Back to basics
Tech has emerged as a major private equity deal driver in TMT but the sector has been hit by a serious valuation correction
In 2021, the tech sector experienced an unprecedented period of private equity investment growth, characterised by soaring multiples and a seemingly endless stream of dealflow.
The global tech sector attracted a staggering $675bn from PE in 2022, a significant leap from the $100bn recorded in 2012, according to global management consultancy McKinsey & Company.
The surge of PE interest within the software sector was driven by its promising growth potential. The increasing adoption of software, particularly software as a service (SaaS), coupled with the continuous digitalisation of industries like construction, finance and healthcare, served as the primary driving forces.
Notably, within SaaS, the substantial predictability of growth became a major attraction for PE firms due to the recurring nature of revenue models.
However, the tide began to turn in 2022 as a valuation correction, triggered by high inflation and interest rates, reshaped the landscape. This correction left investors, including private equity firms, recalibrating their investment strategies.
We recognised significant overexposure with excessive capital deployed into the tech space at rapidly accelerating valuation rounds
The market, once characterised by robust activity across various subsectors, experienced a notable downturn in dealflow as the valuation mismatch stymied transaction activity. This trend was particularly evident in the software subsector, which accounted for about 30% of all PE total assets under management in the tech industry.
According to tech M&A advisory firm Aventis Advisors, during the last seven years, the median software company traded at 16.8 times EV/Ebitda and 3.3 times EV/revenue. Valuations peaked in 2021 at six times EV/revenue.
Since the correction, software valuations have returned to the median average seen before 2021. This correction has created a valuation mismatch that subsequently affected dealflow.
“In hindsight, we recognised significant overexposure with excessive capital deployed into the tech space at rapidly accelerating valuation rounds,” says Tassilo Arnhold, co-managing partner, AnaCap. “The pace of incremental valuation rounds and the pursuit of revenue growth, rather than fundamental cash-generative profitability, led to inflated sectors in the technology world.”
The flight to quality has been accompanied by a ‘flight to profitability’.
Wessel Ploegmakers, partner and head of Nordics at Main Capital, says: “The correction has primarily targeted loss-making software companies, leading to a notable shift towards profitability. Our strategic focus has always been on profitable businesses and, as a result, we have not been significantly impacted by this correction. This underscores the importance of quality assets and serves as a validation of our chosen strategy.”
This means that businesses that can demonstrate Ebitda growth can still fetch a handsome valuation. Therefore, there was still a steady stream of opportunities in the market despite the headwinds, according to Sergio Ferrarini, partner and head of technology at Inflexion.
“Last year, general dealflow was slower and this extended to the software and SaaS sectors. High-quality SaaS businesses in Europe are scarce but those that have come to market are still fetching good valuations,” says Ferrarini.
Historically, within SaaS, there was a diminished emphasis on profitability, with investors often adopting a strategy of pursuing growth at any expense. However, this paradigm has notably shifted during the past year to 18 months. Presently, companies and investors, both in the private and public spheres, are progressively prioritising profitability alongside growth considerations.
"The wider investor community used to lean more towards emphasising revenue growth, multiples and discounting profitability. This trend is evolving, with more emphasis now placed on finding the right balance between growth and margins. Profitable growth is the new mantra," says Ferrarini.
While the environment has become generally more challenging, deals – both acquisitions and exits – are still possible for PE firms that have deep sector knowledge, according to Main’s Ploegmakers.
He says: “We've maintained a robust deal pipeline by focusing on the right product-market combinations with market intelligence. Our goal is to create international market leaders, supporting entrepreneurs in navigating complexities, particularly during internationalisation.”
The correction has primarily targeted loss-making software companies, leading to a notable shift towards profitability
AnaCap’s Arnhold agrees. He highlights the fact that the GP managed to beat a tough exit environment by selling three businesses last year for a healthy return.
