Private equity is roaring back into the world of enterprise tech.
The sector is on pace to record high investments in the software industry after a dip in 2020. So far this year, private equity firms have poured $16.1 billion into the sector over 105 deals, according to data compiled for Protocol by PitchBook. The top five most active firms are HG Capital, Vista Equity Partners, Providence Equity Partners, ABRY Partners and TA Associates Management, respectively.
That's up from $13.2 billion for all of 2020. It's also outpacing 2019; that year, the industry invested $20.4 billion in the sector over 126 deals. The biggest deals announced so far in 2021 include: Thoma Bravo's $12.3 billion purchase of Proofpoint in April, KKR and Clayton Dubilier & Rice's $5.3 billion purchase of Cloudera, and Symphony Technology Group's $4 billion purchase of McAfee's enterprise business. More are expected; Medallia, for example, is reportedly in talks with both Vista Equity and Thoma Bravo. And on Monday, Thoma Bravo, a long-standing investor in software companies, said it would spend $2 billion to take QAD Inc private. That deal, which is not reflected in PitchBook's data, would bring the total for 2021 to $18.1 billion.
"As software has continued to perform very well — you see that in venture, you see that in public markets and you see that in private equity — more firms are piling in," PitchBook analyst Rebecca Springer told Protocol.
While private equity has been investing in enterprise tech for decades, the confluence of several trends in the sector is making it more competitive than ever before.
Subscriptions are increasingly the norm in SaaS, which provides healthy recurring revenues, something investors value highly. The IPO market for software is blazing hot, opening the door to a potential exit strategy that other industries can't match. The sheer number of software providers also presents a major buying opportunity that could allow private equity investors to beef up their portfolio companies with a more robust suite of products or customers.
A potential hike to the capital gains tax is motivating sellers. And as businesses of all sizes make digitization an increasing priority, there's massive opportunity for growth. Gartner, for example, expects software spending to grow 8.8% in 2021 to roughly $506 billion.
Ultimately, the interest in the sector is a reflection that the traditional boundary lines between venture capital, hedge funds and private equity are fading away.
"The private equity playbook is becoming more creative, more diversified. There are more options that firms are taking advantage of, in terms of minority investments, doing more transformative M&A through buyouts, working on longer holder times," said Springer. "You're going to see proliferation of different models getting at different points of the value chain."
More competition, more opportunity
For vendors, specifically those that may have once been viewed as category pioneers but are struggling to sustain that momentum, private equity offers an attractive way to raise cash while gaining valuable operational advice, like key personnel changes.
Sometimes, those investments can take a while to pay off. Permira, for example, purchased Genesys in 2012 alongside other investors. The company continued to putter along until it hired long-time tech exec Tony Bates as CEO in 2019. Now, Genesys is quickly remaking itself for the cloud era, launching new AI-based tools and bringing on top talent from Salesforce, Twilio and Microsoft. Genesys said it added 800 new customers in the last fiscal year and had record cloud sales.
One reason why tech executives are more open to private equity backing than they may have been in the past is a move away from the traditional cost-cutting measures that gave the industry a bit of a Disney-villain persona.
Private equity managers, for example, are increasingly listing revenue growth over cost reduction as a key driver of investment returns, according to research from the University of Chicago's Booth School of Business professor Steven Kaplan.
And there's many potential avenues for firms to achieve that growth. Investors tend to target providers that are category leaders but have potential for expansion beyond the core customer base. That often means acquiring complementary vendors or doubling down on emerging tech that can bolster the existing product suite to capture more users.
Warburg Pincus, for example, invested in Businessolver in 2018 and quickly went to work. Alongside a revamped C-suite, Businessolver, which provides software to help companies manage employee benefits, has made AI a focus.
And the same day KKR and CD&R took over Cloudera, the company announced two purchases: Datacoral and Cazena. Both are providers that can help the once-promising data analytics vendor beef up its cloud-based tools. Combine those deals with Cloudera's still-sizable customer base and private equity's skillful way of squeezing profits while growing the topline, and the $5.3 billion price tag begins to make sense.
Higher acquisition costs, however, have made the strategy of gobbling up smaller providers more tricky. And there's an open question of whether there's "too much money chasing too few deals," according to University of Virginia professor Susan Chaplinsky, prompting investors to begin to factor in more of their traditional cost-reduction tactics to their long-term strategies to compensate for a potential decline in valuations.
"You can still make a healthy return even if you're not able to sell at a higher multiple or at the multiple you purchased at," Chaplinsky told Protocol.
Private equity investors, however, could see upside if the current economic boom cycle in the industry takes a dip. That would likely force valuations, which are sky-high right now, to come down.
"That would certainly create a big buying opportunity for us and other private equity firms," said Thoma Bravo managing partner Scott Crabill. "There's just so much to buy."
But as returns in the sector appear to slow, some are pushing for a new strategy, one in which a firm's various portfolio companies begin to work more closely together to build a "business ecosystem." That creates opportunities for cross-selling and other benefits. It's a model billionaire Romesh Wadhwani is using with Symphony AI.
Still, with other investors — including hedge funds, venture capitalists and mutual funds — also making enterprise tech a focus, private equity has to prove its model, which typically requires larger ownership percentages to address the operational efficiencies to manufacture returns, is right for the business.
But right now, in an era where SaaS is exploding, there appears to be ample space for all types of funding.
"It's definitely more competitive," said Crabill. "But there is also so much more opportunity now than there was 10 to15 years ago. They counterbalance one another."
Update: This story was updated with news about Thoma Bravo's acquisition of QAD Inc. Updated June 29.