By Aman Singla and Siddharth Tripurani (NYU)
Photo: Kevin Ku (Unsplash)
The growth of tech in the last decade has led to a significant impact on the PE industry. Tech-focused PE funds have outperformed non-tech buyout and non-tech growth-equity strategies in terms of internal rate of return and the volatility due to the COVID-19 pandemic has only added fuel and improved the growth prospects in the tech industry due to the resiliency that we have seen. In fact, as of September 15, tech funds accounted for 22.5% of all PE capital closings in 2020. This percentage of funds raised is significantly more than the 14.1% five-year average and even greater than the 21.1% raised in 2019—a banner year for tech funds in which Vista Equity Partners and Thoma Bravo raised flagship funds. North America- and Europe-based tech-focused PE firms have raised $68.3 billion across 34 funds YTD, already capturing the most capital ever raised for the strategy on an annual basis.
Generalist vs Specialist
The graph above displays the PE capital raised by those operating across various fields and sectors versus tech-focused investing such as the Big Three mentioned above. Tech investing has mostly been done by particular specialized players, although recently, large generalist players having moved into the tech space. Specialized investing allows PE firms to take advantage of a rising market share, with mutual momentum allowing the sector’s returns to continually increase. Furthermore, as generalists seek a greater presence in the tech industry, they are migrating their portfolio concentration into the specialist space. Most of the movement into the tech sector occurs when firms look for first-round funding which most generalists consider a safer investment: early investment for long term returns.
Tech companies will only continue to eat into the market share and will continue to generate double-digit growth rates and returns for investors. This will continue to attract both specialised and generalist PE firms to continue to increase their investments in the industry. The size of the funds can vary from $10 billion+ mega-funds to funds of just a couple hundred million dollars. The approach taken by these PE companies for investing in tech companies is unique as they are different in several ways. They are often asset-light businesses, requiring little capital to scale, and can achieve rapid growth for prolonged periods of time. Additionally, tech companies with the SaaS business model produce highly standardized recurring revenue with products that are very sticky. Tech-focused PE funds and traditional buyout funds are also differentiated by their geographic mix. The former is primarily a North American phenomenon. Although there are some Europe-based vehicles dedicated to this space, most PE tech capital is raised in the US, which is home to a more mature venture ecosystem and a myriad of tech companies.
PE is infamous for its use of leverage and cost-cutting; however, when investing in tech companies, PE firms often use less leverage, around two to three turns compared to six to seven turns in non-tech buyouts. PE firms must continually reinvest in the company and try to grow the top line in order to achieve superior investment returns because companies in the space are often valued based on revenue multiples. And while growth certainly plays a part in traditional buyouts, the focus is far more explicit in tech investing.
As PE firms have continued to incorporate these strategies into their operations, more and more tech companies will be encouraged to continue making deals with these PE firms. The technology companies are being provided with a good amount of flexibility and autonomy to continue to grow in their respective domains.
The record amount of capital raised in the tech space isn’t simply the result of an increase in PE commitments more broadly; tech-focused PE funds have accounted for a higher proportion of total capital raised in each of the last several years, comprising over 17% of PE capital raised across North America and Europe in 2019.
Specifically, 2019 was a huge year for specialist technology PE firms because both Thoma Bravo and Vista Equity Partners closed their flagship funds. Since they are two of the biggest players in this PE domain and Silver Lake is taking a considerably slower approach to utilizing their dry powder to make deals, LPs looking to enter this industry will have to potentially wait for a few years till these big players come back and start new flagship funds. However, till then there has been a growth in middle-market funds with Accel – KKR coming into the picture.
Dry Powder/EBITDA/Cash Flow Influx
The huge amounts of investments being made in both middle market and flagship funds are resulting in a huge influx of cash. These PE firms now have huge amounts of Dry Powder available at their disposal. Over $100 billion has been raised for the strategy in the past three years, more than had been raised for the strategy between 2008 and 2016 altogether. After a prolific bout of fundraising, many in the industry are asking if these GPs are sitting on too much cash and calling attention to potentially excessive pricing due to the surfeit of capital. Not only have these firms been inking multibillion-dollar tech buyouts at a rapid clip, but tech buyouts often use less leverage than similarly sized buyouts, meaning capital is drawn down even more quickly to fund these deals. Thoma Bravo has been deploying cash so swiftly that, as we discussed earlier, the firm is expected to launch a $15.0 billion flagship vehicle in mid-2020 after having already closed on a $12.6 billion fund in January 2019. Despite tech companies requiring huge amounts of reinvestment, not having dividend recapitalizations, and overall lag in cash distributions the overall call down rate remains more or less the same between these funds and normal non-tech PE funds.
The Big Three
Big Three funds as a proportion of overall tech-focused PE funds as of 2019 (USD)
Silver Lake has a prominent global presence in various tech verticals with a portfolio of $60 billion in combined assets turning over a revenue of $180 billion annually. Companies such as Blackstone, BYJU’s, and Reliance Retail have dipped into Silver Lake’s pockets. Silver Lake focuses on non-control, downside-protected, privately negotiated structured equity and debt investments. Given the consistently large-scale investments, they seek to optimize risk-adjusted return forecasts, factoring in the stability of company growth and eventual market leadership.
Thoma Bravo is a relatively smaller growth capital firm, based out of Chicago, with a portfolio of $30 billion in combined assets. They’ve invested in J.D. Power, Barracuda, and LogRhythm, which are all companies that use the funding to focus on scaling and product innovation. Thoma Bravo begins its equation with companies as they grow into sizable market shareholders to establish the trust that would allow them to continue investing at a higher rate of return.
Vista Equity Partners operates with private equity, permanent capital and credit/public equity. Their committed investment totals to $58 Bn with nearly 500 company transactions. Their investment has gone into companies such as Solera, Lonewolf Technologies, and Kazoo. Vista pioneered a sector-based approach to their investments in the last 2 decades, allowing them to specialize in creating market leaders before diversifying their portfolio’s resources.
The presence of the Big Three can lead to anti-competitive market strategies and concentrated areas of growth. However, as is the case with any economy bearing the presence of a monopoly or coalition across large market shareholders there could be potential antitrust concerns if they start consolidating a huge number of companies through their multibillion-dollar funds.
Current growth in private equity investment into technology is expected to continue due to investments by both tech-specific investors and generalists. Due to the huge amount of growth we are seeing in this domain, the level of competition will continue to increase between Generalist and Specialist companies, each with its own sets of pros and cons. That being said, both LPs and GPs are looking to join both Middle Market and Flagship Funds that are being started at regular intervals which will continue to grow the cash flows and margins of different tech companies. It is clear that LPs want a private market investment option that lets them tap into the growth of the digital economy led by proven managers who can create value and outperform their peers.