Market View - November 2016
What makes a SITS business attractive to private equity

In this article Tom Wrenn, Head of TMT at ECI Partners, provides an independent perspective on what makes software and IT service companies attractive to private equity houses and their investee companies. More about ECI is to be found at the end of the article.

Software has long been an attractive sector to private equity, with businesses in the space possessing several attractive characteristics. They are highly scalable, in that they are able to increase sales volumes considerably with comparatively little increase in cost, and become more profitable as they grow with development costs being spread over a larger number of customers. They are also able to generate meaningful barriers to entry as products are generally underpinned by intellectual property and, once customers are won, they tend to be very sticky.

The rise of SaaS models in particular has attracted the interest of private equity investors, due to the extra resilience characteristics that they give to a business. Unlike traditional up-front licence and maintenance models, SaaS businesses do not need to continuously win new business in order to maintain revenue at a constant level. Existing customers provide a solid, recurring base of revenues, with every new customer win adding incremental turnover. SaaS-focused businesses also have attractive cash-flow dynamics (once they reach scale) as the customer tends to pays for services up front, and tend to be more resilient through a downturn as the customer only has to pay small regular fees, as opposed to large up-front CAPEX.

Whilst SaaS models are generally considered more attractive by private equity, traditional annual licence and maintenance fee models can also be of interest. The main consideration for private equity is the revenue mix between one-off licence revenues and recurring revenue in the form of support and maintenance. As a general rule, businesses with this revenue model are likely to be valued more highly as the proportion of recurring revenue increases. Private equity will generally value businesses on EBITDA multiples but we will also want to understand the makeup and levels of ongoing CAPEX required by the business in order to understand more about how much free cash can be generated.

Whilst it has perhaps not attracted as much interest as software historically, IT services is another sector that has seen much private equity activity in recent years. Historically, IT services have generally been delivered through a “man-hours” consultancy model, which provides little revenue visibility and is reliant on continual one-off sales. However, the emergence of the managed services model has made the space an increasingly attractive area for investors, with businesses exhibiting greater visibility of earnings, and a higher level of recurring revenue.

Many IT services business started out focusing on individual areas such as help desk support or data centres, and have gradually expanded the services they provide either through in-house development, or M&A. In general, those businesses able to become a first port of call for a range of services are most interesting to mid-market private equity, as they are able to become highly embedded in their customer’s organisation and thus switching costs for customers become very high. Best of breed players in specific horizontal market niches (hosting, support, data centres etc) tend to need significant scale to be able to compete with the larger behemoths in the space and therefore less relevant for mid-market firms but potentially more interesting to large buy-out firms.

The customer base is also an important consideration for private equity when investing in IT services businesses. In particular, many businesses within the space have significant customer concentration, especially at the smaller end of the market, where firms have often started out serving one or two larger clients. This is considered a risk by PE, as a large proportion of revenue can be lost overnight with the loss of one, or a very small number of clients. In addition to this, the end market that a business sells into is an important consideration to PE. Businesses supplying cyclical end markets such as recruitment or construction are generally less interesting than those selling into more stable markets (this is the case with software as well as IT services).

For any business private equity looks to invest in as a platform, the management team is of great importance. We do not run businesses; we back great management teams who do.

When it comes to bolt-on acquisitions for our portfolio companies, whilst retaining the key people can sometimes be very attractive (e.g. when moving into an adjacent product/service area that requires specific knowhow), on balance it is likely to be of less importance. Acquisitions in software can be challenging from a platform integration perspective and, therefore, private equity is more likely to be investing for organic growth (via geographical expansion, for example). In managed services, however, there is a strong appetite among private equity backed businesses for add-on acquisitions that can help them broaden their service offering, typically bringing many synergies with them. Therefore, if you have a smaller managed services business you are looking to exit, this could be a route to explore.

In summary, private equity has always been and will continue to be interested in making investments in the software and IT services sector due to the winning combination of growth and resilience that can be found in the right businesses, specifically those with a strong management team, high recurring revenues, low customer concentration, low customer churn and serving attractive end markets.

About ECI Partners

Established in 1976, ECI is the UK's leading growth-focused private equity firm, investing in management buyouts, buyins and acquisition finance deals for medium-sized growth businesses.

Over four decades of working with great management teams and founders, ECI has supported businesses across the technology sector – recent investments include IT Lab (IT Managed Services), ATG Media (online marketplace), Wireless Logic (M2M platform), CliniSys (healthcare IT), Kelvin Hughes (marine navigation systems), XLN Telecom (B2B telecoms), Fourth (SaaS), Ascribe (healthcare IT) and CarTrawler (travel technology platform). ECI raised £500m, its tenth fund, in 2014, and is busy investing it in growth tech companies.