Private equity firms kept an affectionate gaze toward software companies in 2022. And you can expect private equity to keep targeting software stocks this year, provided rising interest rates don't get in the way.
The Federal Reserve is expected to continue its rate hikes amid its inflation battle. So financing acquisitions with debt could be harder for some private equity firms.
But earlier this month, Francisco Partners continued the 2022 trend when it swooped in to buy Sumo Logic for $1.7 billion. And indications are that major private equity players are gearing up for more software shopping.
"As we head into 2023, we believe we will continue to see elevated (private equity) activity within software as a result of persistent multiple compression across the industry reducing valuations of solid assets," Raymond James analyst Terry Tillman said in a recent note to clients.
Names To Watch For 2023 Action
If that trend continues, there are two private equity names to keep an eye on as the year progresses: Thoma Bravo and Vista Equity Partners. The two were the most aggressive private equity firms chasing software stocks in 2022, and are still flush with cash, thanks to their investor bases.
Thoma Bravo and Vista Equity "have been the most active buyers in the market and are likely going to continue given the massive reset in valuations we've seen in software over the last 12 months," Cowen analyst Derrick Wood told Investor's Business Daily in an email.
Wood added: "It's going to be hard to get large deals done because they tend to carry a much larger debt component whereas smaller deals like Sumo can be funded through just cash."
Thoma Bravo, for example, in late 2022 raised $32 billion in capital commitments across multiple funds for all kinds of acquisitions. Thoma Bravo's focus, though, has been on software and technology investments.
Software Stocks: Cybersecurity Targeted
The number of private equity software deals for 2022 seemed unlikely to exceed a high reached in 2021. But indications are that last year's deals remained plentiful and were bigger on average.
According to figures from PitchBook Data and William Blair Equity Research, there were 587 private equity deals for software companies through the first nine months of 2022. That's not on pace to break 2021's mark of 1,103 deals for $175.4 billion. But the overall value of the 2022 deals came in at $129.3 billion. That already exceeded the totals of each of the nine years prior to 2021 by Sept. 30.
Among the 2022 deals, Thoma Bravo acquired Anaplan for $10.7 billion as well as Coupa Software for $8 billion. Thoma Bravo also bought three cybersecurity firms — SailPoint, Ping Identity and ForgeRock. Vista Equity and partners gobbled up Citrix Systems for $16.5 billion in early 2022. Vista Equity also purchased Avalara for $8.4 billion and cybersecurity firm KnowBe4 for $4.6 billion.
Among other notable deals, a private equity consortium led by Permira and Hellman & Friedman acquired Zendesk for $10.2 billion.
Meanwhile, software valuations declined. The iShares Expanded Tech-Software ETF — comprised of many of the major enterprise software stocks — plunged 35.7% in 2022.
Caveats For 2023 Among Software Stocks
The outlook for software growth stocks remains largely tied to what happens with inflation. Also figuring into the mix are Federal Reserve rate hikes and 2023 earnings outlooks.
In the current earnings reporting period, many software companies offered outlooks below that of Wall Street estimates.
As private equity firms eye potential targets, software stocks that generate free cash flow are more attractive, analysts say. Another financial metric is positive operating margins.
Amid higher interest rates, software companies that will need to soon refinance maturing convertible debt may be less attractive as buyout candidates. The reason is refinancing likely reduces free cash flow.
Further, software companies with high exposure to stock-based compensation may be less attractive to potential buyers.
Public Firms Less Active
Public software companies have been less active making acquisitions, though Adobe agreed to buy Figma for $20 billion. Salesforce is unlikely to make purchases amid scrutiny by activist investors.
However, Microsoft and Oracle loom as potential buyers, analysts say.
RBC Capital Markets analyst Matthew Hedberg said private equity firms are more focused on building profitable businesses from software stocks.
"We continue to see momentum in what we have dubbed 'the new private equity playbook' in which financial acquirers seek out unprofitable growth or stalled growth companies (Anaplan, Zendesk, Coupa, SailPoint, Cornerstone, Medallia, Cloudera) as opposed to the standard model of buying declining businesses and optimizing for cash flow," Hedberg said in a note to clients.
Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.
