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Winna Brown

Today, I’m joined by Jeff Vogel, head of the Software Strategy Group for EY-Parthenon. Jeff’s primary focus is on advising private equity companies on technology acquisitions. Now Jeff, I’ve spoken with a number of PE operating and deal team partners who trust your judgment implicitly. They say you call it as you see it,” both the good and the bad, and this has earned you and your team the reputation of being the go-to guys in technology commercial diligence. I’m really excited to have you on the podcast today. Thanks so much for joining me.

Jeff Vogel 

Brown

Why don’t we start with the basics. I’ve heard you mention the software economy on multiple occasions. Would you be able to explain to our listeners what that is?

Vogel

Sure, sure thing. Software economy is a term that I believe was invented by my partner at our predecessor firm, Bulger Partners, that’s Chris Bulger. And by software economy, first we mean the obvious, which is software companies, companies that sell or license software or even software subscriptions, or SAAS companies. And then this whole other slew of companies that are really software-enabled business services, but not any software-enabled business service, a software-enabled business service where the proprietary software that the technology that’s built by the hundreds of engineers and the tens of millions of lines of code and possibly the hundreds of patents that a particular company has where that software enables the company to compete and they differentiate on the basis of their software. Another way to think about this, this is really the economy that Marc Andreessen described on the 2011 he wrote a pretty famous op-ed piece in The Wall Street Journal called, “Why Software Is Eating The World.” People may have heard that expression, that’s where it came from. It came from the title of that op-ed piece and Marc talked about a bunch of companies that he called software companies, but they really weren’t software companies, they didn’t sell software. And he talked about the largest bookstore in the world being the software company Amazon. He talked about the fastest-growing entertainment company in the world being a software company Netflix. He talked about the largest recruiting firm in the world LinkedIn. And he talked about the largest marketing firm in the world Google. And none of those four companies sell a licensed software. Google sells ads, 98% of their revenue is from ads. LinkedIn sells jobs or recruiting ads. Netflix sells movies, right, and TV shows and entertainment. Amazon, right at the time, this was almost pre-AWS, Amazon sold books and sold everything, right, everything but software really. But all of those companies, they hired thousands or tens of thousands of software developers. They probably have hundreds of millions of lines of code at this point and they certainly differentiate on the basis of their software. And Marc didn’t even mention Uber, OK, because Uber did not exist in 2011 and that would be an example, of course, of a software-enabled software-economy company that does not sell software. Uber sells transportation services, right? So that’s what we mean by the software economy.

Brown

So when you say that, does that mean when I think of technology and software company deals, we’re not really talking about a company that sells code, or sells any RP system? We’re talking about a company that sells potentially a service or something else, but just happens to be technology enabled?

Vogel

Well, we’re certainly talking about both. But yes, a growing number of, a growing proportion of the software economy is no longer software companies. Because all of those companies I mentioned, many of the unicorns and certainly the Ubers of the world, the Teslas of the world, the Googles of the world, are not selling software and they make up a big proportion of the software economy, so correct.

Brown

So when we think about PE and their investment in this software space, where are you seeing the deals?

Vogel

Yeah, so it’s interesting. So, there’s clearly, right, a slew of, you know, you have the first generation. Let’s talk about upper mid-cap and large-cap private equity, right? There was an early generation that started investing in software 10 to 20 years ago, right? So, some of the first big software private equity deals was, you know, H&F taking DoubleClick private. OK, and then later selling it to Google. Bain Cap and Golden Gate did BMC, right? These were some of the watershed deals because, you know, if you go back 10, 15 years, private equity firms didn’t invest in software because they didn’t get it. They couldn’t understand these crazy valuations. They didn’t know about businesses that had 95% gross margin. It was really not something that they understood. So, there were some early players that started doing that and then, of course, over the last 10 years, given the growth of the software economy, everybody and their brother said we better learn how to invest in this. And they started where they were more comfortable, which was business services, software-enabled business services. And some of those were more software enabled than others, so some of them I might not consider the software economy if there wasn’t any differentiation software. Like a lot of BPOs (business process outsourcing) companies used technology, but it’s not really differentiated in any way. So I might not call them all software economy. Even an e-commerce player, right, a company selling stuff on the internet through e-commerce — if they’re doing it through all off-the-shelf technologies, you know, Yahoo! Storefront, Magento e-commerce engine, Shopify shopping cart, like it may not really be a software economy company. It may just be a retain or a distribution company of some form. But when they’re starting to leverage their own technology to do that, they cross over into software economy and that’s where many of the PE firms got busy, because they’re like, OK, we know a lot about business services so moving into software-enabled or tech-enabled business services wasn’t as huge a stretch. So, you saw a lot of companies playing there. But meanwhile, some of those early players who got smart about software 10 or 20 years ago, OK, said hey, in this new world we’re still going to play in core software, or core enterprise software. And there’s a lot of larger companies that have been around for 10 or 20 or 30 years and fit the PE portfolio, which is lots of recurring revenue usually through maintenance, sometimes through SAAS, very, very sticky so the customer base is solid. Some of them are going through some form of transformation, but there are now a lot of companies that are, you know, at that stage where they’re really good fits for private equity so you do see large-cap private equity players spending a lot of time in established enterprise software. And then you see some of the newer guys and the mid-market guys looking at this slew of tech-enabled business services because they understand it better because they’re not all that tech enabled. And then some of the newer ones are becoming more differentiated and more tech enabled than other ones. So, that’s sort of how we see the landscape of where the software economy meets private equity.

