Private equity firms have reaped substantial rewards from shrewd investments into leading technology companies, while avoiding the common pitfalls of buying into the sector. Firms are also proactively adopting new technologies, enabling the industry to achieve much-needed scalability and meet the growing requirements of institutional investors.
Mickael Fischer, Director of Client Coverage at RBC Investor & Treasury Services, shares his insights on how technology is re-shaping private equity investing and operations.
1. Focusing on software investments
Private equity-led technology deals totalled USD 284 billion in 2021, corresponding to 25% of total buyout value and 31% of deal count, making it the biggest sector in the industry's overall portfolio.1 Software deals accounted for USD 256 billion, or 90% of the total technology buyout value, with the majority of transactions comprising public-to-private deals.2
“A decade ago, leading experts were predicting that software and technology would become dominant sectors, and they have. Providers such as Amazon, Netflix and Uber have disrupted our everyday lives. At the same time, technology companies are literally made for private equity investment as they tend to be capital light with strong revenue growth,” says Fischer.
Software deals accounted for 90% of the total technology buyout value
In addition, private equity has recognized the importance of cloud services and particularly cyber security, with several managers acquiring stakes in high-profile cybersecurity companies, including McAfee and Zimperium, with the latter specializing in mobile threat defence.3
“More companies are using cloud-based infrastructure to achieve economies of scale and growth, while the threat of cybercrime escalated dramatically during the pandemic. As a result, software companies will likely be a major component of private equity portfolios moving forward," says Fischer.
Looking further ahead, Fischer anticipates that private equity firms will increasingly invest in technology enterprises focused on decarbonization, such as the burgeoning meat substitute industry. He notes that a handful of managers are also exploring early stage opportunities in the Metaverse, although whether this translates into actual investments is yet to be seen.
2. Steering clear of riskier technologies
Many industries are embracing digitalization and innovation as new technologies, including artificial intelligence (AI) and blockchain, come into the fold. At the same time, a number of investors, dispirited by low bond yields and volatile equity price movements, have turned to digital assets for returns, including cryptocurrencies.
Despite the growing appetite for DeFi (decentralized finance), only a handful of private equity firms have invested into blockchain and AI companies, with activity in this space seemingly dominated by venture capital. “In the case of blockchain companies, there are growing questions about whether the technology is as widely applicable as people initially thought, while concerns are mounting about its ability to scale," says Fischer.
Only 3% of larger managers are investing in cryptocurrencies
Interest in cryptocurrencies among private equity firms is negligible. According to an EY survey, only 3% of larger managers are investing in crypto-related or digital assets.4 This comes as managers express unease about the volatility in this asset class, along with the absence of proper regulation and price fundamentals.
“Private equity managers are taking a more cautious approach to disruptive technologies such as blockchain and crypto—some of which have arguably been overhyped. It’s important to remember that both technologies are still relatively new, and it could take some time for them to mature," says Fischer.
3. In with automation, out with manual processing
As private equity managers face potential performance challenges in the face of higher interest rates and growing inflation, managers are looking for efficiencies in their operating models.
Automation—shifting away from analogue systems and Excel spreadsheets—is one way to achieve this objective. “Not only can automation reduce costs but it also helps mitigate risk as errors are less likely to occur in an automated environment versus on an unwieldy, legacy system," notes Fischer.
The industry is also having to address the highly customized needs of institutional and technology-savvy investors, many of whom want portfolio and risk reporting delivered to them near real-time and in formats that are accessible through modern devices. This is forcing private equity firms to dispense with paper-based processes, in favour of new technologies and systems.
Not only can automation reduce costs but it also helps mitigate risk
“Automation can help private equity managers obtain operational alpha and cost savings. And given some of the wider challenges facing managers, this will make a significant difference to their operating margins” says Fischer. “Automation is also essential as investors move into the Web 3 era. If private equity firms are to appeal to digitally-native investors, they need to take a very forward-looking approach towards automation," he concludes.
So how are managers working to achieve automation? “The big firms are building the technology internally, while others are acquiring technology businesses. Most managers, however, are outsourcing this work to third parties,’ says Fischer.