Private equity firms that invest in technology companies face a challenging and dynamic environment in 2024. On one hand, there are several headwinds that have made it harder to achieve the original investment thesis or find attractive acquisition. On the other hand, there are also several tailwinds that create new opportunities for value creation and differentiation. In this blog post, we will explore both sides of the coin and offer some suggestions on how PE firms can find clear skies in the tech sector.
Headwinds: The Challenges of Investing in Tech
The Private Equity specific technology sector is not what it used to be a few years ago. Market conditions have changed significantly, and PE firms are aware of the some of the challenges:
Cost of capital: Interest rates are at an all-time high, making it more expensive to borrow money and finance acquisitions. This reduces the returns on investment and limits the number of attractive targets. According to Private Equity Info, the average holding period for PE tech deals has increased from 3 years to 6 years. This means that PE firms are facing more operational and financial challenges in managing their tech portfolio companies and delivering returns to their investors.
Seller / Buyer gap: There remains a big mismatch between the expectations of tech sellers and PE buyers. Tech sellers are often overvaluing their businesses based on historical growth rates, future projections, and market hype. PE buyers, on the other hand, are more cautious and realistic, taking into account the risks and uncertainties of the sector. This makes it harder to reach a mutually agreeable price and close deals. According to Value Add, PE tech exits are down 86% since the Fed and ECB started raising rates 2 years ago. This means that PE firms are holding on to their tech portfolio companies longer, hoping for a better exit opportunity in the future.
Change from greed to fear: The sentiment in the tech sector has shifted from FOMO (Fear Of Missing Out) to avoiding risk (Don't Want To Catch A Falling Knife). Many tech companies have seen their valuations drop significantly due to regulatory pressures, competitive threats, and slowing growth. PE firms are more reluctant to invest in tech companies that may be overhyped, overleveraged, or underperforming. According to Value Add, there is now $2.5 trillion in dry powder in the tech focused PE segment alone. This indicates that PE firms are finding it harder to find attractive tech deals that meet their criteria and expectations.
Tailwinds: The Opportunities of Investing in Tech
Despite the headwinds, the tech sector still offers compelling reasons for PE firms to focus on. There are compelling technology enablers that are key drivers of value creation and differentiation in the tech sector:
Cloud is proven: It is now mandatory for any tech company to have not only a cloud strategy, but offer lower friction and higher value cloud enabled services. Cloud computing enables tech companies to scale faster, reduce costs, improve performance, and enhance security. Cloud adoption also opens up new markets, customers, and revenue streams for tech companies. For example, the cloud application market was worth $200 billion in 2023, and is expected to grow at a compound annual growth rate of 18% until 2028, according to Gartner. This means that customers are increasingly preferring cloud-based solutions over on-premises or hybrid ones and are willing to pay for the benefits of cloud computing. This has created a huge and growing demand for cloud services and solutions, and a large and diverse customer base for tech companies to tap into.
A deliberate Generative AI position is required – both internal and external: Recognizing that a lot of the GenAI washing is taking place and ‘powered by PowerPoint’ is prevalent, there is no doubt GenAI presents a platform shift like smartphones, the internet or PC’s have presented in the past. Last Month, at the World Economic Forum in Davos, Satya Nadella stated it was the “the largest shift in technology since I have been in the industry” – and I agree. And hence, all technology companies need to have a deliberate approach towards GenAI. For sure as a productivity enhancer for the organizations (McKinsey estimates that there will be a 32% productivity increase for software firms by 2025 for developers alone). This means producing code is getting a lot cheaper, which is also good news for the competition. Software companies should recognize both the threats and opportunities to the core offerings. Tech companies that miss this wave are taking a big risk with their investor’s capital. Innovation is not optional, but an existential priority: “Since 2000, 52% of companies in the Fortune 500 have either gone bankrupt, been acquired or ceased to exist.”, according to Harvard Business Review.
Data matters: We have all heard that "data is the new oil" (I frankly disagree, but we’ll leave that for another blog post). That said, many tech companies have access to vast amounts of data, both from their own operations and working on behalf of their customers. In the age of GenAI, the purpose of a data moat is more than an opportunity to increase profitability, it becomes an imported barrier towards competitors (and irrelevancy). One could argue that data is the only ‘competitive moat’ left protecting the software assets, and hence a deliberate approach towards data strategy and governance is existential. Data at the same time remains a valuable asset that can be leveraged to generate insights, improve decision making, optimize processes, and create new products and services.
What Do We See PE Firms Do?
Given the turbulent skies for private equity in the tech sector, what can PE firms do to navigate this environment and succeed in their investments? Based on our observations we see PE firms fall in either 1 of two camps:
Delay and Pray - Extend the holding period. This means calling the bank, extending the loan, and renegotiating the covenants while accepting a higher interest rate. This option may be suitable for some PE firms that have a long-term view and a strong relationship with their lenders and investors. However, this option also entails more risks and uncertainties, as the tech sector is constantly evolving and changing, and the exit opportunities may not improve in the future.
Move & Improve - Seize the opportunity. This means using the longer holding period as an opportunity to create more value in their tech portfolio companies by combining cloud and business transformations. This option was always the attractive choice for 'growth equity' investors, but we are seeing more and more traditional Private Equity firms take a more strategic and holistic view towards value creation. Especially in the technology sector, there is an increased appetite to ‘Think Bigger’ - leveraging their expertise, resources and especially the extended runway to help portfolio companies adopt and implement scalable and sustainable SaaS offerings, yielding accelerating ARR revenue and ultimately increasing the enterprise value by doing so.
At Wingspan, we believe that the Private Equity winners of this decade will predominantly emerge from the second category: amplifying and accelerating their investment thesis by combining cloud AND business transformations. A key lesson learned from our experiences is that no POC or engineering roadmap stand alone will yield a revenue outcome, nor is another commercially driven subscription proposition going to make the software more attractive to customers. What does help accelerate value creation is to get serious about connecting the investment thesis with the ‘Rule of 40’ aspiration: A deliberate and holistic strategy to achieve the outcome. By leveraging a prescriptive methodology, leveraging real-life operator experience, and embedding programmatic hyper scaler support we help both de-risk and accelerate ARR growth.
Bottom line: To maintain a competitive edge and create sustainable value for their investors, the private equity sector will need to take advantage of digital innovations both technically and commercially. What are your thoughts?
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