Private equity investing in technology

This horizontal-vertical arrangement provides a starting point to break down vendors and solutions into even more refined groupings that enable assessments of key growth factors. For example, in the horizontal HR Tech category, G2 includes smaller categories like software for talent management, benefits administration, or HR analytics.

See Exhibit 2. Along with our explanation of these steps, we also offer some additional context around the various growth factors. Sales Headcount Assessment We tested whether there was a link between salesforce headcount growth and other metrics correlated with revenue growth. Merging the G2 data with Revelio sales headcount data, we also found that net promoter score NPS and sales force growth were correlated.

Size of Investable Universe Private equity buyers in most software LBOs purchase the acquisition either from other PE firms or from previous venture capital-backed companies. We defined an addressable target as companies that are either backed by private equity funding, have raised Series C, or companies that raised Series B more than three years ago. To elaborate on funding, private equity firms are moving from executing traditional LBOs to investing in minority ownership or VC-style investment—so software vendors with VC backing are likely to be targets of other investment firms.

Although traditional majority investment still accounts for much PE investment activity, it is now more common to see minority or non-control investments made alongside other investors. A large range of different software solutions are included in this penetration analysis.

Nonetheless, many vertical software categories are still underpenetrated. We used this benchmark to compare both current downmarket penetration x-axis with changes in penetration y-axis , as shown in Exhibit 7. With software types arranged into subcategories, investors seeking to understand the scope, surges, and ebbs of software adoption can key on several factors that our analysis found to be significant: The estimated number of potential targets The overall growth pattern of companies within the sector Maturity of SaaS adoption within the end market Extent of verticalization within the category Extent of downmarket software adoption Assessing each factor sets up private equity firms for several advantages.

Leaders can prioritize target opportunities and make more informed decisions when assigning teams to work on quality deals. Teams will become more adept at determining if future targets are attractive or lack promise. These assessments can also find areas of a target company that may need improvement—say, inefficient pricing models or go-to-market strategy—which the deal team can prepare to address after the acquisition is complete.

Estimate the Size of the Investable Universe For sustained success, an investor needs targets—lots of them—but building a suitable roster of promising software companies foils many investors. A team could find that their deal thesis plays out for only a handful of companies; for traditional leveraged buyouts LBOs , firms identify roughly 16 top-of-funnel opportunities for every one deal closed.

June 1, Investors can anticipate customer adoption of a software type if vendors show increased staffing activity in sales and marketing and engineering. To show where software vendors that could be attractive candidates for private equity backing are gathered in significant numbers—in other words, to estimate the number of potential, addressable investment targets—we started with roughly 13, software companies, based on data from Pitchbook and CB Insights.

We then further reduced the number of targets in the overall market by looking at business model and funding status. See Exhibit 3. Opportunity does not end there, with clusters of promise throughout the technology space. Verticals that offer plenty of targets are health care and financial services; customers in these spaces have extensive technology needs, and the two areas make up a large share of the overall economy.

With this universe of targets in view, investors can then look for noteworthy adoption behaviors and trends throughout each category. Look at Headcount Growth for Signs of Promise Growth in the software world is varied and inconsistent. A single category of enterprise B2B offerings will show more than one growth profile. For example, analytics software—fitting the Pockets of Opportunity growth archetype—consists of both business intelligence and data analytics tools, which experience moderate growth, and machine learning and data science products showing faster and more extensive growth.

Growth and adoption of software can also be the result of several different underlying dynamics. Customer IT budgets can change throughout a sector. In the public sector, increased funding may fuel market growth as agencies spend more on government technology GovTech.

Customers are apt to adopt solutions that directly increase business revenue, such as marketing technology MarTech or donation platforms in the nonprofit sector. New ways of working often create immediate need for enabling technology, such as workplace management systems. Investors are left questioning if these catalysts are driving meaningful, long-term growth or shorter bursts of adoption. However, PE teams can anticipate customer adoption of a software type if the relevant vendors show hiring activity or expanded headcount in two key staffing areas: sales and marketing and engineering.

Assessing Headcount Growth First, for a set of publicly traded software companies, we found a correlation between aggregate sales headcount growth across a category and potential revenue growth. To scale this analysis, we then leveraged alternative data on sales headcount to apply it to a sample of firms in our G2 dataset. Sales headcount is not the only metric of growth. Investors can augment this view by monitoring changes in engineering headcount.

An increase in design, programming, and related personnel may mean that companies in a category plan to develop new products or features in response to market demand. We found that certain categories, such as GRC and Supply Chain—which match the Pinpoint Play archetype of smaller numbers of targets and clear growth patterns—feature high headcount growth in both sales and engineering.

