Back to podcast

Winna Brown     

You’re listening to the EY NextWave Private Equity podcast. I’m Winna Brown, and I’m your host. According to the latest EY Pulse Report, 2021 was the year of the tech deal. Thirty percent of total capital deployed last year was allocated to technology companies. Joining me on today’s episode is Laura Grattan, Managing Director at Crosspoint Capital Partners. Crosspoint’s focus ranges from minority growth equity to control investments in the cybersecurity, privacy, and infrastructure software sectors. Also joining me is Jeff Vogel, Head of the Software Strategy Group at EY-Parthenon. Given the fierce competition for deals and the ever-increasing valuations, we wanted to explore how private equity firms can differentiate themselves and best position themselves to win these deals in the current landscape. I hope you enjoy our conversation.

Brown     

Jeff, everyone’s talking about tech deals these days, but I think it really kind of depends on the context because it can mean different things in different contexts. So, are you able to help us by defining what tech deals means?

Jeff Vogel           

We define the set of companies that some might, in the broader industry, refer to as tech, we think of it as software economy; it’s businesses that aren’t necessarily selling software, they might be selling the business or even a consumer service, but they’re differentiating based on their software. So, they have hundreds or thousands of software engineers, dozens or hundreds of patents, millions or tens of millions of lines of code, lots of software developers and the dynamics that drive their companies, in terms of talent, recruiting, retention, intellectual property, are very similar to what used to be called software company. So that’s the swath of the world that we think of as tech. And last year, you know, tech was the number one sector in GDP, it was the number one in IPOs by a large margin, it was number one in private placements by a decent margin, and number one sector in S&P 500 value. So, clearly that has eaten away in a way to other verticals, because it’s a piece of every vertical. If you’re in transportation, some of that is tech enabled. If you’re in hospitality, some of that is tech enabled. If you’re in education, some of that is tech enabled. So, it’s sort of this horizontal swath cutting across all of our other traditional sectors of the economy.

Laura Grattan     

Maybe another way to say that is, seems like everyone’s a tech investor these days, or certainly, at a minimum, really having to understand the impact of technology on their sectors and their businesses. I think you’ve seen a lot of firms in private equity really shift their focus. So, retail and consumer verticals are now e-commerce or consumer-tech focused, and some industrials groups are now supply chain technology or tech-enabled services focused. And so, even if a company’s not directly selling piece of technology as Jeff noted, you know, they’re certainly using it to more efficiently, and in a more automated way, deliver that product or service. So really understanding technology is important regardless of, you know, where your focus is.

Brown     

How is that impacting valuations and the way you’re looking at tech deals, or you’re looking at deals broadly.

Grattan     

I think with the, everyone, you know, thinking about technology and a lot more folks investing in it, no question, it’s impacting the competitive landscape and therefore valuations. You know, if we rewind a little bit, software used to be a scary place for private equity to invest, you know, not many firms would touch it, and then a few firms went in slowly, and a few firms went all in there; but today, I think most firms have some technology or software effort, if not their exclusive focus. And with the attractive growth you see from a macro level, more investment is coming, and I know you went through some of the stats on a previous podcast here, but last year, the total private equity money into software specifically was about 50% higher than just two years ago. And in the sectors where my firm, Crosspoint Capital Partners focuses, which is cybersecurity software and infrastructure software, I think it was up more than 160% from two years ago to the point where cyber and infrastructure software deals now make up about half of private equity software transactions. And within software, infrastructure software was the more scary place to go. It’s deeply technical, very nuanced and very dynamic. So, you can’t dabble in those spaces, but you see more and more firms doing it. As we look more broadly, you know, no question, valuation continues to creep up. If you look at, you know, the number of public software companies that are trading at over 10 times revenue, I think it’s doubled since three years ago and quintupled since about five years ago, and even though the overall growth outlook for a lot of these companies hasn’t changed materially, I think the average forward revenue multiple of software deals is now something like eight times versus just four times about five years ago. So, that certainly ripples through in private equity transactions. And, as we think about that dynamic, a few models, I think, have emerged to really be able to capture that opportunity given some of the challenges in place. You know, there’s some firms that still take a diversified approach within private equity and maybe want to own the top handful of players in a sector and take more of that basket approach versus trying to pick winners. My firm’s gone a very different route, and I think, by design, we have a model that really utilizes deep sector expertise and operating capabilities investing in a pretty concentrated set of opportunities where we can really drive transformation and value creation, but it’s certainly not the only model and there’s a lot of different models out there.

Brown     

So Laura, can you maybe expand a little bit on that? So, tell us about Crosspoint and how you focus on infrastructure software and how that gives you an advantage or differentiates you.

