Massive multiples and tech-washing

The success of technology-related investments has attracted copycats; LPs must look beyond the headlines.

Olof Hernell is someone who knows how rapidly technology is changing companies. EQT’s chief digital officer since 2015, he has held senior positions at Google, including as its head of Android and Chrome hardware for the Nordic region.

“Over the next 10-20 years, companies who master the craft of automation, machine learning and advanced analytics will have an outsized competitive advantage compared with everybody else,” Hernell says.

Tech-focused funds raised $60.2 billion last year – an almost threefold increase compared with five years prior, according to PEI data. The growth shows no sign of abating: as of early October, TMT-focused funds in market were seeking $72.8 billion – the highest amount for any sector-specific strategy.

The largest vehicles that closed in the last 18 months were Silver Lake’s $15 billion haul for Fund V – the largest private equity tech fund after SoftBank’s $93 billion tech-focused Vision Fund – and Vista Equity Partners’ sixth flagship, which amassed $10.5 billion.

These funds will be competing against a slew of current fundraisings. Thoma Bravo, which focuses on software and technology-enabled services companies, is seeking at least $9 billion for its flagship Fund XIII, while Vista could raise almost $14 billion for its Fund VII, according to documents from the Oregon State Treasury.

Limited partners’ interest in the sector has been steadily growing, says Anders Thulin, head of digital at Triton Partners. The private equity firm holds roundtables on different companies, sectors and themes at its annual general meetings, and the digital one is always oversubscribed, he says.

“The interest to listen and discuss our digital strategy and execution, and results from it, has been very high, and actually increased in terms of importance for limited partners,” Thulin says. “I think that’s a sign that this is a very important theme for investors.”

It’s easy to see why LPs have a strong appetite for tech funds. Software buyouts delivered a 1.9x median gross return, compared with 1.6x for non-software deals between 2005 and 2014, according to data from CEPRES PE.Analyzer.

Sales of tech assets have generated huge exits for private equity firms: the global average for general partner exits from IT companies last year was 35x EBITDA – a jump from 24x in 2016, according to data from S&P Global Market Intelligence.

“There is convincing evidence that the current levels of [tech-related] deal activity and prices are supported by underlying business fundamentals,” Bain & Co wrote in its latest global private equity report. The sector enjoys recession-resistant recurring revenue streams, strong customer loyalty and opportunities to benefit from consolidation through acquiring smaller competitors at discounts. “The tech sector appears to be well positioned for the long haul,” the report noted.

Growing into it

One way private equity firms have been capitalising on the tech boom is by launching smaller dedicated funds – sometimes labelled “growth” vehicles – which invest smaller equity cheques. Apax Partners is a prime example: the firm collected $1 billion for its first dedicated digital vehicle in December, which it uses to invest in tech deals involving less than $150 million in equity.

The firm follows fellow European giant CVC Capital Partners – which raised $1 billion in 2016 for its first fund making growth investments in software and “technology-enabled” businesses – and KKR, which collected $711 million for its debut tech vehicle, Next Generation Technology Growth Fund, also in 2016.

“We wanted to get back involved [with] investing in growth stage companies, because at Apax we see a lot of opportunities that, size-wise, might not be justifiable for our existing later-stage fund,” says Dan O’Keefe, managing partner at Apax Digital. The group now has 21 professionals spread across New York and London deploying a dedicated fund and a dedicated strategy. “110 percent of our day is speaking about Apax Digital and where we might look to invest,” O’Keefe adds.

GPs setting up smaller vehicles to invest in tech or growth assets makes sense, according to Malcolm MacDougall, a partner at law firm Charles Russell Speechlys who specialises in private equity and M&A.

“A lot of these growth businesses are in some way tech-related, so there’s a bigger universe to invest in,” he says. In a seller’s market where there is a lot of capital chasing deals, it is no surprise that firms are focusing fundraising on high-growth areas.

“It’s a lot easier to turn a £20 million ($26 million; €23 million) company into a £40 million company than a £1 billion company into a £2 billion one,” MacDougall adds.

One region that has had a record year so far for technology-focused private equity fundraising and investments is Asia-Pacific. Beijing-based tech manager Hillhouse Capital Group raised the largest Asia-dedicated fund in history, amassing $10.6 billion in September to make innovation-related investments across healthcare, consumer, technology and services sectors.

