It’s been said that private equity has a crush on technology. But dismissing the growing relationship as a crush would not only do it a significant disservice, it would miss the undercurrents at play that are making technology such an attractive, long-term private equity target.
Those raising flags insist we’re witnessing the private equity equivalent of the Gold Rush. The analogy suggests that a wave of funds are now chasing a limited number of appropriate tech investments and will soon find themselves with little ROI or steep losses. These critics have pointed to four key warning signs.
First, there is the seemingly abrupt, marked increase in private investment in tech — from $43 billion in 2015 to $148 billion in 2016.
Second, there’s the paradigm paradox: The private equity model has long favored targeting the underperforming investment for a relatively short-term turnaround and sale. The high valuations of tech firms, combined with pace and peril of changing tech trends, make the sector an odd target for buyout firms.
Third, there’s the surprising shift to sector specificity. Private equity firms have rarely exclusively focused on a sector (en masse) in the manner in which a slew of new tech-focused buyout firms have of late: Vista, Silver Lake, Francisco, Accel-KKR, Symphony Technology, Insight Ventures, Thoma Bravo, etc., etc.
And finally, there’s the more traditional platforms for technology funding, which include tech’s access to both VC money and raising capital via public offering.
A closer look, however, will tell you the flags have been planted on very shaky ground. There are undercurrents at play in the intersection of tech and private equity that not only render the warnings moot (or at least exaggerated), but actually create the foundation for a long-term partnership.
With respect to tech’s other funding sources, it’s worth noting that over the last decade, there’s been a ceiling on VC investment in the sector that’s paled in comparison to private equity investment. At $38 billion, 2015 marked the height of venture capital fundraising for the tech industry — that represents only a quarter of current private equity totals and does not provide the access to the deep capital reserves needed for maturing tech companies to scale.
Going public had long been considered the end of the rainbow for emerging tech companies.
Going public had long been considered the end of the rainbow for emerging tech companies, post-VC fundraising, of course. But that’s fallen out of favor with companies that no longer wish to alter their corporate strategies on a quarterly basis, that can’t stomach or stand up to the increased regulatory requirements of public trading or that do not meet Wall Street’s now exceptionally high bar for market cap and scale.
It’s also worth noting that tech companies often need a bubble not afforded by Wall Street’s demanding expectations. No, not that bubble — rather they need the safety and freedom to experiment with product advancement and revenue streams, which is hard to find under Wall Street’s thumb.
The private versus public route is, in fact, so deeply rooted a trend that it’s actually reversing the IPO pot of gold rainbow lure: three of the top five software deals last year were actually take-private transactions (Qlik Technologies, Marketo and Cvent), which sold for a combined $6.5 billion.
As for the new firms — yes, we may soon reach a saturation tipping point, but these funds have tweaked the traditional private equity playbook such that tech firms now represent a good match.
Where old-school private equity was largely limited to cost-cutting initiatives (job cuts and office closures with debt-fueled deals), the new wave of tech-centered sponsors is continuing to invest in growth and revenue expansion (with some cost optimization). And far from the capital deployment models of old, these new funds have operationally sound value creation playbooks for their portfolio companies, which serve to offset high multiples.
They are also being exceptionally disciplined about where, within the tech sector, to invest. From 2012 to 2016, private equity firms have focused the bulk of their tech-related spend on software and services companies ($152 million and $110 million, respectively). The drop off to the next largest sub-sectors (networking, $44 million; hardware, $38 million; and semiconductors, $5 million) is precipitous.
Private equity firms are attracted to cloud-based SaaS delivery models, which offer recurring revenue streams via continuing renewals of an existing customer base (and which demand value creation investments from their fund sponsors for advancements in customer service and continued product development). Despite the lack of hard assets to lend against, the predictability of subscription-based revenue models offer private equity firms a reason to invest, to hold those investments for longer periods of time and provide a cushion from (somewhat) inflated valuations.
All of which is not to say that there’s not the threat of fracture to this new private equity-tech partnership. Naysayers argue that funds are paying an egregiously unhealthy EBITDA multiple, and, in doing so, are creating a new bubble (yes, that kind of bubble this time). In addition, for the private equity-tech relationship to work in the long-term, funds must be willing to assert unusual control over their investment targets, continue to invest in operationally sound playbooks and must help their portfolio companies nail the subscription model, which requires higher upfront costs.
But naysayers love to nay. The combination of tech market maturation via the SaaS model, with an evolving operational model for private equity and the diminished attractiveness of other funding sources suggests this partnership is here to stay.
All stats courtesy of the American Investment Council.
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