Q&A with PitchBook: U.S. private equity Q2 2023 trends

This Q&A originally appeared in PitchBook's Q2 2023 US PE Breakdown.

West Monroe supports more than 600 private equity transactions every year, performing buyside operational, technology, and market diligence and driving value creation efforts with management teams. This experience, combined with our multidisciplinary approach—which looks at each situation through the lenses of industry, operational, and technology expertise—helps dealmakers plan for and manage the complexities of mergers, acquisitions, and divestitures.

Continued macroeconomic headwinds have significantly impacted the software sector, with many software companies facing slower growth for the first time in several years and struggling to meet their earnings targets. This is causing companies to increase their focus in carefully managing expenses and is causing private equity firms with dry powder to focus aggressively on improving EBITDA margins early in their hold periods.

At a high level, what are some current key themes that you think are evolving in the PE environment over the first half of 2023? 

Chris Stafford: This has been a very different year compared to the past decade. We’ve seen a fundamental slowdown in deal volume that has impacted M&A and transaction opportunities for software companies, and at the same time they are also facing significant revenue challenges and rising costs. This is putting tremendous pressure on software management teams—pressure not seen in a decade—to properly focus on their bottom lines and ruthlessly prioritize their R&D and M&A investments. A lot of value is placed on having the right leaders in the right functions who can make timely and often difficult decisions.

Dhaval Moogimane: It remains uncertain how long these market conditions will last, with some optimism for a rebound in H2 and early 2024. There is still significant dry powder that investors need to deploy, and the assets coming to market are still competitive. A more opportunistic theme that’s getting significant attention is generative AI: The primary focus has been on software company leaders considering strategic uses for it within their products and to support operational efficiency, and increasingly private equity firms are discussing how to best apply it across the portfolio and advise their companies on embedding it in the most effective manner.

From the buy-side perspective, grappling with deal structuring, plus murky growth prospects for many sectors, is daunting enough—what other challenges are your clients seeing?

Chris Stafford: Challenges with revenue growth have made it difficult to pin down valuations and are making it more difficult to get buyers aligned with sellers. In some cases, diligence is uncovering slower revenue growth projections, lower pipeline volume, or greater retention risk than originally thought, which usually leads to valuation adjustments and can lead to buyers walking away from a deal. When growth projections are lower, these fluctuations are critical. 

Developing a precise value creation plan is another big factor. Investors are more focused than ever on executing operating margin improvement initiatives very early in the hold period, partly driven by more tempered revenue growth projections. This requires additional scrutiny and intelligent, one-time investments to make the business more efficient and digitally enabled. 

Dhaval Moogimane: Higher interest rates and the increasing cost of capital are forcing private equity firms to increase their up-front focus on value creation plans across the full P&L—from sales & marketing and RevOps effectiveness, to R&D, COGS, and G&A efficiency.

Are publicly held companies currently a buying opportunity? What factors are at play? Are value creation playbooks highly applicable? 

Chris Stafford: Private equity investors have seen a significant buying opportunity for public companies, as many are not managed toward strong EBITDA margin. The importance of value creation playbooks are being realized (and put to the test) right now. Strong playbooks are being used in very valuable and effective ways, but investors and companies without a clear or actionable approach are playing catch-up.

Dhaval Moogimane: An additional factor at play: Many private equity investors will try to get creative on their financing. In instances where valuations have come down, stock prices are fine but price tags are still large: How can buyers finance these in an effective way? In some cases, we’re seeing all-cash deals now with plans to finance later. 

How are software management teams and private equity firms trading off between revenue growth and margins? 

Chris Stafford: Software companies—and the sector as a whole—are in a pivotal moment: They simply have to become more efficient. How do SaaS companies optimize margins without sacrificing growth? It begins with proper portfolio management and making data-driven decisions regarding product/R&D investment. What does data indicate will drive growth across the customer base? For products at scale, how do you make them more efficient? For new products, how do you design them to have strong gross margins at scale? Oftentimes we see poorly managed product roadmap priorities as a root cause of a variety of inefficiencies across the P&L. 

Dhaval Moogimane: Fundamentally, good management teams and investors aren’t trading off between revenue growth and profit margins; they are focused on both and are determining which specific investments can help to drive growth and optimize costs at the same time. Companies with an increased focus on profitability are getting valued at higher multiples, but the Rule of 40 still holds in software.

What are the best options for software companies to reduce costs and improve profitability without sacrificing growth? How can software companies continue to increase their efficiency?

Chris Stafford: Every SaaS company is built on complex technology, and many are built on older technology that is no longer efficient. Part of becoming fundamentally more efficient is sometimes taking a hard look at the core tech stack, which is a big lever in the R&D and COGS cost base. In the past, updating the tech stack in ways that reduce operating expenses over time was a “nice-to-have,” but it is close to becoming a “must-do” now in many situations.

Dhaval Moogimane: Many companies are rethinking their nearshore and offshore options for R&D, support, and services. We’re also seeing a lot of interest in increasing efficiency and streamlining processes with automation. Companies are also harnessing more data—and using it in more impactful ways—for everything from predicting cross-sell and up-sell opportunities to reducing churn. AI will play a large role in this. 

What are the top value drivers you are seeing within software companies today as it relates to creating value through operational efficiency and innovation?

Chris Stafford: First is R&D efficiency: How product management and engineering operate day to day, how they generate revenue and improve CX, and also the overall R&D cost base. As Will mentioned, offshore and nearshore engineering is continuing to become a default operating norm for the majority of SaaS companies.

A second significant lever is cloud operations. For many SaaS companies, usage costs are not optimized, architectural designs are not conducive to efficient cloud consumption, and companies struggle to quickly reduce their cloud operating expenses and improve gross margin.

A third key driver is automation and AI. The surface is just getting scratched with generative AI and automation, but I think we’ll see a lot of use cases for operational efficiency and innovation over the next several years.

Dhaval Moogimane: There is also innovation around the customer experience. What is the company’s unique offering, and how could it be enhanced to drive increased usage and adoption? Plus, just plugging more into customer sentiment to ensure ongoing satisfaction and retention is more critical than ever to drive net and gross retention.