AnaCap completed three exits last year from a portfolio of 10 businesses, selling 30% of its assets from Fund 3 in 2023. Despite it being a challenging year to exit, the GP generated a 44% IRR and a 3.6x money multiple across all three exits. “We believe this reflects the success of our strategy deployed consistently through the entire business cycle, not just during favourable market conditions,” says Arnhold.
One of AnaCap's notable exits was Oona Health, a Danish digitally enabled private health services and insurance provider.
Arnhold says: “We supported a founder/CEO team to institutionalise and scale the business. Our strategy involved building a strong management team, expanding geographically, improving efficiency with data analytics and launching new products. Despite Covid delays, the business thrived, and in 2023, we sold it to a large strategic, achieving a 3.9x money multiple and a ~40% internal rate of return.”
In terms of creating value, there has also been a shift by GPs away from solely focusing on multiple expansion to a more nuanced approach that emphasises both sustained growth and improved profit margins.
This shift reflects a broader recognition within the investment landscape that simply relying on higher valuation multiples may not be sufficient in the current environment.
Reflecting on this theme, Main’s Ploegmakers highlights Assessio, a Nordics HR and recruitment e-assessment company that was sold to Pollen Street, as an example of the emphasis on growth. “During our investment period, we increased the business's recurring revenue from 50% to 85-90% through various strategies, with a focus on pricing and packaging,” he says.
Besides pricing, the GP executed three strategic add-ons in the Netherlands and Denmark, implemented differentiated pricing and supported the team in a “performance excellence project”, resulting in significant upsell and increased average customer value.
The past six months have shown improved availability of talent due to a slightly slowed economy
Meanwhile, at Inflexion, the firm’s value acceleration team aids portfolio companies with achieving rapid growth and implementing key initiatives, according to Inflexion’s Ferrarini.
He says: “This team includes in-house experts focusing on crucial areas such as commercial and pricing strategies (especially relevant for SaaS and software businesses), tech and product strategies, and recruiting top talent at senior and board levels. We also have local offices in India, China, Brazil and the US to support our businesses' growth in those regions.”
Within Inflexion's tech investments, sales and commercial teams are crucial. “Our board discussions focus on optimising Salesforce, refining pricing and packaging, and addressing talent challenges, particularly in engineering roles. While hiring has been challenging, the past six months have shown improved availability of talent due to a slightly slowed economy. People are more selective in their moves, leading to better retention.”
Main’s Ploegmakers also emphasises the importance of building a team.
He says: “I approach it like building an elite sports team. It's about being consistently in the market, understanding the active players and teams, and aiming to create a winning team in a specific space. Building relationships with managers over time is crucial. This way, when an opportunity arises, I can identify the right manager to bring onboard, ensuring we can create a top-tier team for that specific opportunity.”
Looming over the entire tech industry is AI. The technology has the power to transform businesses, including software firms. But do GPs view it as a threat or an opportunity?
AI will significantly contribute to optimisation, particularly in areas like customer support and service. This extends to the benefits that software companies can derive from AI advancements.
In markets experiencing flux or significant movement – such as legal, regulatory, security, healthcare and e-commerce – we might see a rebound, especially considering the relatively slow pace in 2023.
Arnhold says: “We are yet to see the long-term implications of AI. Our portfolio companies actively incorporate AI for operational efficiencies, integrated into strategic planning and budgeting.
"We don’t believe in large-scale workforce replacement, quite the opposite. AI contributes to augmented improvements in our businesses, which will benefit all stakeholders including customers, employees and shareholders.”
While the ramifications of AI are still unclear, what is apparent is that private equity firms have gone back to basics. The focus on profitability, value creation through strategic initiatives and the integration of AI are shaping the future trajectory of PE investment in the tech sector.
As the industry anticipates a resurgence in deal activity, navigating the evolving landscape requires a blend of market intelligence, strategic foresight and a commitment to building elite teams that can weather the challenges and seize the opportunities that lie ahead.
