Why Private Equity Firms Are Embracing Enterprise Cloud Software

Technology investing is typically associated with venture capital and the financial backing of unheralded yet highly promising startups. But private equity firms, which invest in more established businesses, are also vital players in the technology market. There has been private equity in the tech market for decades, led by firms like Technology Crossover Ventures, Summit Partners and General Atlantic. They were true pioneers in late-stage investing and technology buyouts, and they remain active partners with deep experience in the tech market. These firms will continue to stand out, even as a more diverse range of PE firms inevitably start to target the lucrative technology sector.

In fact, more and more private equity firms are setting their sights on the technology market—and many of them are placing a particular emphasis on enterprise cloud software. A good example is Vista Equity Partners. Recently, the firm has executed some of the most impressive deals in the cloud space, such as its acquisition of marketing-automation software firm Marketo from the public market for $1.8 billion and its sale of the company a few years later to Adobe for $4.75 billion.

As a result of this success and others, large PE firms inside and outside of Silicon Valley, including firms based in New York, Chicago and other regions, are increasingly making moves in the cloud market. Most recently, Hellman & Friedman and Blackstone teamed up to purchase cloud-based HR and payroll software company Ultimate Software for about $11 billion. Meanwhile, Thoma Bravo acquired Ellie Mae, a cloud-based platform provider for the mortgage finance industry, for $3.7 billion.

We expect to see even more traditional private equity firms from the East Coast and elsewhere get active in Silicon Valley, where many of the top cloud companies are located. Already, there is a rising tide of PE fundraising in the Bay Area. The region has raised over $80 billion in private equity capital since 2017, a dramatic increase from the $27.4 billion raised in 2015 and 2016, according to PitchBook. Why are PE firms attracted to cloud companies? For starters, they love the recurring revenue nature of cloud business applications companies—the fact that customers pay these companies a subscription fee every year to run their software. PE investors appreciate the consistency and longevity of that recurring revenue stream.

And then there’s the importance of the cloud in business overall. Most companies today simply can’t operate without cloud software to run the various parts of their business, from customer management and marketing to financials and the supply chain. Even businesses that are struggling refuse to relinquish their cloud applications. They will cut other expenses long before they abandon their business software.

PE investors also appreciate the high gross margins generated by cloud companies. These investors often use a mixture of equity and debt to purchase businesses. And they have a large degree of confidence that they can pay down that debt in a fast and flexible manner due to the fact that cloud businesses come with high margins and recurring revenue streams. Personally, as a venture investor, I’m thrilled to see growing participation in the cloud market by PE firms. There is more than enough room for both types of capital here because they bring different and necessary skillsets to the market.

As early-stage venture investors, our operating experience is what sets up apart. We are also able to introduce our portfolio companies to customers and partners and even assist in the recruiting and hiring of key personnel.

By contrast, PE firms are not only extremely skilled at deal structuring and financial modeling, many also have teams of experienced operators that can come in and help portfolio companies reposition themselves and/or pursue new growth strategies. Moreover, PE professionals have a tremendous knowledge of the public markets as well as strong networks with potential buyers, which means they can add significant value at the later stage. Additionally, many of the large multimarket PE firms own manufacturing companies and other operating companies, which means they can bring a portfolio of potential customers to their cloud business application companies.

We also like the fact that as cloud companies in our portfolio reach the series C and D stages of their lifecycle, the growing presence of PE firms provides them with greater funding options. There is now a broader universe of investors that cloud companies can call on who are motivated and interested to lead those late-stage $50 million to $100 million financings.

What’s more, the growing presence of PE firms potentially opens up a new exit path for cloud business application companies. Instead of going public, they can be acquired by PE firms who are interested in owning whole companies outright. Previously, it might take a cloud company seven to 15 years to become a publicly traded company. But now there could be a buyout exit strategy in just five or ten years, without all the requirements and complexities of going public.

We are excited to see more large PE firms entering the cloud market, which is a net positive for everyone. It’s good for cloud business entrepreneurs because they will have more financing choices in the later stage. It’s good for early stage investors because deep-pocketed PE firms are in a position to pay higher multiples. And it is good for PE investors, because cloud companies are proving to be highly profitable investments. That’s what we call a win-win-win.