Acquisitions in the internet software and services sector have led M&A deal activity, with China driving the bulk of the transactions. Ant Financial Services Group – China’s largest online payment platform – collected $14 billion in June from investors including Canada Pension Plan Investment Board, Singapore’s GIC and Malaysian sovereign wealth fund Khazanah Nasional.

Between 2013 and the first half of 2018, China accounted for around $34.8 billion of the $49 billion in internet software and services deals in Asia-Pacific, according to data from S&P. During the first half of 2018 alone, internet software and services deals in China totalled roughly $1 billion out of about $1.7 billion worth of total acquisitions in the same sector across the entire region.

Tech-washing

The high prices buyers are willing to pay for tech assets – GPs have paid 22x EBITDA for IT companies globally so far this year  according to S&P Global Intelligence – have led some private equity firms to market non-tech businesses as technology-driven enterprises to command higher pricing.

“We are seeing a lot of GPs trying to rebrand their companies as tech companies,” says Jonas Nyquist, until recently head of private equity and infrastructure at Swedish life insurer Skandia. “It might be something outside tech and they add a bit of a tech angle.”

Companies themselves are also attempting to ride the tech boom by changing the language they use to describe their revenue streams. Annually recurring revenue, or ARR, is a concept used in enterprise technology and is attractive to investors because it shows steady recurring revenue.

“Over the last couple of years, all of a sudden everyone has started calling their revenue ARR,” says O’Keefe. “You might look at it and go, wait, it’s not contractual, it’s not really recurring, why do you call it ARR? It’s positioning.” Smart entrepreneurs will figure out what nuances will drive the highest valuation and start communicating those nuances, O’Keefe adds. Investors must parse those nuances.

For EQT’s Hernell, the role of tech-focused private equity investors is equally clear.

“We know that if we can make every single investment a digital leader in their industry, that will be a fantastic thing for the LPs.”

SoftBank takes tech world by storm

The $93 billion tech-focused SoftBank Vision Fund, backed by sovereign wealth funds of Saudi Arabia and Abu Dhabi and global corporations including Apple, Sharp and Qualcomm, has taken the world of technology investing by storm since its inception last year. Capital from the mega-fund has been invested in about 30 companies, according to media reports, with the smallest investments at around $100 million, including in autonomous vehicle start-up Nauto and robotic software company Brain Corp. The largest was a more than $8 billion investment in ride-hailing giant Uber in June.

SoftBank founder Masayoshi Son is all about aggressively pursuing tech development in artificial intelligence and big data, and the Vision Fund will not be his last mega-fund. He says he will raise a new $100 billion fund every few years. For perspective, the largest private equity fund in history is Apollo’s $24.6 billion Apollo Investment Fund IX, according to PEI data.

Saudi Arabia, the largest supporter of the Vision Fund with $45 billion of committed capital, is also preparing to double down on its tech bet. Public Investment Fund chairman and crown prince Mohammed bin Salman said in an interview in October this year that the fund plans to invest another $45 billion into the second Vision Fund, paving the way for even greater influence on the tech industry. “We have a huge benefit from the first one,” he said. “We would not put [in], as PIF, another $45 billion if we didn’t see huge income in the first year with the first $45 billion.”

This was before the killing of Saudi journalist Jamal Khashoggi who was murdered in his country’s embassy in Turkey in October. The incident has cast a shadow over business deals involving the Kingdom, which as of mid-October said ‘rogue operatives’ were responsible for the Washington Post columnist’s death.Firms including Blackstone, BlackRock and global banks have said they will not attend an investment summit in Riyadh in late October. A spokesman for the Vision Fund declined to comment on the situation.

Son said in October 2017 that the Vision Fund has seen a 22 percent return, or roughly $3 billion in profit, since May last year.

California State Teachers’ Retirement System chief investment officer Christopher Ailman says he expects private equity disruptors such as the Vision Fund to change the way the industry operates. “The huge size of these funds lends themselves more to buying and holding a company, and less to the speed of turnover,” he notes. “The sheer bite size to come in and actually move the needle for these funds is going to be a very interesting challenge.”