After years of bumper valuations, top tech stocks lost $3 trillion of market cap in the first six months of 2022, according to data from S&P Global, as investors fled the asset class. The big hits to consumer brand names like Apple, Microsoft, Alphabet and Amazon in the public markets cooled investor sentiment and brought valuations down in the private markets, too. Yet buyout firms targeting enterprise software deals remain undeterred.

John Park, who leads the technology industry team within KKR’s Americas private equity platform, says: “This job continues to get more difficult as we navigate the challenges of the current market. Technology valuations increased the most over the last five years, and in the correction over the last seven to eight months, they have been hurt the most. When you look through the landscape today, if you write out the last two years of valuation up- and down-swings and rewind, in some ways valuations have normalised.

“If you write out the last two years of valuation up- and down-swings and rewind, in some
ways valuations have normalised”

John Park
KKR

“Even after the recent market trade-off, the very highest growth companies are still trading at a premium. But investors are now being a lot more discerning around the longer-term sustainability of that growth and the ability of businesses to generate real cashflow. It is not about growth at all costs any more – the ability to show you can grow profitably is paramount.”

There is also an increasingly marked differentiation between private equity firms targeting growth models in the technology market, and those favouring the more reliable enterprise software deals that have become so popular in recent years.

Chris Russell, managing director of the PE technology industry vertical at Partners Group, says: “We view tech as really two categories. There are the B2C growth models, which are more likely to be loss-making and are much more unpredictable. Those stocks have gone down as much as 70 percent so far this year in the public markets.

“The other part is profitable B2B, or enterprise, software-as-a-service, and that is really where we spend our time. Even those public companies are off as much as 30 percent this year.”

In flux

Across the board, Russell says that valuations are in flux in the private equity tech space, as buyers and sellers are misaligned following the public market turmoil.

“In the private markets, we see seller expectations are still high and buyers are not really sure where to sit on valuations right now,” says Russell.

“That means the pipeline and investment activity is a little muted, because sponsors are not bringing much to market. But that pressure to deploy will build and eventually that gap will narrow, and transaction volumes will pick up again.”

While there were rumours of buyout firms taking the summer off to wait for valuations to stabilise, few planned to step back from the sector to any meaningful extent.

Zia Uddin, president of Monroe Capital, says: “We are still in the early innings of this digital transformation, and we are expecting one in three private equity deals to be technology- or software-related by 2025. Covid has accelerated some adoption, but at the end of the day, if you believe we are facing a recessionary environment, then technology and software should continue to attract investment from customers because it is one of the only places where companies can create massive productivity gains and operating leverage.”

Russell shares that long-term view: “The need for digital transformation is still strong across the economy, and we are focusing on those high-quality, durable businesses with a lot of value creation opportunities. Most of the companies we look at really do solve pain points, helping customers to create efficiencies and cut costs, and once the customers buy into those, they have high retention and very durable business models.”

There are many who argue that a short-term drop in valuations will create plenty of good buying opportunities for private equity investors looking for longer-term returns. Certainly, more private equity firms are taking companies private, with figures from Dealogic showing PE spent a record $227 billion on delistings in the first half of 2022, up 39 percent on the same period last year. One of the biggest deals was the $16.5 billion acquisition of software company Citrix Systems by affiliates of Elliott Investment Management and Vista Equity Partners.

Park says: “We are getting a lot more open-minded interest from boards of directors of public companies. And management teams that weren’t returning our phone calls 18 months ago are now willing to enter into a conversation. They want to know how they can do the things that they want to do without the volatility of the public markets.

“This is where private equity has an opportunity to excel. When companies in the public markets can’t afford to have any hiccups or mistakes, and when anything deemed out of the ordinary is seen as a negative, private equity has a real opportunity to continue to be thesis-driven in companies and sectors that we like, working with management teams that align with our approach, with a longer-term horizon in mind.”

The latest deal stats from PwC’s 2022 Midyear Outlook show tech deals down 37 percent in the first half of 2022 compared with H1 2021, while value was up thanks to a number of mega-deals. Private equity players are increasingly cautious: specifically, the number of PE acquirers on tech deals dropped from about 85 firms to about 60 over the same period, according to PwC data.

Park says that potential buyers need to scrutinise acquisitions more heavily, with the focus shifting to value creation at a time when growth rates might slow. “As we look at acquisition candidates, those management teams that are most open to pivoting and changing a bit of what they do are the most attractive,” he says.

“That may mean shifting from wanting to take the last five or 10 basis points of growth and understanding that it may be more important to manage those basis points to higher margin. That alignment with management teams is going to be especially important for private equity sponsors looking at public-to-private opportunities.

Best in show

The best-performing sectors have included those related to cybersecurity and enterprise software

David Flannery, president of Vista Credit Partners, says: “Enterprise software involves a long sales process before a company buys or licenses a product, but once it is up and running that really doesn’t come out. Even if a company files for bankruptcy and has to reorganise, it keeps its software running. We are in a pretty tough, uncertain economic environment, but that stickiness is why these enterprise software deals hold up and why there will continue to be a market for lending to those deals.”

Flannery adds that part of the appeal of software businesses is their position as a vertical across sectors. “We don’t necessarily think about subsectors so much as we think about great enterprise software solutions for a diverse range of end markets,” he says. “If the software is state-of-the-art, then we consider how cyclical the end market that it is servicing is. You might have to be a bit careful with more cyclical end markets like retail or apparel, but even then, retail isn’t going away. If you’re a software company with one of the best technology solutions and a broad customer base in retail, then you are in a pretty good spot.”

“We have the largest operational team of any private equity sponsor out there, so we are especially well positioned to support our companies. We try to manage margin the right way, and determine the best ways to grow faster, profitably. That can do wonders for the companies that have gotten into the mindset of growing at all costs.”

An example is WebMD’s parent company Internet Brands, the software services company, which KKR invested in with Temasek back in 2014. That business completed a recapitalisation in July 2022, bringing in a new group of investors led by Warburg Pincus, at a valuation of more than $12 billion. It had grown more than eight times since KKR’s initial investment.

“We had a significant cost take-out as part of our thesis,” Park says, “but the way we were able to effectuate change led the organic growth rate to almost treble, while margin almost
doubled.”

Russell says that the Partners Group tech portfolio, which includes the UK software and digital solutions provider Civica, is in good health: “The capital structures on our tech investments are all sound and we structured well and hedged well, so there are no issues on that front.

“On the M&A side, we will be more selective, but we are still trying to do portfolio add-ons that make sense. We are still investing in growth and pushing all those value creation levers because our core thesis is that customers need these businesses.”

As these deals continue to do well, private equity buyers are sitting on significant dry powder so there is the potential for a deal activity pick-up before long.

For now, the environment is choppy. “Over the last six months, we have participated in processes where sellers have had high-level discussions with sponsors and then abruptly pulled the deals,” Park says.

“There is a lot of nervousness, and banks have become less willing to underwrite risk as well. This valuation environment is tough because of the volatility in pricing and the dearth of credit out there for those large deals.”