PE investments into software startups benefit from tech experience

The rise of software startups is creating considerable opportunities for the Private Equity (PE) industry, finds a new report. PE firms are well positioned in terms of experience to take advantage of the bonanza, with an expected boom of more than 900 software startups between 2017 and 2021 presenting investors with experience in technology the opportunity to improve internal rates of return by up to 20%.

The venture capital market has, over the past decade, increasingly focused on supporting startups in the software and technology segment. Total venture capital investments hit $127 billion last year, at around 50% of money in play being relating to software development. In the same period the private equity market has exploded, with buyouts last year hitting $257 billion and exits generating $328 billion for the market as a whole.

In a new report from The Boston Consulting Group (BCG), titled ‘Cracking the Code in Private Equity Software Deal’, the consulting firm considers the current activity of PE firms in the software segment, as well as the wider context in which deal activity is taking place. The research from the firm, which was performed by BCG and the HHL Leipzig Graduate School of Management, included data from more than 1,800 deals entered into between 1997 and 2010, as well as the exit results related to 27 of the exists from software companies between 1998 and 2012.

The number of PE deals in the software segment has increased over the past two decades. The industry saw around 1% of deals in the segment in 1997, grow to 4% ten years later. Since 2012, deal activity hovered at around 6% before, in the most recent analysis hitting 8% of total deals.

The growth in total deal volume, up from around 5,600 in 2007 to 6,200 last year, and the increase in software as a share of total deals, has seen the total number of software deals increase from 228 to 441.

The study also included a breakdown of data from the past two decades. This aspect of the research shows that corporate divesture has decreased considerably, from 33% in 1997 to 13% in 2016, while the number of private companies snapped up too has decreased in the years since 2007, from 66% of total to 46% last year. Venture capitalists as a source of investment for software companies have more than doubled meanwhile, climbing from 11% in 2007 to 23% last year.

The firm also explored how the companies in its sample performed over the most PE holding period, finding growth averaged 7% while EV/EBITDA multiples were found to increase from 10 to 13, indicating that the portfolio companies tended to perform better.

While the average growth and performance increases were relatively stable overall, the firm notes that considerable differences between investor types was noted. The firm found that around 35% of PE investors in the total sample had performed one deal, of which, 52% were considered opportunistic investors, 6% serial investors in the segment, 14% serial experience investors in the segment and 28% experienced investors in the segment.

Experience counts

The research found that the different investor classes were able to considerably improve their respective return on outcomes, while serial investors were able to outperform the industry median by 15%, and experienced investors were able to outperform the medial by 20%. Opportunistic investors by contrast only managed to outperform the median by 2%.

VC buyout opportunities

PE firms that are well positioned in terms of experience in the market for software company buyouts are, according to BCG, able to benefit from the large number of venture capital backed software companies that are expected to hit the market over the coming years.

Late stage companies, while decreasing in number of the past two years, are expected to see increased buyout activity between 2017 and 2021, with, around 200 of the 900 startups going to market likely to be bought up by PE firms.

According to Nicolas Hunke, a BCG partner and a co-author of the report, “Serial and experienced investors typically apply a rigorous proprietary playbook to create value at software companies, addressing a distinct set of industry-agnostic and software-specific levers. Four software-specific value creation levers typically applied are sales and pricing initiatives, changing to a cloud-based software-as-a-service offering, productization, and state-of-the-art software engineering.”