Software remains an attractive sector and we predict the rapid growth of M&A activity is set to continue. As various asset classes target the sector and increasing competition drives higher valuations, investors need a laser-focused strategy to unlock attractive deals and safeguard returns.
There has been a step change in the level of software M&A activity, as multiple asset classes - but in particular PE and public listings - target the sector. Deals have almost doubled compared to the previous year, now representing 15% of all deals (up from 9% in 2019). This growth is across all deal sizes with both US SPACs and a high volume of smaller deals fueling activity.
|Software deals % of total deals||8%||9%||12%||15%|
This overall increase in activity is in turn driving up the valuations of many assets. As illustrated below, revenue multiples of the Nasdaq EMCLOUD index have grown from 7.5x in Dec 2019 to 15.3x in Sep 2020.
Cyber and HealthTech continue to be hot segments and are seeing strong valuations, but we are also seeing increased activity in many other vertical and horizontal categories. Scale-up assets in particular are attracting venture capital at unusually high multiples.
There are strong sector trends underpinning the increased adoption of software across all industries and business functions. As cloud technology moves companies up the digital maturity curve, they are able to take advantage of numerous benefits from digital customer engagement, interconnected supply chains, and automation to improve workflow efficiencies and data & insights. We expect this to continue apace across all sectors. Further, the pandemic has given some sectors a further boost as companies move to remote working. On a case-by-case basis, investors need to consider whether this is an exceptional bump, and may dampen future opportunities, or whether current adoption / growth is likely to be sustained.
Software assets have distinctive business models that offer multiple ways to play for investors, depending on whether they have growth or profitability focused strategies. Software assets offer investors predictable and sustainable recurring revenues alongside the ability to scale efficiently with strong operating leverage. For those with growth strategies in mind, there are a wide range of options, whether that might be to develop into new markets (international, vertical or customer size segment) or expand the core proposition through data and insights, automation or connecting digital value chains.
Record levels of undeployed capital in the Private Equity (PE) space has created increased demand for deals - and this is increasingly being turned to the software sector. This has flipped historical buyer dynamics, with PE now the leading drivers of M&A (accounting for c.60% of deals). While US-based PE have traditionally led the technology sector, there has been rapid growth in UK PE funds that have developed strong software playbooks.
There has also been a rapid growth of highly acquisitive PE-backed platforms and corporates - especially in the ERP/System of Record vendor space, which contains a wide universe of bolt-on offerings. They have strong acquisition strategies to expand their platforms and build service ecosystems inorganically by acquiring capabilities, functionality and talent.
Meanwhile, the reopening of the listing markets has provided an alternate opportunity for exit. In the UK, homegrown businesses such as Darktrace, Deliveroo and Trustpilot have driven a wave of tech IPOs on the traditionally old-economy heavy London Stock Exchange (LSE). The recent successful direct listing of Wise - combined with a review of listing rules to make these easier - will support this as a strong exit strategy in future, particularly for local scale-ups that previously turned to US public markets.
The sector is also increasingly the target of other asset classes such as sovereign wealth funds, and the addition of these sources of capital will support ongoing high valuations.
The UK’s tech startup and scale-up ecosystem has seen rapid growth and is the largest in Europe. This is creating a vibrant ecosystem of new software vendors who are rapidly scaling to be the growth businesses of tomorrow.
Options are not restricted to new entrants by any means. Existing vendors are looking to professionalise and position themselves for growth. And these owner-managed or bootstrapped vendors are to a greater extent seeking investment to achieve growth and valuations.
Strong competition for software assets is likely to continue and we expect high valuations to be sustained. Consequently deal-makers need to identify the segments where there is not just a good flow of opportunities, but also where they are positioned to win.
Successful technology investors are creating strong playbooks which include deep sector expertise and a focus on asset characteristics (growth, profitability) that match their capital and risk appetite. There is reduced margin for error at current valuations, so investors need to diligence not just the growth and profitability of short term business plans, but also developing exit strategies at the outset. Investors must also develop the capability to move at pace to win competitive auctions.
Opportunities exist across the software landscape. They range from mature, highly profitable assets, to rapid scale-ups. This covers both IT infrastructure software and enterprise applications.
There are specific hot-spots, where there has been a strong flow of opportunities recently
Finally, succeeding in this competitive environment won’t only be about a narrow focus on the right segments to fit existing investment strategies and risk appetites. Investors also need to keep in mind the need to differentiate themselves. Sellers are increasingly looking to investors that can support their value creation strategies, whether this is in terms of optimising growth with profitability, bringing expertise managing software companies, moving into new geographies, creating partnerships, opening up sales opportunities, or enabling successful M&A processes. Successful investors have carefully curated these capabilities and their reputation to stand out in a crowded market.