Has Private Equity Hit Peak Software?

No, we expect software investing to continue to loom large in private equity as it expands to incorporate the opportunities presented by artificial intelligence (AI) while managers also work rapidly to protect existing investments, which are most at risk.

Not long after the Federal Reserve began increasing interest rates in March 2022, ChatGPT was publicly launched and became the fastest-growing consumer application in history. Alongside rising interest rates, beginning in late 2022, software revenue growth rates and valuations quickly receded, creating long-term challenges for general partners who overinvested based on growth and valuation assumptions that turned out to be short-lived. By December 2022, median valuations for publicly traded software companies—which are used in valuing private software companies—had tumbled from a pandemic high of 19.0x revenue to 5.6x revenue.

More recently, median software revenue multiples have further compressed to 3.4x, reflecting investor concern that AI is going to eat software. Advancements in AI and their impact on the thousands of privately held software companies and valuations will not be as universal or immediate as what we have seen recently in the public markets. Some business models are immediately vulnerable, while others may exhibit more resilience due to having well-established moats across a range of attributes, such as solutions leveraging longstanding proprietary data or deeply embedded in customer workflows. AI represents both a risk and an opportunity in the private markets; thoughtful management of existing exposure and careful allocation toward this development could be long-term value drivers for today’s private investment portfolios.

Most private investment portfolios have long had material exposure to technology, and not just through their venture capital allocations. Technology, and really enterprise software, has held the top spot in private equity for more than ten years with a commanding lead. From a private markets perspective, current investment outcomes for this sector may ultimately sort themselves into two cohorts: pre-mid-2022 investments and post-mid-2022 investments. The first cohort is arguably most at risk, deployed at entry values, growth rates, and leverage assumptions reflecting a bygone era; it is not surprising that returns have come down and distributions have slowed for these vintages overall. While the second cohort was deployed in an environment that had begun to reset, it still must grapple with the implications of AI for its business models and investment success.

Managers and management teams have been assessing AI’s risk to business models while also integrating AI as a means to enhance, expand, or protect those models. At present, private equity managers are busy communicating with investors about their firms’ AI capabilities and portfolio company initiatives because sustained operating performance proof is yet to come. It will take varying amounts of time for these ongoing efforts to show up in the financials, which will ultimately determine investment value. In the meantime, we expect to see a slowdown in overall enterprise software transaction activity as managers and companies re-tool for this paradigm shift, alongside an increase in investment activity involving AI-native companies, either as platforms or as add-ons.

The paradigm shift isn’t down, it’s forward. AI will further expand the technology sector and will drive more investment; it already has, having largely taken over venture capital activity. Appreciating that it is a tumultuous period for enterprise software, technology as a whole is not going to stop being a dominant sector for investment. In fact, it’s likely to continue to expand. Limited partners are actively monitoring existing software investment developments in their portfolios for indications of progress or regress, which in turn will inform portfolio management decisions and also forward investment. In addition, as managers adjust to current developments, forward investing activity should reflect and express their views on how to earn their target return in this new paradigm. As performance unfolds, there will be a separation between those who find their way successfully through this market and those who do not; investor capital will move accordingly.