Private equity (PE) has traditionally been a sector that focused on fundamentals: what are the earnings and how can they be increased? While that remains the case today—healthy profits are required to pay down debt service from the acquisition and give PE firms room to breathe as they look to improve the underlying business—we are seeing technology changing how private equity firms view potential investments.
In short, companies with better technology are commanding higher prices, and companies with best-in-space technology are fetching multiples more commonly associated with pure software plays.
Capital naturally flows to the places where returns are greatest—and that place for the foreseeable future is technology, be it tech itself (software) or non-tech spaces that are using technology to support their businesses. As PE firms adjust their pricing expectations for companies with heaver technology profiles, the need for thoughtful scrutiny on technology matters increases.
When assessing potential portfolio companies, there are three threads of technology scrutiny that matter most:
- Identifying demons within the company’s technology stack or its personnel: dated software, frameworks or databases; inadequate practices around disaster recovery and business continuity; the company’s cybersecurity threat profile; and the competence of the existing management and technology staffers. These are the kinds of things probed by traditional IT diligence. PE has paid attention to them for years.
- How well the company has leveraged technology to build its business and automate away tedious labor. Sometimes, less optimization here can be a good thing, in terms of earnings potential, as PE buyers know, there are easy gains to be had by introducing better software and processes. Liberty Advisor Group often counsels buy-side clients on finding value based on picking companies that need technology overhauls that aren’t overly onerous and that can be carried out while the company continues its core operations.
- Proprietary advantages afforded to the prospective portfolio company via its technology. Ideally, this would include a proprietary software platform developed in-house. Companies that have built their own software to provide clients and users with something unique in the marketplace earn a special place in the eyes of investors, private equity and venture capital alike.
As tech-forward companies have netted better returns, the market has seen an increase in the amount of PE money aimed directly at acquiring and backing them. PE companies see tech as one of the only ways to beat a market where GDP continues to claw out only modest gains and where EBITDA multiples on all deals, not just those in tech, continue to be high. Pitchbook reported in late 2019 that dry powder – or cash reserves – belonging to tech-focused PE firms totaled $93 billion.
PE companies on the sell side now regularly huddle with bankers—and their technology advisors—to find ways to spin a progressive tech story into the sales pitch. Sell-side decks that once contained one or two pages on technology now contain 10 or more.
Recognizing that many sellers operate from a similar playbook, PE players on the buy side should ensure that the tech story they’re being sold holds up. Having been through these processes dozens of times during the last year, Liberty has learned how to best and most quickly pressure test a company’s tale of technology prowess. Some key elements:
- Projects in-flight need to be thoroughly vetted. We often see tech roadmaps that are barely tethered to reality, with the next 12 months being closer to aspirational than to something actually achievable. These roadmaps and projects are conjured with the intended purpose of telling a better technology story to increase a valuation. These plans need to be evaluated not only for their ability to be completed on time, but also for their end-state efficacy, which is often overstated. Not every enterprise resource planning (ERP) implementation, even if they succeed, ends in glory and greater cash flow.
- Outside digging is required to thoroughly evaluate companies that claim best-in-class technology platforms, and there are a lot of them. Some light-touch commercial diligence around competitors’ technology can go a long way to either affirming a company’s claims or debunking them as hyperbolic. This is also something that can be done outside of the normal banker-controlled diligence process, which makes it extra attractive for PE shops weighing major investments.
- Ask how the data warehouse has changed operations. Lots of companies have data warehouses. Few companies build or use them well. Any company of size going to market right now will almost certainly have something to show in this category. Cagey buyers should demand evidence of how the data asset has helped the company change how it operates. A good data resource that is well leveraged will usually pay dividends in the first year. Companies who can’t point to specific learnings coming from their data/business intelligence implementation may not have a solid resource or the right people at its helm.
The formula for successful private equity portfolio building continues to grow more sophisticated as more capital pours into the space. As buyers pay more for technology-driven companies, it’s imperative that PE deal teams understand what’s under the hood, how it compares to the market, and how well a target is executing on technology.
About Liberty Advisor Group
Liberty Advisor Group is a goal-oriented, client-focused and results-driven consulting firm. We are a lean, handpicked team of strategists, technologists and entrepreneurs – battle-tested experts with a steadfast, start-up attitude. In 2019 Liberty Advisor Group announced the launch of Cybeta™, a suite of intelligence products and services designed to help keep your business off the Cyber X. The product suite is tested and proven to predict future breaches and will give you the business threat intelligence needed to outpace your competition in the cybersecurity battle. Cybeta was built by US intelligence-trained experts that have gained their skills from decades of experience at the DoD and U.S. National Intelligence communities. In 2019, Liberty has been named to the 2019 Best Places to Work in Chicago and to FORTUNE’s list of Best Workplaces in Consulting and Professional Services.