ODDO BHF Asset Management: Flash info - ODDO BHF Artificial Intelligence
STORY OF THE MONTH
In this new monthly flash, we would like to draw some lessons from the recent wave of acquisitions in the US software sector, mostly by private equity funds. Software is the sector most heavily represented in the ODDO BHF Artificial Intelligence fund.
Private equity funds are stepping up their acquisitions in the US software sector
Since the beginning of 2022, the US software sector has been in a phase of successive acquisitions by private equity funds. First came Citrix, in late January, which unveiled plans to acquire Vista and EverGreen Coast Capital for $16.5 billion (one of the largest deals in four years). Then came Anaplan (a US planning-solutions provider, not a typical PE fund target, due to its low FCF generation), acquired by Thoma Bravo for $66 per share, or a premium of almost 30% on the latest quoted price. In April of this year, it was Datto, which was acquired by Managed Services Kaseya and a consortium of investment funds, including TPG. In the same month of April, Sailpoint received an offer from the same Thoma Bravo, valuing the American cyber-security publisher at $6.9 billion in cash. In the cases of Citrix ($16.5bn) and Anaplan ($10.7bn), the $10bn threshold was broken and no longer constitutes a glass ceiling for total transaction size.
First lesson: software has some of the healthiest fundamentals of any sector
Private equity funds have historically concentrated much of their investments on software, given the intrinsic characteristics of a sector that combines some rare qualities: 1) addressable markets with strong growth and high visibility (as the investment waves in digitalisation, public clouds and cyber security are still in their infancy); 2) business models with recurring sales and that are increasingly so (given the sector’s migration from a license/maintenance model to a subscription model, also known as Software as a Service (SaaS); and 3) free cashflow that is much higher than the market’s as a whole, due to high operating margins and relatively low investments (WCR and capex).
Second lesson: Software is priced to offer entry points considered attractive by funds that know the sector well
The rise in long-term North American interest rates (2.9% at the time of writing) has squeezed the sector's valuations (with around 17% compression of the valuation of these companies for every 100bp rise in interest rates). This provides much more attractive valuations for private equity funds, which have a longer time period to create value (but whose final IRR depends on their entry valuation). At the time of writing, IGV (the US software ETF) had consolidated by almost 27% from its 9 November 2021 peak. As of April 18, 2022, the US software sector was priced at x9.6 sales (versus x9.5 sales for the 5-year average and x17.2 sales at the sector's 2021 high, according to Morgan Stanley).
Third lesson: The sector is now ripe for "multi-pronged" consolidation
In the North American market, the wave of buyouts we are entering into follows an unprecedented number of IPOs in 2019 and 2021. These companies have not all: 1) been recognized by the market in the same way; or 2) found the management teams they deserve (Splunk, Dynatrace, Anaplan as examples). It should also be noted that the need to transition their business model from licensing to SaaS is also a reason why some companies are undervalued (CyberArk, Ping Identity, for example) and, in rarer cases, an incentive to delist.
As private equity funds’ business model is to create value also through debt, it might seem that the current rise in US long-term interest rates would make transactions de facto more difficult. As a result, two things are happening: 1) these funds will not be the only players in consolidating the sector, and we believe that we will now also enter a phase where larger software companies will buy future organic growth by acquiring other "point solutions" companies that will provide them with entry to one or more high-growth markets; or even access to certain technologies. The most attractive segments are likely to remain cyber security, DevOps, analytics, observability, ITSM and ITOM and, finally, collaboration software; and 2) the sector outlook and fundamentals are excellent, as they allow private equity funds to find attractive IRRs despite entering a higher-interest-rate world.
We believe that we are now entering a period of consolidation in the sector that we would describe as "multi- pronged", i.e. characterized by the entry, in addition to private equity funds, of several types of buyers: 1) so-called "legacy" software publishers who need to reposition themselves by buying companies that will give them growth and more modern technologies (Oracle, SAP, Software AG, Teradata, and VM Ware); 2) software publishers for whom external growth represents everything (Progress Software) or part of the business model (Salesforce.com, Microsoft); 3) software publishers whose "family" is too fragmented and that need to create leadership within this family through consolidation (we could see these phenomena in cybersecurity, observability or analytics/big data); and 4) large semiconductor companies wanting to invest in software for financial (Broadcom) or strategic (Nvidia and, perhaps tomorrow, AMD and Marvell) purposes.
