Why PE is a key player in the software economy

NextWave Private Equity

Jeff Vogel, EY-Parthenon US Managing Director and Head of the Software Strategy Group, joins Winna Brown to explore the complexities and key trends shaping the software deal landscape.

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The “software economy” is comprised of companies that sell or license software as well as software-enabled business services companies that differentiate themselves on the basis of their software.

Because a software asset is especially complex to valuate and diligence, PE firms and the advisors who serve them have transformed their talent strategy to attract a wide spectrum of operational experts ranging from serial CTOs to young entrepreneurs. A passion for technology combined with partnering experienced executives with curious young talent helps teams remain agile and responsive to rapid change.

A software asset is different from a traditional asset for three important reasons:

• Markets are amorphous and difficult to size.
• Revenue potential and gross margins are high; however, R&D expenditure is also high because the product is must constantly evolve to stay competitive.
• Technical debt, unlike traditional debt, is difficult to quantify and does not appear on a balance sheet, so a PE investor may unwittingly sign up for obligations requiring significant capex.

Five trends shaping the PE/software deal landscape:

• Role of PE: PE is shaping the software landscape by providing access to capital and focusing on building companies.
• Long-term value: PE is increasingly prepared to hold software assets for longer and are therefore optimizing for LTV.
• Growth: high valuations require PE to underwrite for growth, not solely for cash flow.
• Hybrid deals: PE firms that were traditionally majority stakeholders are now considering minority stakes.
• PIPE deals: private investment in public equity (PIPE) deals are leading to cross-fertilization in management and strategy between public and privately held companies.