Private equity turns to resiliency strategies for software investments

Private equity (PE) investments in software—500-plus deals of more than $100 billion in value last year—have outperformed other investments made by the asset class for upward of a decade.¹PE investments in software generated 25 percent higher internal rates of return than those of other PE sectors from 2008 to 2021; PitchBook, accessed March 2023.

But that was until mid-2021. Thereafter, inflation and rising interest rates were among the reasons why software companies lost some 25 percent of their enterprise value over 18 months. Some software segments, such as fintech, “adtech,” and e-commerce, were affected more than others.²McKinsey analyses on the enterprise value of the top 150 software companies from S&P Capital IQ’s database. Current economic conditions will continue to affect software investments in 2023 as IT spending slows down after years of acceleration.³Gartner recently cut its 5 percent increase in 2023 IT spending to 2.4 percent. See “Gartner forecasts worldwide IT spending to grow 2.4% in 2023,” Gartner, January 18, 2023. In a recent McKinsey survey⁴The online survey was in the field from November 7 to November 11, 2022, and garnered responses from 50 C-suite participants: CIOs or vice presidents of information technology or digital information. The participants work for North American companies with revenues ranging from $100 million to more than $5 billion. Their industries include retailing, manufacturing, healthcare, finance, and technology. of 50 CIOs of companies responsible for more than $10 billion of IT spending, 60 percent of the respondents said they would plan to decrease software-related expenses during a downturn. Seventy-five percent said that they expect to maintain or reduce their spending on new vendors and products.

The near-term spending slowdown will probably have a wide-ranging and mixed impact across software categories—even as many software segments continue to benefit from long-term tailwinds, such as digitization and strong margins. Long-time investors in software are likely to remember its resilience during previous recessions⁵During the 2007–08 global financial crisis, software companies outperformed the S&P 500 index by more than 150 percent in revenue and EBITDA growth. In the dot-com crash of the early 2000s, the sector’s revenue and gross profits continued to grow at the same rates. and may look to boost their portfolios by finding new value creation opportunities that better reflect current conditions.

In this article, we identify the key spending categories and themes from our CIO survey and show how PE investors can take advantage of the opportunities in the software sector.

CIOs shift spending to protect near-term ROI

Our CIO survey suggests that in 2023, spending will remain robust in software domains such as cybersecurity (preventing cyberattacks has a significant ROI), data and analytics (which can help organizations identify additional or more efficient sources of value creation), and automation (some CIOs are being pushed to use technology to help organizations find opportunities to save costs). The surveyed CIOs report that cyclical end markets sensitive to the business cycle or the larger economy, such as retailing, the supply chain, and adtech, will probably suffer the greatest impact from recessionary trends (exhibit).

Optimizing core systems. The CIOs we surveyed said that the change in software spending will largely reflect the use cases of products. They emphasized the need to maintain mission-critical operational spending in areas such as finance, HR, and enterprise resource planning for customer services. Survey respondents already investing in these platforms also indicate that they want to optimize such expenditures and are exploring ways to minimize add-on services and consolidate spending (for instance, by rationalizing instances across geographies or business units).

Increased focus on efficiency for revenue enabling expenditures. Businesses continue to reassess their strategies and business plans in anticipation of a continued economic downturn. Software spending directly associated with revenue streams (such as marketing and advertising technology) will be heavily scrutinized to establish greater efficiency in the go-to-market approach.

Near-term private equity software investment strategies

Against the current backdrop, private equity investors and software portfolio companies have several opportunities this year:

1. Consolidate platforms. PE investors and portfolio managers can explore M&A opportunities that better reflect current spending trends among CIOs. Exploring a potential consolidation play in revenue-enabling tools, for example, could accelerate growth in a world where businesses are seeking fewer, more efficient vendors. On the flip side, investing in software-adjacent domains, such as IT services, can help sustain near-term momentum in growth.
2. Tell—and prove—the ROI story. Decades of continued growth in spending on software have helped illustrate its intrinsic ROI as an overall investment category. Yet telling a sharp near-term ROI story will be critical for future investment. To generate such a story, investors may consider changing their portfolios in ways that can demonstrate results more quickly or provide greater resiliency—for example, investing in categories with faster implementation cycles or in very modular software that can create customer-specific efficiencies.
3. Reestablish the path to efficient growth. Ongoing spending conservatism by CIOs will probably affect the profitability of software companies if it isn’t managed proactively. “Slash and burn” approaches to cost management might provide immediate—but unsustainable—results. Instead, investors and portfolio managers may want their software companies to focus on designing more efficient process management systems across structural categories such as go-to-market expenses and R&D. The aim should be to sustain near-term share while building a longer-term path to optimizing value.

The current economic downturn is likely to create headwinds for certain software segments: areas such as adtech, the supply chain, industrial, retail, consumer, and e-commerce. By contrast, growth tailwinds power areas such as cybersecurity; business process management; automotive; governance, risk, and compliance; and environment, health, and safety. To thrive during this period of uncertainty, investors should leverage the current climate to double down on resilient segments and identify market leaders in challenged ones.