This article is sponsored by BC Partners
What does it take for managers to win tech deals in the current challenging market?
Philipp Schwalber: The deal pipeline is clearly quieter than it was a year ago. The key reason is that the macro outlook is highly uncertain, with a possible deep recession just around the corner. However, technology is a very broad sector and not particularly cyclical, so there are still plenty of opportunities.
This type of environment, though, requires real conviction to get new investments over the line. We ask ourselves: does this opportunity fit our investment strategy? Is it in a subsector or theme in which we have deep experience? Does the opportunity really have all the key characteristics we look for in all BC companies?
Importantly, the seller also needs conviction that it makes sense to sell in a difficult market environment and that a deal is deliverable at a good valuation. Therefore, communicating our own conviction credibly is very important.
Mark Fariborz: Focus is key, and you need to pick your spots to build real angles around a deal. A slower market can give more time to build these angles and enables you to lean in more strongly on deals you like. Where you have real conviction, you have to lean in on pricing and around process dynamics.
I think you’ll also see more structured transactions, including preferred structures, that can help bridge valuation gaps. There is a lot of noise in the market right now, so focus is more important than ever.
What are you looking for in a tech deal?
MF: What defines a good tech deal right now is the same as always: at its most basic, it’s about investing in a business in a position of leadership within an attractive market.
For us, this means investing in the number one or number two player in a market, and relative market share is a key metric for us. Other factors to consider are how protected the market is and the level of barriers to entry. We want to invest in companies that offer products or services benefiting from increased adoption and penetration. These trends can trump potential macro headwinds.
Lastly, the ability to manage inflation with pricing power is also critical and gets back to the point around market position and leadership. If you can identify businesses that are well-positioned against these attributes, you can get through a lot of macro challenges.
PS: M&A often is an important value driver in our investment cases. This holds particularly true in an uncertain market, because M&A provides an additional growth driver – essentially, more optionality in getting from A to B. It also is important to be rigorous and intellectually honest with yourself about, for example, end-market exposure or macro risks you are taking.
What are currently the key levers of value creation in tech investments?
PS: The core levers remain the same, regardless of economic upturns or downturns. Over the long term, it boils down to earnings quality and the sustainability of growth. In software, this focuses on themes such as the quality of the revenue line – what proportion of your revenue is subscription based? The quality of products, go-to-market and customer experience, all of which can be driven forward in a downturn.
In terms of challenges, the last 12 months have been marked by a ‘war for talent’. But we are beginning to see evidence from our portfolio that pressure on salaries is abating. Europe looks set to enter a recession and this would create different challenges.
However, market-leading businesses in enterprise application software have robust business models, and it is possible to continue investing in and delivering value growth even in a difficult macro environment. You can even win market share more easily in these markets.
MF: Fundamentally, we can take a long-term view and look through some of the volatility and pressure on short-term performance to create better businesses over time. On balance, I think the downturn will benefit many of our companies. The challenges are obvious, but we are investing in businesses that have good secular growth and will benefit from more end customers adopting technology in a meaningful way. As we saw through covid, our technology investments continued to grow even through a pretty difficult macro context.
In the current context, we expect many companies will look to technology to reduce costs and create efficiencies, and this should create incremental demand for many of the software solutions that our portfolio companies provide.
On the inorganic front, I expect we’ll be able to do more tuck-in acquisitions. As valuation expectations rationalise and venture funding dries up, we think sellers will be more willing to transact and we hope to accelerate M&A at our portfolio companies, at better prices.
How has the outlook for exits changed over the past year and has that changed your approach?
MF: We are not market timers, so as long as we have good businesses, capitalised properly, we can weather the storm and exit at a more favourable time. Our focus on investing in high-quality businesses means we should grow organically through downturns. We also expect to double down on M&A and build incremental value through acquisitions.
Lastly, I’d note that high-quality businesses can still get financed and will continue to command strong multiples. We saw this same dynamic following the financial crisis, where M&A volumes declined but the market skewed towards the highest-quality assets, and these deals were able to garner what at the time were viewed as very high multiples. So there’s no question that we’ll still be able to exit high-quality businesses even in a tougher macro context.
PS: It is hard to raise debt at the moment, but the technology sector is proving more resilient to this. So, while the current landscape raises the bar, it does not make exits impossible.
What does the deal pipeline look like going into 2023?
PS: There are fewer opportunities, so we are concentrating on a very small number to ensure we have the conviction we need to move forward. This relies on strong relationships with management and a thorough understanding of how the business might perform in recession scenarios. Take-privates are not as big a theme in Europe as in the US because there are fewer listed software companies.
MF: Public-to-privates are on the rise in the US, given how stocks have performed over the past 12 months. The recent price decline has been so severe, however, that lots of management teams are not yet ready to transact. Still, we expect activity will increase as public market valuations show no signs of a meaningful pick-up.
For us, it is all about proactive deal origination. We focus on certain thematic sectors, and have identified three or four businesses in each of these. Vertical software will continue to be interesting for us, as will niche horizontal software, such as governance risk and compliance software, where we have had good success on existing investments, and where we see an opportunity to leverage those learnings on new deals.
Mark Fariborz leads BC Partners’ technology investment activity in North America and Philipp Schwalber leads BC Partners’ technology investment activities in Europe and co-leads coverage of the DACH region