Fundamentals, not fluff, spur tech-sector valuations in private equity
Is the technology sector overheating?
Private equity investors have eagerly plowed capital into tech firms in recent years. Since 2010, they have closed 120 to 170 deals globally, and 4 of the 10 largest leveraged buyouts have been tech companies: Dell, BMC Software, Veritas Technologies and Solera Holdings.
Average purchase-price multiples for tech deals exceed multiples in most other sectors. Bain & Company compared the five largest software public-to-private deals to the five largest non-tech deals closed during 2015 and 2016. The average price-to-EBITDA multiple for the software deals was 18.1 vs. 10.2 for the nontech deals. These high prices may lead some investors to question whether the sector has overheated.
To be sure, investors must choose their tech targets carefully and think through what operational toolkit they will apply to realize adequate returns. But there is convincing evidence that the current levels of deal activity and prices are defendable and supported by underlying business fundamentals.
Consider that over the five years preceding acquisition, the five largest software public-to-private deals in 2015 and 2016 had average annual revenue growth of 22.6 per cent vs. just 5.7 per cent for the nontech deals. None of the software companies had declining revenue in any year, while one of the nontech companies did.
Software and tech-enabled services account for roughly 80 per cent of technology deals by count and value. Providers in these industries enjoy ample and often recession-resistant recurring revenue streams, because customers often view these products as critical systems used daily in their core business. Many software providers also benefit from strong customer loyalty: Business leaders view them as a small part of their overall cost base and are reluctant to go through the cost, pain, and risk of implementing new systems and retraining employees. That creates both customer stability and an ability for software vendors to raise their prices for additional value delivered over time.
Recession resistance figures into valuation multiples as well. The premium on technology’s valuations rose in recent years as the economic cycle has grown long in the tooth and general partners sought assets that could be safely leveraged in the event of a recession.
Finally, in many software markets, two or three firms have clear leads, benefiting from a virtuous cycle of reinvestment in an industry that can add customers at near zero cost of goods sold. Established market leaders frequently can buy smaller competitors at a discount valuation, eventually migrating the customers to their own platforms and incorporating any useful technology. Given the asset-light nature of software, investors often realize significant cost synergies when they combine the departments of two companies.
These strong business fundamentals stand in contrast to the speculative thinking and fluff of the dotcom bubble, or a past trend of investing at the wrong point in the cycle in capex-heavy subsectors such as semiconductors. Indeed, recent technology deals outperformed those in many other industries. Software deal-return multiples have been higher, and fewer deals have suffered from capital impairment, according to CEPRES, a provider of products and services to support PE investment decisions.
Looking ahead, the tech sector appears to be well-positioned. More and more corporate spending is devoted to IT and digital projects. Software and analytics are becoming essential for firms in industries ranging from consumer packaged goods to healthcare and financial services. Indeed, many of the largest deals in other sectors, including MultiPlan and IMS Health, rely heavily on technology.
Despite the past success of many tech companies—or perhaps because of that success—investors often find untapped opportunities for operational improvements. Successful software businesses often are so profitable that management teams may not aggressively optimize costs, operating efficiencies, or revenue models. That leaves room for experienced investors to step in, restructure or refine, and thereby improve performance.
One rule of thumb that experienced tech investors use as a preliminary asset screen is the “rule of 40,” which says that software businesses should have organic revenue growth plus EBITDA margins of 40 per cent or higher. A company much lower than 40 is probably investing too much relative to the profits it takes out. (By contrast, a company that’s far in excess of 40 may not be investing enough to support growth.) Most software companies and the vast majority of recent software leveraged buyout targets fall short of this goal, implying significant opportunities for adding value. Bain’s analysis of 10 US public-to-private tech transactions in 2015 and 2016 found that 8 targets fell below 40 in the two years prior to acquisition. These deals would have been spotted by investors using the rule of 40 screen.
Of course, investors need to be alert to the risks, and dabblers may be disadvantaged. Specialist funds including Vista Equity Partners, Silver Lake and Thoma Bravo are prolific buyers of technology firms and experts at evaluating and pricing assets. Given the sophistication of the specialist funds, other investors will need to undertake high-quality due diligence to avoid incurring a painful winners’ curse.