The global tech sector attracted $675 billion from private equity (PE) in 2022, up from $100 billion in 2012.1 Within this world, software and the software-as-a-service (SaaS) sector have long been preeminent thanks to a combination of growth, profitability, and sectorwide multiple expansion. But our analysis found that recent market corrections have depressed valuations in the space by more than 40 percent.
Recent marquee exits by PE firms in the tech services segment have also brought tech services into the spotlight for investors that were traditionally more focused on software.2 We estimate that tech services currently accounts for 25 to 30 percent of the total assets under management in tech. This represents a ten-percentage-point increase over the past decade.
Disruptive technological innovations have created opportunities across a range of assets. However, understanding the structural differences between software and SaaS and tech services—particularly between their business models—is important. Stakeholders, especially PE investors, may consider carefully evaluating these differences when assessing the segment. Here are a few key insights.
Disruptive technological innovations have created opportunities across a range of assets. However, understanding the structural differences between software and SaaS and tech services—particularly between their business models—is important.
Tech services: Three considerations
We observe three considerations that PE firms could keep in mind when venturing into the tech services space.
The Rule of 40 applies. Tech services companies have lower valuations compared to software and SaaS companies with analogous performance as measured by the Rule of 40 (that the sum of a software company’s growth rate and profit margin should be greater than 40 percent). However, tech services companies that exceed the threshold of the Rule of 40 see a disproportionate jump in their valuation multiples (Exhibit 1).3 Our analysis shows that the enterprise-value-to-revenue ratio almost doubles when companies cross the Rule of 40 threshold compared to their counterparts with annual earnings growth of 30 to 40 percent. The difference between these two cohorts is explained by the difference in their revenue growth profiles. In short, investors are willing to pay a premium for tech services companies that can deliver industry-leading revenue growth with high efficiency.
Investors value revenue growth more highly than margin growth. A company’s service portfolio mix is critical for revenue and returns (Exhibit 2). Specialization and exposure to new digital technologies—such as the cloud, data and analytics, cybersecurity, the Internet of Things, and blockchain—are essential for higher performance and valuation.
We’ve observed that system integrators with a mix of digital and traditional technologies and providers focused on infrastructure services tend to trade at a discount and struggle to significantly boost their earnings. In contrast, companies that specialize in digital and new technologies have shown that they could produce higher revenue, margins, and returns. This suggests that it is important for tech services companies to have a well-defined service portfolio mix.
Sustaining or elevating performance is a bigger factor in returns than multiple expansion. Multiple expansion in software and SaaS has been a prime driver of the sector’s high returns, particularly when PE investors invested in assets that were about to breach the Rule of 40 threshold and when they’ve exited through IPOs.
Although they enjoy a valuation premium, high-performing tech services companies above the 40 percent threshold from the Rule of 40 have still delivered unlevered returns (assuming that 100 percent of investments are equity, with no leverage) of 20 to 25 percent.4 If these were typical tech services deals, which use leverage for 50 to 60 percent of the funding, the levered returns would be 40 to 45 percent (Exhibit 3).
Our experience suggests that, unlike in software and SaaS, returns in tech services are mostly the result of performance rather than multiple expansion. However, our assessments of recent exits show that PE investors that significantly boost a tech services company’s performance have also received an additional 25 to 30 percent in returns from multiple expansion in the sector.
These findings underscore the importance of a thorough evaluation of tech services targets’ business models. Investors would ideally account for factors such as targets’ service portfolio mix, specialization, and exposure to emerging technologies.
It’s also important to assess the potential for using operational improvements to achieve higher multiples. However, evidence from the recent past suggests that this is the exception rather than the rule, and PE investors would ideally avoid relying on multiple expansion to generate returns in tech services.
A proven value-creation playbook for stable returns
Our analysis of past PE deals in tech services found many successful exits and a few that generated outsize returns of more than 25 percent. We found almost no failed exits. A close examination of those deals revealed that the companies had five things in common:
- They scaled or differentiated their competencies. Those companies focused on two to four competencies in either vertical offerings, such as the cloud, or analytics or digital service lines.
- They shifted their portfolios to serve tech-native customers and customers who continuously reinvest in digital capabilities, who we project will drive about 75 percent of incremental tech spending over the next seven to ten years.
- They increased their sales efficiency by increasing the share of large deal wins to their largest accounts.
- They boosted their capital efficiency by optimizing platform costs and deriving more synergies from M&A.
- They had entrepreneurial, customer-focused leaders who delivered consistent performance even in uncertain times.
The playbook for these outcomes is fairly straightforward, and a few PE investors use this as their go-to approach for achieving stable and satisfying returns in tech services.
Less glamorous than software or SaaS, tech services companies create value through performance. Decision makers attuned to the dynamics specific to the sector may uncover insights and returns.