As private equity firms continue to make deeper entry into the software industry, people like me, who were perhaps aware of the existence of such firms but ignorant of the details, continue to learn more and more.
So here's a round-up of various interesting things I've learned recently.
- Private equity firms have been particularly active in the software segments usually referred to as advertising technology ("adtech") and marketing technology ("martech"): Private equity firms keep gobbling up ad tech companies — and the trend shows no sign of slowing.
Basically, this is because there are too many of these companies, and the market that they are in keeps changing:
John Prunier, partner at Petsky Prunier, told Business Insider: "Confronted by scant interest from the largest and highest-paying strategic companies — Google most visibly — and a consequent drying up of growth capital, ad tech companies were forced to retool their products and business models."
Apparently the well-known Silicon Valley meme of: "Build me an adtech company; sell it to Google; retire!" has finally reached the inevitable result: "because there is a large supply of ad tech companies in the market, many ad tech company valuations still remain attractively modest enough for private equity firms."
As private equity partner Julie Langley observes, the private equity approach still requires certain properties of the business to be acquired:
Private equity much prefers enterprise software because of its stickiness. In other words: It’s painful to rip out and replace. A SaaS license model offers a degree of assurance in terms of driving longer terms revenues. This means private equity firms can feel more comfortable in putting more debt into the business, this in turn helps to drive their upside.
Along the same lines, Prunier notes that the sort of adtech company that private equity firms are looking to acquire should be ones that, among other things, have:
- Repeatable, if not wholly-recurring revenue
- Evidence that operating leverage or some other driver of EBITDA margin expansion will be attainable
That is: there must be reason to believe that revenue will remain mostly flat while expenses are slashed.
- Much of the new private equity money that is flooding into the software industry is coming from investors in China. Here's more background on this from TechCrunch: Serial entrepreneurs Rick Marini and Michael Levit are selling companies to China — for a lot of money. As Levit notes in the interview:
You have massive pools of capital in China that want to be deployed in the U.S.; you have entrepreneurs in the U.S. who want do business in China. What’s missing is a level of trust and understanding of how the two sides do business with each other. CSC solved that problem in part by partnering with AngelList. We’re doing something similar for much bigger deals and for M&A.
Levit further notes that, although the Chinese investors have many similarities in approach to American private equity firms, the details are different:
The Chinese are most concerned about profit — true net income. It’s a very non-Silicon Valley mentality. Here, you reinvest your profit to make your company bigger. That doesn’t work so well in China.
We’re looking for companies that are massive in scale and throwing off earnings and look a lot more like a private equity target, though the Chinese are often willing to pay more than private equity.
- And, in his always-superb Money Stuff column, Bloomberg columnist Matt Levine talks about how the last decade of monetary policy has had dramatic effects on American private equity firms: Big Data and Expected Returns
lower interest rates meant that expected returns on all sorts of asset classes went down. And so Goldman had to go out to investors and be like "hey it's not 20 percent anymore, sorry," and it was awkward.
Anyway, eight years into the modern low-interest-rate environment, private equity is going lower and longer
Levine's column links to articles on the Blackstone Group: Blackstone Considers a Lower-Return, Longer-Term Approach to Private Equity
Joseph Baratta, the head of private equity at the Blackstone Group, the biggest alternative investment firm, said at a conference in Berlin on Tuesday that the firm was speaking with large investors about a new investment structure that would aim for lower returns over a longer period of time.as well as to this Financial Times article, which you may have trouble reading if you're not an FT subscriber: Private equity funds take a longer view of lower returns
Many private equity executives say that these structures allay selling forced by a too-short time horizon, adding that longer time horizons will lower the number of sales between private equity shops as an exit strategy, which had surged this year.
They may also help combat the image of private equity as squeezing out profits in the short term, according to Jay Freedman at law firm Ropes & Gray.
I must say, I don't know what data Mr. Freedman of Ropes & Gray is seeing, since from my own personal observations, there is no change in the behavior of "squeezing out profits in the short term." I see many examples of "operating leverage", and of "throwing off earnings", and of "putting more debt into the business", and much less of "reinvest your profit to make your company bigger."
In fact, "invest" seems to be rapidly becoming a dirty word in the technology industry: Amazon is routinely pilloried for it, while companies that emit dividends or perform stock buybacks are correspondingly celebrated.
From where I stand, the direction of the industry is clear.
Still, it's interesting stuff, even if much of it is still very puzzling to me.