Software LBOs. Growth problem.

Private equity exit activity has picked up over the last two quarters after a very slow start to the year. But there is no proof yet that things are back to normal. In fact, as the deal market reawakens, it’s looking quite different than the one before the downturn.

In the Private Equity buyout market, we’re seeing a growing separation in the prices acquirers will pay for the best companies versus middling ones. And yet, many PE managers are still coming to us with questions, trying to understand what will move the needle from a company that sells for a small multiple on EBITDA to the ones that are going for more than 30x.

That there may be some confusion is understandable. After a disastrous 2022, the signals around tech valuations in 2023 have been more positive, but still at times contradictory and confusing. Also, the macro-economic environment has still not stabilized, and many indicators still point towards an upcoming recession.

Much of the panic around tech began with the Nasdaq’s plunge last year. So far in 2023, the tech-heavy index is up 26.3%, though it has slid back down since mid-July after surging the first six months of 2023. It’s hard for even seasoned investors to project where it goes from here.

Meanwhile, the venture capital industry is still frozen, with a significant decline in deal activity in 2022 and 2023. Even though the IPO window may be reopening - which is still to be confirmed with the recent introductions of Arm, Instacart and Klaviyo – there is a long path to recovery ahead and huge amounts of capital trapped in the VC ecosystem as of today.

And yet, we’ve seen some exceptions play out in some high-profile deals in the buyout market.

?In July, US PE firm Francisco Partners announced it would buy out financial data provider Macrobond from PE firm Nordic Capital for almost €700 million. Macrobond was founded in 2008 and Nordic has reportedly made 6x its initial 2018 investment.

And in October 2022, Providence Equity Partners acquired French automotive data firm A2Mac1 from Five Arrows Principal Investments for about $1.36 billion. Sources told Reuters that the PE buyout valued A2Mac1 at a multiple close to 30x its core earnings of $49 million.

How did these companies buck the larger macro narrative to achieve such significant multiples?

One element we can highlight is that both are European software companies. That’s notable because Europe has seen more tech acquisitions than the US for 6 quarters in row, according to CB Insights, an indicator of the value investors are still identifying across the continent.

But there is an even more fundamental reason for these 2 successful buyouts: Growth.

Amid the turmoil of past 18 months, growth has been hard to come by. This was not the case during the pandemic-driven boom years of 2020 and 2021. Now, companies that can demonstrate sustained growth are rare and therefore in high demand.

The challenge, then, is spotting those gems amid the rubble. Certainly, PE firms are still looking at EBITDA as the crucial indicator for valuation. And debt can only be serviced using cash flow left after expenses.

?While revenue, even when it comes from steady subscriptions, should never be the basis for borrowing heavily, its quality and growth command to a large extent valuations in today’s market.

The top-performing public companies – those trading at 10 times ARR or more - are growing at rates of 25% on an LTM basis according to our proprietary research.

?Yet not all growth is created equal. Savvy managers are making their decisions based on the numbers behind the numbers that help identify companies with high-quality growth. This requires a granular understanding of the company’s key business model characteristics (i.e., revenue model, pricing, go-to-market motion, etc.) to have numbers correctly reflect that reality.

?There is an urgency to mastering the techniques for sorting these companies and betting on the right ones. In a recent study, Bain predicted that that “an incoming wave of tech asset exits will create a crowded, competitive buyer’s market” for PE buyout managers. If such a wave emerges, there will be a temptation to chase what appears to be the hottest deals at uniformed multiples just because other firms are chasing them, heightening the risk of choosing the wrong targets or overpaying.

Fortunately, the data to make an informed analysis is all there to be discovered by the right kind of due diligence. To surface that information, our firm has developed a Hybrid Growth Diligence framework that is specifically designed to help investors gain a conviction on the solidity of a company’s growth, this being a core component of valuation.

?While HGD provides a sophisticated matrix for a deeper analysis of a company’s metrics to measure its resilience and potential for disruption, there are 3 categories that help us know how and why some PE buyout managers are agreeing to big multiples on deals: Quality of Revenue, Quality of Growth, and Quality of Margins.

?Let’s break those down.

Quality Of Revenue

?Understanding the resiliency and sustainability of growth starts with Quality of Revenue.

We can assess this by conducting an exhaustive review of the customer base to understand elements such as types of clients. Are they well-known brands? Is there a risk that some portion could potentially fail? Companies addressing to a large extent high-growth scale-ups have seen growth strongly decline over the past 18 months on top of high churn associated with failures. Also, is the customer base concentrated?

