BLOG
Discover new strategies for navigating the shifting software market. Learn how AI, cybersecurity, and efficient operations are creating fresh exit opportunities for venture capital and private equity firms.
7-MINUTE READ
October 30, 2024
Recent market conditions have created challenges for both venture capital and private equity firms in the software sector.
A tougher initial public offering (IPO) market has made it harder for companies to go public, while a cautious corporate sector has led to reduced mergers and acquisitions activity, further constraining exit options. In addition, increasing regulatory scrutiny has introduced uncertainty and potential compliance costs for big tech companies. This perfect storm has caused a notable decline in global buyout-backed exit volumes and valuations.
For private equity firms, these adverse market conditions have led to a massive backlog of unsold investments within portfolios and a large accumulation of dry powder earmarked for future cross-sector leveraged buyouts.
With median holding periods of software investments growing 23% over the last year and over $1 trillion of undeployed capital, there is mounting pressure for private equity firms to execute deals.
While market conditions may not be as favourable as they were pre-pandemic, software deal activity is still expected to increase into 2025. Recently announced interest rate cuts and declining market volatility have brought dealmakers back into the playing field. And the software industry, a steady source of technological innovation, is poised to expand its share of private equity investments with a wave of opportunities rapidly emerging around a growing AI and Generative AI ecosystem.
As software investments continue to gain share of total private equity and venture capital investments—15-20% of capital allocations over the last three years, up from 8-12% of capital invested from 2011–2017—software investors and portfolio company leaders must adapt to changing market expectations for the industry to successfully generate returns.
Over the last two years, the software market's focus has shifted from rewarding high growth at all costs to emphasizing disciplined growth rooted in strong unit economics. From Meritech’s research of next twelve-month revenue multiples going back to 2017 (Link), it becomes clear that more holistic measurements of growth and operating efficiency—like the industry’s ‘Rule of 40’ stating that a software-as-a-service (SaaS) company’s combined annual growth rate and operating margin should be at least 40%—have become better indicators of software valuations.
As a result, we have seen public SaaS companies shift their focus toward efficiency, with forward growth rate expectations decreasing dramatically and free cash flow margins rising across the board. This shift in priorities indicates that investors are placing greater emphasis on balanced growth and profitability rather than just top-line expansion.
For software investors—who have historically underutilized operational interventions relative to their peers investing in other industries—this signals that the time has come to revamp the traditional operating playbook for their software investments.
While private equity firms over the last decade have increasingly adopted a more hands-on operational approach, software investors have historically been less directive. Given the shifting valuation dynamics of the industry, software investors will need to adopt a more aggressive value creation playbook to deliver the same returns to limited partners.
As the world’s largest system integrator and a leading go-to-market and operational partner to software companies, there are four things that we are seeing software investors adopt to best position their investments for successful exits in this evolving landscape:
Pressures on IT spending, accelerated innovation, disruption via AI and increasing regulatory scrutiny are rapidly shifting the dynamics of the software industry. Placing bets in the right software areas is critical for technology investors looking to avoid fighting an uphill battle to deliver returns on their investments. We identified three major archetypes for attractive software investments:
A. High demand and fragmented segments: Software segments like cybersecurity, data & analytics, and sales & marketing technology will continue to be major focus areas for IT spend, while providing private equity firms sufficient opportunity for organic and inorganic growth.
These segments will present consolidation opportunities for investors and operators looking to execute bolt-on acquisitions—with minimal threat of regulatory scrutiny—while they design solution suites with cross-sell initiatives across targeted customer segments.
B. AI-Led product enhancements and rurnarounds: Many market incumbents will find themselves in a race to embed new AI capabilities into their products as the rate of AI-led market disruption accelerates. For companies struggling to achieve operational efficiency—particularly public software businesses under quarter-to-quarter market scrutiny—commitment to these medium-to-long term product investments will be challenging.
Private equity firms will be crucial to the success of these companies. By providing essential capital and strategic guidance, private equity firms can enable businesses to reinvest in core products and platforms, prioritize returns on AI initiatives and access specialized talent. This support will be instrumental in developing and executing a revitalized product strategy and AI roadmap, unburdened by the pressures of public market scrutiny.
C. Resilient IT spend categories: While growth has slowed across many IT segments, software investors can continue to develop winning strategies in stable spend categories.
Mission-critical business applications such as ERP and infrastructure solutions like cloud platforms or databases will continue to be necessary spend items for enterprises. Software investors can target these as candidates for improved operational efficiency.
Growth has become increasingly challenging and costly for software companies. On the demand side, extended sales cycles and more demanding buyers have led to rising sales and marketing (S&M) expenses relative to new annual recurring revenue (ARR). On the supply side, growing competition and pressure to innovate AI capabilities have caused research and development (R&D) costs to balloon.
Despite recent re-organisations and cost-cutting measures, software companies are still spending heavily on go-to-market (GTM) and R&D despite lower growth expectations. To address these challenges and drive more GTM and product engineering efficiencies, private equity firms can direct software companies to:
Implementing these initiatives—and shifting the focus from ‘nailing it’ to ‘scaling it’—will enable software company leaders and investors to improve their sales and marketing efficiency, while fostering a culture of engineering efficiency and judicious capital expenditures for AI innovations.
A recent Accenture survey among 250 private equity leaders suggests that software investors possess the potential for further value generation through operational efficiencies. We found that these leaders are not exploiting various levers for cost savings and cash benefits as much as their counterparts in other sectors.
Private equity firms investing in software companies are leaving additional EBITDA expansion opportunity on the table:
By leveraging these underutilized levers, software investors and company leaders can bring operational maturity and new capabilities to their portfolio companies.
In the same private equity leader survey, we found that almost two-thirds of technology investors struggle with the lack of right leadership to execute their value creation plans. In addition to leadership, nearly half cite organizational culture as an obstacle to execution.
By playing an active role, complemented with transformation-oriented leadership, private equity firms can drive commercial and operational value. Without effective execution at the portfolio company level, investors may struggle to maximize returns on their software investments.
To mitigate this risk, private equity firms can strategically supplement portfolio company leadership teams with experienced industry operators and transformation experts. These individuals can provide invaluable guidance, inspire cultural evolution, spearhead change initiatives and adeptly navigate challenges during periods of uncertainty.
Despite the industry’s turbulence over the last two years, software will continue to be a major part of investor portfolios as market conditions are expected to rebound into 2025.
By adapting their investing and operating strategies to fit the current market dynamics, private equity firms can continue to generate satisfactory returns for limited partners while providing software companies a path to achieve new levels of scale and profitability.