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Industry Expertise Drives Outsized Returns for Private Equity Firms Investing in Software Companies

To Capitalize on the Wave of Software Companies Hitting the Buyout Market, Firms Must Use a Distinct Set of Value Creation Levers, a BCG Study Finds

MUNICH—Private equity firms that have greater experience investing in software companies capture higher returns than those that invest in such companies opportunistically, according to a new report by The Boston Consulting Group (BCG) and the HHL Leipzig Graduate School of Management. What sets the more experienced investors apart is their superior understanding of how to create value in the software industry. The report, titled Cracking the Code in Private Equity Software Deals, is being released today.

Like other investors, PE firms have been attracted to software companies by the potential for profitable growth and high valuation multiples. As a share of their total investments, PE firms’ investments in software companies increased from 4% in 2007 to 8% in 2016. The number of annual acquisitions more than doubled, from 228 in 2007 to 481 in 2016.

Returns from software acquisitions have generally outperformed the market. Software deals exited by PE firms from 1998 through 2012 outperformed the median internal rate of return of other industries (excluding high tech) by 9 percentage points and the median IRR of high-tech deals by 11 percentage points.

However, the study found that expertise in software deals makes a tremendous difference. Among the PE firms doing software deals:

  • 1% were “serial” investors (those that had made at least ten software deals), doing 6% of deals.
  • 38% were “experienced” investors (whose software deals represented at least 20% of their total deals), doing 28% of deals.
  • 3% were both serial and experienced investors, doing 14% of deals.
  • 58% were “opportunistic” investors (neither serial nor experienced), doing 52% of deals.

In deals with available performance data, serial investors outperformed the median IRR of other industries (excluding high tech) by 15 percentage points; experienced investors outperformed by 20 percentage points. In contrast, opportunistic investors, outperformed by only 2 percentage points.  

“Serial and experienced investors typically apply a rigorous proprietary playbook to create value at software companies, addressing a distinct set of industry-agnostic and software-specific levers,” says Nicolas Hunke, a BCG partner and a coauthor of the report. “Four software-specific value creation levers typically applied are sales and pricing initiatives, changing to a cloud-based software-as-a-service offering, productization, and state-of-the-art software engineering.”

The importance of knowing which levers to apply is especially relevant given that a new wave of software companies, funded by venture capital investors, is expected to reach the market during the next five years. The study estimates that VC firms will exit their late-stage investments in more than 900 software companies, with PE firms acquiring approximately 200 of them. Given the median holding period for software investments of 4.2 years, there will also be an increase in software deal exits by PE firms during the next five years, bringing additional software companies to the buyout market.

“Although investments in software companies have the potential to generate high returns, success is far from assured,” says Tawfik Hammoud, a BCG senior partner and a coauthor of the report. “PE firms just getting into the game must rapidly crack the code of software deals by understanding how to both target the best opportunities and create value at a company once it is part of the portfolio.”

A copy of the report can be downloaded here.

To arrange an interview with one of the authors, please contact Eric Gregoire at +1 617 850 3783 or gregoire.eric@bcg.com.

About HHL Leipzig Graduate School of Management

Founded in 1898, HHL Leipzig Graduate School of Management was the first business school in Germany. Currently, HHL is one of the country’s leading graduate schools, offering a variety of academic executive programs for different graduate degrees, including MSc, MBA, and PhD. The Center for Corporate Transactions, headed by Prof. Dr. Bernhard Schwetzler, is HHL’s major research unit in the field of mergers and acquisitions and private equity. It is designed to bring together scientists of HHL and its research partners working in the areas of corporate finance, accounting, law, and game theory to analyze and discuss problems in corporate transactions. For more information, please visit www.hhl.de/finance.

ABOUT THE BOSTON CONSULTING GROUP

The Boston Consulting Group (BCG) is a global management consulting firm and the world's leading advisor on business strategy. We partner with clients from the private, public, and not-for-profit sectors in all regions to identify their highest-value opportunities, address their most critical challenges, and transform their enterprises. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 85 offices in 48 countries.

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