It’s also important to understand whether revenue streams are diversified. If yes, we also need to know which revenue segments are commanding high-margins, and whether some secondary streams of revenue are overly contributing to top line growth.

Yet one must also analyze recurring revenue. Recurring revenue offers greater resilience and visibility into future growth potential and is critical in a company’s valuation. In the case of software, there is the matter of whether revenue flows from software subscriptions or whether it is transaction or usage based. With the rise of GenAI and its transformation of existing SaaS models, usage-based revenue should rise in the near term. Transaction-based ARR is already a well-known model in payment type businesses and has grown as SaaS companies embed finance in their revenue models. Both Transaction-based and Usage-based revenue command specificities in Quality of ARR analysis to determine the true level of recurring revenue associated to the related consumption.

Some companies may have both usage and license revenue streams, in which case separating and analyzing the quality of each is an important skill.

Quality Of Growth

This second category reveals not only the level of growth, but also just how efficiently a company is growing. Another way to think about this: How much does it cost to add each customer? What does it take for the company to add $1 in new ARR? How much opex/cash does that require?

For some companies, customer expansion might come through a carefully managed acquisition strategy. The playbook for assessing efficiency of Sales & Marketing spend is already a well-known one and is critical to resilient growth for a software company.

For others, this might result from a powerful product innovation that both attracts new customers but also allows them to upsell and expand their relationship with existing customers. The Product-led-growth (PLG) model has become the default growth strategy for the top-tier SaaS companies (at public level) and requires a different reading of a software’s company P&L as a portion of acquisition expenses are captured in the Research & Development costs. Macrobond, for example, is currently growing at 34% LTM ACV growth, and has tripled its ACV (annual contract value) under Nordic’s capital ownership, partly as a result of successful product expansion.

Or perhaps, they can implement price increases that better capture the value of the company’s products. This should be carefully monitored to avoid bad surprises in YoY growth.

Quality Of Margins

High quality margins are an important indicator of a company’s ability to sustain growth and its scalability.

The starting point here is gross margins which help measure the quality of the technology. Higher gross margins tell us that a company has developed powerful tech compared to a company that relies on services and therefore will likely have lower margins.

High margins tell us that a company can reinvest in S&M and R&D. This, in turn, will drive Gross Margin improvement which leads to a virtuous growth cycle that can make a company an attractive buyout target.

At the OPEX level, the key is to analyze different spending categories such S&M, R&D, and G&A, and to get a clear understanding of the ROI of each of the projects incurred within these categories.

Finally, getting a conviction on the sustainability of the company’s free cash-flow margin is critical in a buyout operation. Analysis here mostly rests on understanding the positive or negative effects of working capital dynamics, and unbundling OPEX from CAPEX costs at R&D and S&M level to compare one company with the other.

GenAI and Climate

Let’s look at two other topics that should be high on the radar for PE buyout managers evaluating deals, and that are not as easy to capture as more traditional financial items as Revenue, Growth and Margins.

The first is GenAI. Everyone is aware of the immense hype. VCs are massively investing in GenAI. But we believe this is much more than a short-term bubble. This technology will be deeply transformative. Gen AI can dramatically improve margins through productivity gains while enhancing many other aspects of the business. With GenAI, the well-known Rule of 40 could quickly become the Rule of 50 or even the Rule of 60, but only on the medium term once the first adjustments on pricing structures have been made by SaaS companies as incorporating GenAI - with the underlying costs of foundational models - first starts by negatively impacting gross margin.

As is typical, many companies are trying to ride the buzz. But companies that are serious about GenAI should have relatively large R&D budgets. And executives should be able to provide a clear GenAI product roadmap. This will allow acquirers to weed out the pretenders.

Likewise, Climate Resilience should be considered an essential building block when evaluating high-growth SaaS companies. As I have written before, climate metrics can make a company be a more attractive investment or acquisition because we can see that the executive team has found ways to unlock growth opportunities, reduce costs, and future proof their brand in the eyes of an increasingly conscious public.

The sector for tools that let companies measure their carbon impact is flourishing. This should allow leadership to track their emissions and the transitions being made to mitigate their impact on the climate. Such tools translate those elements into the financial impact on company statements with a need for a new vision of Quality of Earnings taking into account those effects, as well as those of GenAI.

No single one of these metrics should be considered enough to validate a deal or to be a deal killer. Instead, they are pieces of a larger puzzle that should reveal the resiliency and sustainability of a company’s growth, and that are critical on determining the intrinsic value of a company. By embracing the right framework for putting them together, savvy PE buyout managers will have the confidence to pick the right targets in an age of digital transformation that continues to present massive opportunity, and to get their top assets into shape for an imminent sale.