Private equity investment in technology services

global technology field It raised $675 billion from private equity (PE) in 2022, up from $100 billion in 2012. In this world, the software and software as a service (SaaS) sector is experiencing growth, profitability, and multiple expansions across the sector. However, our analysis found that the recent market correction has seen valuations in this sector fall by more than 40%.

The recent large-scale exit by PE firms in the technology services sector has also put technology services in the spotlight for investors traditionally focused on software. We estimate that high-tech services currently account for 25-30% of his total assets under management in the high-tech sector. This represents an increase of 10 percentage points over the past 10 years.

Disruptive technological innovations have created opportunities across a variety of assets. However, it is important to understand the structural differences between software and his SaaS and technology services, especially the differences between business models. Stakeholders, particularly PE investors, may consider carefully assessing these differences when evaluating segments. Here are some key insights.

Technical services: 3 considerations

We highlight three considerations that PE firms should keep in mind when entering the technology services space.

The rule of 40 applies. Technology services companies are undervalued compared to software and SaaS companies with similar performance as measured by the Rule of 40 (a software company’s growth rate plus profit margin must exceed 40%). Become. However, valuation multiples have jumped disproportionately for technology services companies that exceed the 40-Rule threshold (Exhibit 1). Our analysis shows that when a company exceeds the “Rule 40” threshold, its value-to-revenue ratio nearly doubles compared to companies with annual earnings growth rates of 30 to 40 percent. The differences between these two cohorts are explained by differences in their earnings growth profiles. In other words, investors are willing to pay a premium for technology services companies that can deliver highly efficient, industry-leading revenue growth.

Investors care more about revenue growth than profit growth. The mix of a company’s service portfolio is important to its revenue and bottom line (Exhibit 2). Specialization and exposure to new digital technologies such as cloud, data and analytics, cybersecurity, Internet of Things, and blockchain are essential for higher performance and recognition.

It has been observed that system integrators that combine digital and traditional technologies, as well as providers focused on infrastructure services, tend to trade at a discount and struggle to significantly increase their revenues. . In contrast, companies specializing in digital and new technologies demonstrate the potential to generate higher revenues, profits, and profits. This suggests that it is important for technology services companies to have a well-defined service portfolio mix.

Maintaining or improving performance is a bigger driver of revenue than multiple expansions. Multiple expansions in software and SaaS are the main drivers of high returns in the sector, especially when PE investors invest in assets that are likely to break the Rule of 40 threshold or exit through IPOs. ing.

Despite enjoying a valuation premium, high-performing technology services companies above the Rule of 40 threshold of 40 percent still earn unleveraged returns of 20 to 25 percent (if 100 percent of the investment is leveraged in equity). (assumed to be none). If these are typical technology services deals where 50 to 60 percent of the capital is leveraged, the leveraged return would be 40 to 45 percent (Exhibit 3).

Our experience shows that, unlike software and SaaS, technology services revenue is most often the result of performance rather than multiple enhancements. However, our evaluation of recent exits shows that PE investors who have significantly boosted the performance of high-tech services companies have also gained an additional 25-30 percent from multiple expansions in the sector. Masu.

These findings highlight the importance of thoroughly evaluating a target’s business model for technology services. Ideally, investors should consider factors such as the target’s service portfolio mix, specialization, and exposure to emerging technologies.

It is also important to evaluate the potential to use operational improvements to achieve higher multiples. However, recent historical evidence suggests that this is the exception rather than the rule, and PE investors should ideally avoid relying on multiple extensions to generate profits in technology services. .

Proven value creation strategies that deliver stable returns

When we analyzed historical PE deals in technology services, we found many successful exits and some deals that generated outsized returns of over 25 percent. Few failed exits were found. A closer look at these transactions revealed that the two companies have five things in common:

1. They expanded or differentiated their competencies. These companies focused on two to four competencies, either in vertical services such as cloud, or in the analytics or digital services space.
2. They have transitioned their portfolio to serve technology-native customers and customers who continually reinvest in digital capabilities. We predict these customers will drive approximately 75 percent of incremental technology spending over the next seven to 10 years.
3. They improved their sales efficiency by increasing their share of large deals to their largest accounts.
4. They increased capital efficiency by optimizing platform costs and extracting more synergies from M&A.
5. They had an entrepreneurial, customer-focused leader who delivered consistent performance in uncertain times.

The strategy for achieving these outcomes is very simple, and some PE investors use it as the go-to approach for achieving stable and satisfying returns in technology services.

Although not as glamorous as software or SaaS, technology services companies create value through performance. Decision makers who are sensitive to sector-specific trends can discover insights and benefits.