCG expects that over the next five years, VC firms will exit their late-stage investments in over 900 software companies, with PE firms snatching up about 200 of them. The reason for this sharp increase in software deal exits is a gradual reduction in the typical holding period for software investments, with the median holding period decreasing from 5.3 years in 2012 to 4.2 years in 2016. This trend has not been observed in other industries, as the median holding period for PE investments in non-software companies remained at 5.3 years over the same period.

According to the BCG data, software deal categories with the highest returns were spinoffs of software assets from their parent company, with a mean IRR of 37%, sales of software companies by founders to third parties at 30%, followed by secondary buyouts and take-privates at 18%.

The reason why serial software investors are able to generate higher returns from their investments is that they typically apply a robust proprietary playbook to create value at portfolio companies. After identifying targets based on indicators such as recurring revenues, pricing power, customer retention and ability to scale, investors then apply a distinct set of both industry-agnostic and software-specific value creation levers.

In efforts to build a higher multiple business, BCG highlights three software specific value levers that private equity firms can employ: sales and pricing initiatives, cloud/software-as-a-service transformation, productization and state-of-the-art software engineering. While sales and pricing initiatives, including deal pricing/discount management and license bundling and pricing, is the most efficient short-term lever for boosting the valuation multiple and the top line, the other levers require about three to five years. Supporting a transition to a cloud-based SaaS offering is noted as the most fundamental type of transformation, as it provides a stream of recurring revenues. Productization, or the standardization of software products and services, is superior to developing for the individual customer as it allows companies to increase scale at a lower variable cost and boost profit margins. Top of the line development capabilities also help companies adjust product features quickly, increase the frequency of releases and ensure stable and higher-quality software.

Some industry agnostic value creation levers listed by BCG include sales excellence, enhanced and new products and build-and-build, which refers to finding synergies in sales, marketing, administrative expenses and operations.