We are in one of the most dynamic markets since the dotcom boom’s aftermath. Major indices are reaching all-time highs,driven largely by the “Magnificent 7”, against a macro backdrop suggesting a soft landing and potential rate cuts in 2024. Meanwhile, Al continues to dominate as the most investable theme, driving significant investment activity and forward-thinking strategic M&A. Yet, many software companies are grappling with growth, profitability, and/or valuation support. This dichotomy has created a nuanced environment. One where broad market optimism coexists with sector-specificchallenges and opportunities, demanding careful strategic decision-making from all market participants.
Software Market Perspectives
Broad indices are at all-time highs, while software lags due to reset growth expectations. The Nasdaq and S&P are up 18% and 17% year-to-date, respectively. Yet software stocks are down 9% on average in 2024. The sales momentum experienced by many software companies at the end of 2023 has moderated, giving way to elongated sales cycles and continued high levels of budget scrutiny. As a result, forward guidance during earnings season fell below Wall Street expectations for many companies, driving software’s relative underperformance.
Valuations are stable and near historical norms, extending a conducive deal environment. Public software company valuations have remained rangebound at 5-7x forward revenue over the past 18 months, with a current median multiple of 5.6x. Investors are again rewarding growth, although capital efficiency remains key. High growth, high margin companies are trading at 2x+ peers. While secularly favored software sub-sectors such as supply chain and data & analytics aregarnering premium valuations.
M&A activity is broadening, with dollar volumes up 30%. Increasing confidence is driving an uptick in M&A, with several key themes emerging. These include a continued focus on streamlining operations and portfolios, a pickup in bold strategic M&A (particularly in GenAl & Security), and strong competition among PE firms for quality assets. “Non-process, processes” from prior years are converting into real processes in 2024 as liquidity needs trump valuation recovery hopes. And growth buyouts that used to occur in public-to-private transactions now happen in private markets, as VC-backedcompanies skip the IPO and go straight to private equity (e.g. AuditBoard / Hg).
Wide dispersion of fortunes in the private markets underway. 2024 private market investment volumes are trending towards pre-COVID annual levels. There is a significant difference in investor receptivity for Al versus non-Al companies, affecting financing process length, premiums paid, and capital availability. As a result, we are seeing three distinct situations: companies growing through valuations, those raising down rounds or structuring around valuation, and those selling or shutting down. The profitable growth sea change is creating a new archetype: the “Capital Compounder”. The widespread push towards profitability driven by the increased cost of capital has created a new cohort of software companies. These companies are VC-backed, operating at scale, growing nicely (but not at VC levels), with established profitability and no financing needs. We believe this profile creates a generational opportunity to partner with alternative forms of capital to transform market positions and to avoid becoming a “ZIRP era zombie”.
Capital markets are reopening, with delayed IPO green shoots finally appearing. ECM activity is up 39% over the past year, while three of the 11 recent Tech IPOs have come from the software sector (Klaviyo, Rubrik & OneStream). Recent Tech IPO issuers have demonstrated profitable growth at scale, with a median revenue scale of $917M, while growing 23% with 16% cash flow margins (a Rule of ~40 profile). Positive IPO performance by OneStream (+34%), Rubrik (+9%) and the broader IPO index (+6%) may spur the large backlog of IPOs to go public. However, the higher IPO bar may send some traditional IPO candidates in search of alternative exit options