Private equity is best known in the tech sector for big deals with the likes of Dell, Seagate Technology, EMC and Freescale Semiconductor. Now a new type of deal flying lower on the radar is drawing welcome attention from the venture capital industry.
The companies involved peddle enterprise software, and the private equity firms eyeing them bring a new source of liquidity, both through traditional takeovers and newly conceived growth-equity investments, at a time when liquidity isn’t always easy to find.
These deals break the mold in another way. Their goal is to enable companies to continue their growth, rather than milk cash flows, and they apply leverage based on the recurring revenue SaaS companies generate. They also are filling a need at a time when traditional software incumbents have slowed their acquisitions.
“Absolutely, PE is stepping into the void and engaging with a lot of software companies we know in the market,” said Adam Marcus, a managing partner at OpenView Partners. “We can’t see that trend slowing down and, in fact, we see it stepping up given the amount of dry powder out there.”
At the root of the trend is a half-a-decade-long change in the way the capital markets operate. With an abundance of cash in circulation and an often unreceptive IPO market, private companies remain private longer and experience the majority of their growth before going public. It is a growth spurt private equity doesn’t want to ignore.
It also means a great deal for venture investors. Finding exit returns hasn’t always been easy for an industry that’s raised a substantial amount of capital in recent years. PE is becoming the third leg of the liquidity stool, along with IPOs and strategic acquisitions.
The unanswered question is just how long it will last.
From the PE perspective, the deal surge is a reaction to the new realities of finance. Quantitative easing flooded the financial system with cash and allowed capital to drive strategy. As a result, PE shops have begun to look beyond their traditional and now highly competitive deals for value. Some have set up pools of growth-stage capital for the opportunity.
They also have adapted to the new rules of software. The typical takeover game plan in tech used to be to find a high-margin company with modest, but reasonable, growth and use leverage to take control. Then managers would cut expenses to improve margins and pay down debt.
Now instead of cash flow, PE buyers are more comfortable leveraging recurring revenue and making bets on the expansion of a less-mature business. Deals can see debt levels of 2x recurring revenue, and PE buyers contribute more equity than in the past, sources close to the deals say.
“Historically you made your return on cash flow generated,” said Ted Coons, a general partner at Technology Crossover Ventures. “It’s not that cash flow is no longer important. But now these private equity buyers are going to make more of their money on the growth of the business.”
Also new is an apparent willingness to pay up for deals. In the past, takeover transactions frequently were done with a 2x-revenue price tag. Today’s deals see 6x or 7x.
“I think what you’re starting to see now is PC firms willing to pay higher multiples,” said Ariel Tseitlin, a partner at Scale Venture Partners. “Now you’re seeing PE firms paying a premium.”
At the same time, it is no coincidence deal activity has centered on enterprise software. Enterprise software, more so than consumer software, has steadier renewal rates, high margins and relatively low customer churn, bringing predictability to recurring revenue.
Venture investors say these deals target companies with growth rates of 30 percent to 50 percent and a substantial trove of revenue, generally $20 million or more. Churn can be measured more accurately at companies of this size, and, in many instances, a company isn’t far from breakeven.
The predictability of recurring revenue enables the new owners to manage expenses and plan for positive cash flows. Sometimes deals become part of a rollup.
“We have seen this trend coming for the last three years,” said Alberto Yepez, a managing director at Trident Capital Cybersecurity.
Among the first examples was the 2016 purchase of Marketo, then a public company, by Vista Equity Partners for $1.79 billion. Deals also have involved Infoblox, Datto, BlueCat Networks, DoubleVerify, Applause, Jitterbit, Ping Identity, Frontline Education and Riskonnect, with such firms as Vista, Thoma Bravo, KKR and Providence Equity Partners playing a role.
Through the first nine months of 2017, this activity has been on fire. While private equity deal making has been slower in general, 345 U.S. software deals took place, up 3 percent from last year’s already fast pace, according to PitchBook. Dollars put to work were $39.5 billion, up 7 percent.
Many observers expect the activity to continue, though they acknowledge its pace will likely rise and fall with interest rates and the cost of debt.
“Some of these funds are brand new,” said Peter Fair, a managing director at Golub Capital. “They have to put that money to work.”
What this means for VCs is more phone calls from private equity managers examining companies and hoping to benefit from the expertise venture capitalists have in areas such as security.
As it is, “we get a fair amount of inbound,” Yepez said. “We definitely see this an alternative liquidity option in the lifecycle of our companies.”
So far, PE managers appear to be viewed favorably. They move quickly, handle due diligence efficiently and are metric driven, often bringing a thesis on a market with them, venture investors said.
The challenge ahead will be building lasting networks as VCs often syndicate with people they know and rely on co-investors who deliver more than just cash.
“We see private equity firms wanting to participate in what we do,” and “I’m always looking for alignment of interests,” said Robert Ackerman, a managing director at AllegisCyber.
One active investor is KKR, which raised a $711 million growth equity fund last year and primarily targets enterprise software. The firm prefers to lead rounds, take minority stakes and secure board seats. It places a focus on unit economics and an understanding of whether a business model scales, said Vincent Letteri, a director of private equity. Deal making is more about finding alignment with management teams and shareholders, and less about cash flow, he said.
The firm notes it has a stable of large enterprise companies in its portfolio to make introductions.
“It’s more about operations than financial engineering,” Letteri said. That’s why, “a lot of our people have operating experience.”
To many venture capitalists, the benefit of PE participation is the new avenue it provides for growth capital and liquidity.
“It gives you optionality,” Tseitlin said. Even if it doesn’t yet factor into an original investment thesis on a company, “it increases the pool of available options for getting liquid.”
More so, multiples, in many cases, seem to match those offered by strategic acquirers or exceed them.
One entrepreneur to benefit is Toby Scammell, founder of Womply. Sageview Capital led a $30 million growth round last year, and Scammell describes the firm as a good fit for the company. Sageview is focused on building a business and on the financial metrics that are necessary to do so, he said.
He added that he was pleased with a valuation that was in line with market comps.
“Most investors at this stage, they have a pretty good understanding what the forward multiples should be for a SaaS company,” Scammell said.
As to having a PE firm as an investor, he added, “that was surprising.”
The trend also delivered results to IVP. The firm has had PE investors involved in three deals — Marketo, LegalZoom and DoubleVerify — and all have been positive, said Steve Harrick, a general partner at the firm.
With LegalZoom, IVP sold a third of its holdings and still has a position in the company. It describes Permira as a partner that has invested for growth and said the company is very profitable.
LegalZoom in November kicked off efforts to pay a $249 million dividend.
“It’s a company that is working well for us,” Harrick said. “We’ve received a strong return to date. We believe the best is yet to come.”
But clearly not every deal will work out and the alignment of interests is not always easy. Some VCs believe PE deal making has helped pump up late-stage valuations and brought renewed requests for deal structure, such as guaranteed multiples. In some deals, pricing seems to imply near flawless company execution.
“In general, valuations tend to be pretty high in the market,” Letteri acknowledged. “There have been many deals we have looked at where we couldn’t pencil out a return.”
PE interest also seems available to only a select group of companies. On top of that, signaling risks appear when a venture investor sells.
“While I think private equity creates a third leg to the stool, it’s a narrow passage for the right business,” Coons said.
It also may create a false sense of security for venture investors who expect PE liquidity to be available well into the future.
“PE has absolutely become part of the calculus,” Marcus said. “It creates liquidity for some early investors, even if the company (hasn’t reached) its full potential.”
Just how long this option will remain when interest rates rise is difficult to know.
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