BREAKINGVIEWS-Tech’s also-rans are ripe for the plucking

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Pranav Kiran

TORONTO, Aug 30 (Reuters Breakingviews) - Software buyouts are ready for a reset. A host of firms went public in the pandemic years only to lose investors’ favor. Yet, as high interest rates bore down and the path for valuations remained unclear, private equity has coaxed fewer and fewer sellers to sign deals since 2021’s peak. Bulging war chests, increasingly diverging fortunes between the haves and have-, and regulatory limits on Big Tech may break the logjam.

Young software firms are in a bind. The -standard model is that, in the early days, they spend heavily to chase growth and snag clients on renewing subscriptions. That weighs on profitability, though - and with the era of zero rates in the rear-view mirror, promises of future rewards are discounted. Over 85% of the companies on Software Equity Group’s SEG Software-as-a-Service Index fall short on the rule of 40 metric, a combination of revenue growth rate and EBITDA margin used to benchmark profitable expansion. Those exceeding the threshold win valuations over twice the median company’s 5.7 times trailing revenue.

That gap has increased since 2021, while software stocks overall have lagged the broader market. The direction of travel might finally influence executives’ outlook. Even fast-growing GitLab GTLB.O, sporting a buy recommendation from 12 out of 15 analysts polled by Visible Alpha, is considering a sale, according to Reuters. The $7 billion company’s shares are down 60% since its initial public offering.

Buyout barons will hope others follow suit. With a record $2.6 trillion in dry powder, they have plenty of firepower. Recent results show managers like Blackstone BX.N and KKR KKR.N spending it in earnest. And for sellers weighing their options, private equity may sometimes be the only choice: tougher trustbusting under the Biden administration has crimped tech goliaths from scooping up smaller rivals.

Recent buyouts fit the mold. Education software maker PowerSchool PWSC.N and website builder Squarespace SQSP.N both went public in 2021, lagged on the rule of 40, and have sold, to Bain Capital and Permira, respectively. To grease the wheels, existing investors eyeing a richer payday can come along - Squarespace’s backers General Atlantic and Accel will reinvest in the company.

None of this means that M&A overall will zoom back to its peak. Nonetheless, despite a chilly start to the year, private equity has 661 software deals in 2024 so far, on pace to pass the pre-pandemic five-year average of 673, according to Preqin. Stragglers ripe for the plucking will help.

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CONTEXT NEWS

GitLab, a U.S. provider of cloud-based software development tools whose investors include Google parent Alphabet, is exploring a sale after attracting acquisition interest, Reuters reported on July 17, citing people familiar with the matter.

(Editing by Jonathan Guilford and Streisand Neto)

((For previous columns by the author, Reuters customers can click on KIRAN/
pranavkiran.t@thomsonreuters.com))