Grattan     

Yeah. So, Crosspoint was founded in 2019 by a handful of operators and founders of what became some of the largest cybersecurity and infrastructure companies on the planet. And, the model here was focused at really combining that deep sector expertise, top underwriting talent and superior operating capabilities, you know, with a very specific focus on a really important sector. So, we’re not just a tech private equity firm. We’re not just a software private equity firm. You know, we’re specifically cybersecurity and infrastructure software focused, and cybersecurity and privacy are among the top risks that are facing most enterprises and they’re representing and increasing proportion of the technology spend at any company, and we think those trends have incredible staying power. And Jeff lives and breathes these and advises clients on these all the time, but really just the increasing complexity of enterprise IT environments is driving the need for this related software spend. And so, at Crosspoint, with these deeply technical markets, they’re really dynamic, they’re really nuanced, just rapid innovation and disruption; you really have to understand those and you really have to be able to underwrite a thesis with your companies that is differentiated, you know, having the ability to understand the reality of some of the risks you’re underwriting and what can be done about them, as well as looking ahead to underwrite a different value creation plan. And so, as we think about leveraging that sector expertise in these operating components, I think there’s several components of what that might look like with the given opportunity. So, part of it is certainly a differentiated vision and that stems from just familiarity with the underlying technologies and where the markets are heading. And I think really bringing, importantly, that view of a customer, just because we walked in their shoes here at Crosspoint. In one case, in the consumer security segment, one of my colleagues had previously run the biggest competitor of the asset that we were evaluating and so had just tremendous insights, not only into the risks, but also the levers we could pull and what we could build there. And, in another case, the senior team at Crosspoint actually owned the asset that we were evaluating when it had previously been within a strategic and so really seeing the specific functionality of this technology, but being able to apply it to a broader set of use cases to really grow it there. And, I’d say the second bucket beyond just the vision, and equally important, is really just the relationships with being sector experts, probably most helpful to, you know, just being able to secure talent. I think part of really knowing a sector is knowing the talent base, and not only knowing it, but having a talent base that wants to be affiliated with you and wants to work with you. You know, being able to go to a CEO and saying, hey we know that the CFO and the CRO that can really help drive a cost transformation, while not missing a beat on revenue and not only do we know them, but we know that we can land them in partnership with you. It’s just really, really powerful. And the other part of the relationships that can be equally important is things like channel partnerships are other ways to access new markets, you know, often internationally that companies couldn’t do all their own. And then, of course, with any investment, there’s always a tactics and execution component to it. Whether that is a cost transformation where we can bring a real bottoms-up view or just other levers to accelerate growth. And, in one case, the Crosspoint team went in as interim management — CEO, CTO, CFO, CRO — for the first nine months and, you know, that was just a really powerful proof of the model that we can bring to bear. So those are some components we think about that all stem from that sector expertise and just operating talent that we bring.

Brown     

So given what you’ve just outlined, I mean, it sounds very innovative, it sounds very focused, is it influencing the trends of the types of deals that we’re seeing given this deep expertise that’s being brought to the table?

Grattan     

I think so, I think a few trends in technology investing, some are newer but some you’ve been seeing for a few years, and a few that I would point to that we certainly reflect on as we refine our model at Crosspoint is that the market is going to always reflect what sellers and owners want and prioritize. You know, traditionally in private equity, it’s speed, certainty and valuation. Those are always there. We talked about valuation earlier, but some other trends that are emerging is first, what we call kind of 50/50 deals. So existing investors that have done well, want to sell a meaningful stake but also roll a portion of their investment, and, in those cases, you know, the relationship and the value-add that a partner can bring are a really big factor. Not only can I get along with this party, but what do they bring to the table that could really help this investment continue to grow. And I think the second trend that we’ve observed is just fewer broad actions. I mean buyers don’t want to play there, and most deals that do have an intermediary involved result in just a handful of parties who’ve been close to the company for a while, really know their stuff, can move quickly are on the short list to be able to invest there. Another trend I think is just the speed at which these deals are clearing. It continues to get faster and faster, you know, preempting used to be the exception, but now it’s what you have to be prepared to do in most cases. I mean, we call Jeff and say, Jeff you’ve got a week, we need to know the answers here and you know, it’s just becoming increasingly fast. And I think that all leads to just how firms are differentiating. Part of why I joined the firm that I’m at just really feeling that that deep sector expertise was going to be more and more important. I think even firms that do have a broad technology investment effort, you know, under the covers there are a handful of identified sub-sectors, where they truly are experts, you know, as well. I think the industry used to differentiate on just access to capital or underwriting in a different way, and then the sourcing engines emerged where, you know, being their first really mattered, but I do think now there’s far more of a burden on that sector expertise and specifically how it can translate into value creation.

Brown     

And Jeff, what are you seeing from your side of the fence, getting these phone calls in a week you need to turn everything around?