This data indicates the categories are building new innovative products through engineering hires and driving top-line expansion through sales roles. See Exhibit 4. Investors should be alert for various conditions when scrutinizing headcount growth. For example, firms should confirm the type of funding evident throughout a sector, as software vendors with early-stage venture capital backing often focus heavily on product development.

These companies will not recruit more outbound sales staff until leaders are convinced that the product fits a clearly defined market. Only then will vendors scale their sales teams to cover the market; for example, many GRC software providers are still ramping sales teams well after a wave of product development moved forward.

Investors should also remember that after a market has run through an initial spike of adoption, vendors with sufficient sales staff in place to acquire new customers will curtail sales headcount growth—even if revenue continues to increase. Sales and product headcount become more stable as a category matures and adoption stabilizes.

Some software types are easier for customers to implement and require less vendor support for deployment and training, limiting the need for sales staff involvement after deployment. However, external sales teams may play a larger role in customer onboarding of technologies like CRM software—fitting the Target-Rich Growth archetype—where increased headcount may mean favorable returns for investors.

Keep Pace with Adoption by Weighing Saas Maturity The spread of Software-as-a-Service SaaS and cloud technology across many areas of commerce continues; however, much on-prem software—which is costly to replace or upgrade—remains in use today. Investors can measure SaaS penetration across horizontal categories to determine where more adoption could still occur. Lower SaaS penetration may mean that companies are still using on-prem software in those categories—where growth could increase as these companies replace the on-prem resources with SaaS solutions.

Exhibit 5 shows an estimate of cloud penetration by horizontal categories, derived from IDC data on both SaaS spending and overall software spend within a category. Areas of lower penetration—supply chain and office and collaboration solutions—appear to be horizontal categories where future adoption may occur. At first, investors may think that plenty of whitespace exists for adoption of newer SaaS resources to replace older on-premises software installations.

However, private equity teams should pause where SaaS adoption could be limited to a modest push. One place it did not stifle investment was in the automotive industry, which reacted to a large drop in sales at the beginning of the pandemic by accelerating a shift from internal combustion engine vehicles to electric vehicles. DuVarney: As more people buy things virtually, traditional brick-and-mortar stores are being forced to pivot.

The disruption here is that this new way of shopping bypasses both the big box stores of the world as well as independent retailers, like bike shops. Francese: From the consumer experience side, COVID accelerated where the market was likely headed anyway, from brick-and-mortar to online shopping.

Companies had to be nimble to survive and one result is that whereas companies, pre-pandemic, might have considered themselves exclusively a manufacturer, a distributor or a retail store, now, because of the way they have had to adapt, are heavy in technology and may also be considered a tech business. What trends do these investments reflect? While there is some overarching market uncertainty and volatility in the current environment — which the technology sector was not immune from, as the deals closed during Q2 was a quarter-over-quarter drop — technology nevertheless continues to be an attractive sector for capital investment and to PE investors.

DuVarney: It is possible that because of labour shortages in so many industries, and the decision by companies to deal with that talent gap by outsourcing certain functions like payroll, accounting and human resources, PE investors may become more interested in professional services firms that could provide these services. This may be a large enough opportunity to support the notion that PE firms might be looking to invest in one of the many professional service providers with products that will help companies implement platforms that support AI technology.

FW: What advice would you offer to PE firms on target identification and early evaluation in the emerging technology space? When PE investors are evaluating an emerging technology, they may be assessing whether that technology is too focused on solving a specific market issue or business disruptor. If conditions change in the market, will the emerging technology suddenly be irrelevant, or can the technology be adapted to address a different type of business or different problem?

DuVarney: Companies offering technologies that address labour shortage and cost inflation problems may be attractive to PE firms. Bergen: It is important to be aware of anything that is related to experiential change within an industry, for example e-commerce or retail change disruption in the retail industry. There are many aggregator companies in the start-up world focused on D2C sales. What particular due diligence and risk management issues should be part of the process?

Bergen: PE firms should continue to be aggressive in creatively structuring and financing emerging technology deals. Maybe that will include more gainsharing-type deals. Deals involving professional services firms, for example, have to be structured differently because people may come and go.

If you buy a company that has top talent, you have to figure out incentives so these people stay with the company, because that is where the value resides. Francese: PE firms continue to be interested in the currency of the technology of portfolio companies. Existing data is an important component of being able to leverage technology and emerging technology successfully. Do they have AI in place? What is the condition of their data?

Has it been scrubbed? Can you trust it? Can the business leverage its data to streamline processes and procedures? Understanding where the company is in its data journey is a very important part of the diligence process. Also, how is a company positioned to monetise its data? FW: What are your predictions for the emerging technology space in the months and years ahead?

Do you expect PE investors to play a meaningful role in pushing novel innovations forward? DuVarney: AI will be embedded in everything. Augmented reality features also will continue to expand as people are more comfortable doing things virtually.

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