First and foremost, our hearts go out to everyone on Main Street. The impact the COVID-19 pandemic is having on Main Street businesses, employees, and families is simply unfathomable. Equally, we want to express our sincere gratitude to our nation’s healthcare workers. Thank you.
Like most professionals in our industry, the team at Software Equity Group (SEG) has been hard at work assessing the impact of the COVID-19 pandemic on near-term M&A and equity markets. Public stock market investors have clearly been spooked as major indices, including our SEG SaaS Index (View Update), experienced drastic declines.
While the public market sell-off has been evident, it’s not yet clear how this abrupt ‘Black Swan’ event will impact the software industry’s private capital markets. The private capital markets had been operating with historically high efficiency and strength through the end of February. Equally important, the sheer size of today’s private capital market dwarfs what existed in any time in our history.
As we are all asking questions, we thought it would be worthwhile to share some real-time market insights. We’ve had conversations with some fifty software-focused private equity firms participating in our live mandates. Notably, these firms have collectively accounted for nearly 1,000 software M&A deals over the past five years.
We hope you find this insight to be equally valuable. We welcome any questions you may have on how current events may impact your software company’s near and long-term plans.
How are private equity firms operating in today’s environment?
- Nearly all firms remain open for business and eager to evaluate opportunities. Most are sitting on a tremendous capital base that needs to be deployed. While PE firms are likely to be more selective, it appears lower and mid-market deals will get a higher percentage of “looks” due to risk allocation and a lack of available credit for larger deals.
- Many private equity firms we chatted with are spending a significant amount of time focused on helping their portfolio companies navigate these uncertain days and weeks, although the level of time spent with any individual company is highly dependent on that company’s end market/exposure to an economic slow-down.
- Critical mass (i.e., total revenue), mission critical products, and defensible vertical markets are center stage. Contractual recurring revenue and high net dollar retention are key. Those exhibiting resilient annuity streams through Q2 and Q3 will be ever more impressive.
Which market segments are attractive?
- Highly recession resistant segments will be in heightened demand and less likely to see significant valuation impact. Think EdTech, GovTech, Healthcare, Pharmaceutical/Life Sciences, Tele-Everything, etc. What’s more, it’s clear many PE investors see terrific win/win opportunities to make platform investments and subsequent add-on acquisitions.
- The current uncertainty surrounding verticals like hospitality, vacation rentals, retail, and oil & gas will cause many investors to forego near-term investments in these end markets. For a minority of investors, however, these end markets present significant long-term upside. The challenge will be bridging the bid/ask spread during this uncertain period. Many of the best private equity investments made during the 2008 Global Financial Crisis (GFC) involved markets experiencing short-term pain.
How is the debt market holding up?
- It depends. Funding appears to currently be frozen for large debt and syndicated debt financings of deals greater than $750M. Lenders in these camps appear to be hunkering down. Additionally, lenders with exposure to multiple end markets beyond software also appear to be in wait-and-see mode. It does appear software-focused lenders, particularly those focused on lower and middle market deals, are open for business, remaining pragmatic in their assessment of long-term risk. Many recall the strength of the software industry during the GFC. Debt is likely to become a bit more expensive due to heightened market risk and uncertainty and will likely require private equity investors to get more creative in structuring deals.
What is the impact on valuations?
- Public stock market valuations have dropped precipitously in recent weeks and one would conclude the private markets to follow a similar path. The private markets, however, are insulated from volatility due to five to seven-year hold periods and the ability to grow through the next downturn. There is likely to be a negative impact to valuation, but expect it to be less pronounced and subject to the swings of the public market. As discussed, product category, vertical market, and business health will be key determinants of value. This could represent opportunity for sellers looking to roll a larger portion of equity, consolidating an industry, or investing proceeds as part of a large risk allocation strategy.
What is the difference between the Global Financial Crisis and now?
- First and foremost, the software-focused private equity market that exists today is entirely different than during the GFC. At that time, most private equity firms were focused up market and the amount of capital raised was a fraction of today’s massive capital base. Current credit markets are far healthier today and the US Government’s stimulus response appears to be much faster than during the GFC. The buyer/investor supply for software companies is much more distributed as private equity firms drove roughly half of all software deals in recent years vs. a very small percentage at the time of the GFC. On the other hand, this ‘Black Swan’ event is unprecedented and its near-term impact not easily understood. Most feel cautiously optimistic the software industry will emerge stronger for it, though rough waters are likely to be expected.
Please feel free to reach out with any questions you may have on how current events may impact your software company’s near and long-term plans.