Vogel           

It’s a real interesting point. I think you do have to be able to move quick today. But there are other ways to preempt, right. It’s move early, right? So, I think our best clients can develop a thesis 6, 12, 24 months ahead of time, knowing what assets might trade just based on normal timelines for private equity where we cap and sales, take privates companies that have been in the public market and growth is starting to slow and stock price is starting to stagnate and it’s just the point, this thing ever is actionable, let’s be ahead of it. So, there is a reasonable amount of work you can do outside and even product and technology work that my team does. So, I think part of being able to move quick is moving early. That might mean spending some money earlier that firms otherwise would, and they have to kind of factor that into the whole concept. But I think when you bring expertise to the table like a sector focus firm, such as Crosspoint, there are certain theses that you just have a leg up in being able to develop, as you can go deep in a certain sector and know the players and know who to talk to and see all the issues, and they have a talent strategy, you know, may have an M&A strategy that’s a little proprietary. All those type of things are almost necessary today. Double play, everybody’s doing it, you know, every deal we look at is some form of double plays. It’s like we know in order to hit the bid, we’re going to have to put two things together and get some revenue synergy or cost synergy or something. I mean, I love talking about 10X, right? Like, most people in private equity hear 10X and they’re thinking you’re talking 10x EBITA, right. It wasn’t that long ago where that was a pretty good EBITA multiple, at least outside of tech, and today, you’re talking 10X and we’re talking revenue. It’s almost insane and hard to imagine, right? You actually have to clarify when you say things like 10 or 12 or 14X today. What you mean? So, we see that, you know, I think the stake sales, more of that, Laura alluded to that. Club deals is kind of an interesting one. And, you know, we do see that, and it used to be that one of the things that was great about private equity is you didn’t have to do club deals. And you did a deal, you had your thesis, you could build conviction, and you just did it, and it was pretty easy to get things done because you didn’t have to build consensus, at least at the board level, with everything you did. You might have had to build consensus with management, and now I think private equity firms because so many deals are club deals for a bunch of reasons, one is just valuation. What used to be a small under billion dollar and $500 million tech company, maybe it has a couple of hundred million in EBITDA, that’s now a deal that not too many people can do by themselves because it is going for 15 or 20 times EBITDA or something like that, and it’s multibillion-dollar equity checks, and very few firms write multibillion equity checks by themselves. So, as a result, we’re seeing more club deals, and I think private equity firms have to learn some new tools because things that they used to just do, they now have to think through governance and spend more time consensus building. Sometimes that slows down things like transformations. So, I think it remains to be seen how that will play out. Of course, club deals aren’t totally foreign, but there were just few and far between in the past and now, I think you’ll see them more the norm, at least in the upper end of size range of DL sum. Because deal size is increasing, as fast as fund size is increasing, deal size is increasing faster from what we seen. So, I think those are some trends that are front and foremost, you know, as kind of we get into 2022 here and things that we’ve been seeing for the last year and expect to see more of.

Brown     

So Laura, when Crosspoint invests alongside another PE firm, how do you think about those deals? How do you structure it? And how do you make sure that you maintain a voice? Because you’re obviously bringing a really important skill set to the table, which potentially from what I’m hearing, is really, could be differentiating in this highly competitive environment around deals. So, maybe walk us through some examples of how you work with other PE firms and what gives that combination, if you will, a competitive advantage?

Grattan     

Yeah, so we want to have the opportunity to invest in great businesses with differentiated technology that are on the right side of, you know, industry tailwinds. Crosspoint’s strategy is also to create a portfolio that really leverages that deep sector expertise and the value creation capabilities that we bring and how we can really drive transformation at our companies. That’s valuable to us certainly as where underwriting opportunities, but it’s the same things that would be really attractive, we hope, to a management team or to other investors that we’re partnering with. And so, I think when we show up, in the industrial logic of what we’re underwriting is far more than just the LBL math. And I reference some other examples of the experience that some folks at Crosspoint have of previously running or competing against the very same companies that were currently evaluating; but, in some of them, it is, as I mentioned, a differentiated vision. So, one of the opportunities we were involved in last year was a threat intelligence platform that had a very solid, but you know, more narrow use case, and, as we looked into it and having familiarity with the technology for well over a decade, you know, we believe that this very same technology with some work and partnership with us on go to market and the product really has the opportunity to disrupt the entire software supply chain. So, think about solar winds and some of these backdoor implants, and I think those are the exciting stories that we want to be a part of and whether we’re working with other investors or with management or on our own, you know, think that some of the capabilities we bring can help folks kind of see forward, not only with the vision but also how to do it. And that stems from some of the talent that we can bring to help us do it and just some of the execution because we’ve done this in the past and we know what these risks entail and what can be changed, what’s in our control and what’s not. And so, with some firms, we have great partnership, great relationships and a lot of mutual respect, and I think just a mutual understanding of the complementary strengths that we often bring and how we’re going to work together to improve the investments that we take on.

Brown     

The size of your equity tech doesn’t equal the voice that you have at the table.

Grattan     

Ideally, if we’re a minority investor, you know, there is a dynamic where it’s a true partnership and we have a pretty big seat at the table as well, but it’s always, it is a co-GP deal. It’s in great partnership with the folks that we’ve worked with for a long time.

Brown     

It sounds like the tech deal space is getting hotter and hotter. The competition is increasing, speed-to-market relationships and deep expertise are really differentiators if you’re trying to win these highly competitive deals, and valuations are just going higher and higher. So, the stakes are actually higher than they’ve ever been because, you know, you win the deal, then you’ve got to actually create value on a, what’s already been 12X revenue, right? How do you do that? You know, so what are some key tips that you have for private equity getting in there because, you know, you still have to exit this company. So you’ve got to create value off the back of a very, very high base. And what’s the secret sauce to being able to do that?

Grattan     

Yeah, if it were one thing, it would be easy, right? As we think about it, it’s not rocket science, what do you have to do? It’s just really hard to actually do it in practice and get it right. And if you think about four kind of domains and private equity or components of a deal, there’s sourcing, there’s buying and underwriting these deals, there’s monitoring them and creating value, and then, of course, exiting. And I think that sector expertise in operating capabilities and the value creation, if done well, impacts all of these activities and really differentiates. It’s just one model; there’s plenty of other, very successful and durable models out there, but this is how we have designed ourselves. And starting with the sourcing, it’s really important to pick your spaces, be really focused on them, and know them cold. And it’s equally important to know where to not spend time and having that discipline with the most valuable resource being the time that you have. And, on the sourcing side, just really having that knowledge to have a head start, as Jeff referenced before, just really knowing the opportunities and limitations of a specific, you know, piece of technology and to really know what you can focus on. And I think the place that you would want to be is where you become the partner of choice and the first call of anyone that’s thinking of transacting, really because of that expertise and the capabilities you bring, and knowing what you’re good at, what’s something that you can do better than anyone and focus on those opportunities that will really leverage that expertise and skill set that you bring. On the buying and underwriting, as well as creating value side of it, I think that expertise that comes with just the sector focus and the operating experience really gives you a pattern recognition to know what will work and what won’t. What levers can you really pull that both enable you to take on some risks that might scare some other buyers away, or underwrite some upsides that others may not see. You know, to your point Winna, you’re already in it at 12 times revenue, and you have to achieve a pretty good robust growth rate in order to make that a successful investment. And so, knowing what levers you can pull there, either having that talent in house at the private equity firm to do it, or ideally, having that network of talent that you can go attract to help, which is a far more scalable model. And really just knowing whether it’s go-to-market side, building out an inside sales team for a high-velocity sales motion or helping them construct channel partnerships or entering adjacencies, just knowing really what you’re good at and what you can bring to bear at a certain opportunity. Then I think another big, big focal point that has mattered, sometimes more than others, is not just growth but profitable growth. End of the day, you know, how can you transform a company, make it more efficient, continue to grow, but end of the day be generating cash flow while you do it? And it’s a beauty of these underlying software business models, you know, highly recurring revenue, higher gross margins, and, as they scale, they should really see those efficiencies and earning more cash with every incremental dollar of revenue that they’re generating. And, to put all of that together, it’s hard. You know, again, it’s easy to say, I have to do these five things, but actually doing them, knowing where you’re not going to make a mistake and just bringing it all together is pretty tricky and that pattern recognition and that deep sector expertise, you know, really matter.

Brown     

That sounds like really, really good advice. And how are you seeing it play out? Are you seeing those combinations of skills coming together on these deals, or is it too early to tell, the deals that have closed over the last couple of years and time will tell?

Grattan     

I think we’re seeing plenty of opportunities where they do, or have the opportunity to, and that’s where we’re focused. I think we see plenty of attractive companies that, maybe aren’t a good fit for Crosspoint, and then we see others that might be a really good fit with how we can help but end of the day, not a good long-term, you know, bet for us to make. So, that’s another beauty of Crosspoint’s model, is we do have a pretty concentrated portfolio. So, we’re putting a lot of our efforts into a fewer number of deals where we do really get involved, and we don’t need to do 30 deals a year in order to be successful. But, again, there are many different models that are incredibly successful that are a different approach than Crosspoint and will continue to do well in technology investing. I think it’s important that we are niche in a sector that is more difficult to understand. I think there’s a fear and going back to the earlier part of our conversation, over time it’s, parts of technology can be a little scary, and as you get more technical, just really understanding, what might I be missing here, you know, the company’s growing, looks well, in a big market that’s growing, but how the technology is deployed. 

Back to podcast