Brown

And so, I mean, obviously, what you’ve described is a very varied type of call it software sector. How is PE evaluating these deals and evaluating these companies? Have they got all of this in-house expertise or are they typically outsourcing to people like you?

Vogel

Yeah, so same thing. So, we built a business, right, on the backs of people outsourcing to us. Some bought this trend that private equity folks, the large cap guys, are smart as all hell. They know what they don’t know and when they find advisors that they like, they’re going to leverage that and that’s certainly been a big part of our success. Having said all that, the folks that have been around are also smart enough to know that if they can build some of these expertise in-house then that’s going to help them differentiate and benefit them. So you are seeing the serious software investors have people in-house, right, the most notable of course is Vista Equity that has a whole consulting arm, OK, with lots of people who are former software practitioners. Then you see other private equity firms bringing in operating partners at some level where they were CEOs or executives in software companies. So, some of that expertise is starting to make its way into private equity. And I expect that as you see the degree background of undergrad and even MBA and master’s programs, as more of that shifts to technical degrees, which we’re seeing, I know that like when I graduated 30ish years ago, 25 people in my graduating class of 1,500 had computer science degrees. Today it’s 250 at that same school, at Brown, as a great general background and not all of those 250 are going to go off and write code and be software engineers. They’re just using it as a great general background into the software economy. I think you’ll see the same thing happen at private equity firms. The “generalists” are going to join private equity firms, but the generalists are going to have pretty strong software jobs, either because of a degree or because of their first job out of school or an internship or even building an app and selling it to Google when they were in high school. And we’ve actually seen some of those and have some of those people working for us. So, I think the world is changing both in the makeup of the companies that private equity firms invest in and the DNA of the workforce.

Brown

Do you think then, given what you’ve just said about the workforce, you mention the Vista model – the Vista model is predominantly, I mean, all they do is invest in technology and, as you say, they’ve got a deep consulting arm that’s focused on technology. Do you think that gives them a competitive advantage, or do you think because people are coming out of university with a lot more tech smarts it kind of doesn’t matter because you’ve got these people embedded in all, even the general PE firms?

Vogel

I mean, I think whenever you can get that many smart people together who share common vocabulary, knowledge and experience set, it has to be an advantage, right? Vista has a great pattern recognition because they’ve seen five of everything because they do so much tech investing. So anytime you specialize, of course it’s an advantage, right? You just develop great expertise, you know, as long as you don’t get tunnel vision. So, I think that’s why you have sector teams in private equity firms for the same reason. And then it’s just a question of can you do that at scale? A private equity firm may have a TNT team — that’s good because those people get to have pattern recognition — but they’re not seeing the same number of deals and deal velocity that a Vista, that only does tech, might see. So, you know, it’s hard to say that’s not an advantage. The only other side of that is the side to a specialist firm that does things in a very focused way, is it’s not always one size fits all. And sometimes in the marketplace, when you’re talking to portfolio companies, or potential portfolio companies, while the focused firm might make arguably better investment decisions, portfolio companies like the broad approach because they get to leverage the portfolio. And one thing is that the tech companies get to work with the non-tech companies in a portfolio. They become business partners, they sell software to them … that kind of thing. And you see that the cross-silo horizontal nature of private equity firms that work across verticals has some advantages of its own. But all things being equal, it’s hard not to say that a firm that does a lot of transactions in a slice of the economy, in a lower case “s” sector, is going to have some advantages that firms that are spread a little thinner just don’t have.

Brown

OK. Well, I mean that makes sense. So if we think about just investing in a software asset, how is it different when you’re thinking about due diligence, you’re thinking about making an investment of a software asset? How is that different from investing in a traditional asset?

Vogel

Yeah, so there’s a few things that we love about software. So, first of all, it’s heart. Here’s and why is it heart? So, there’s many ways to skin a cat. The first thing I like to think about is when you think about the TAM or the addressable market for software, it’s not just like in some consumer product company where there’s five vendors that all make, you know, coffee makers (I’m sitting here looking at a coffee maker). So yeah, you know, there’s Cuisinart and there’s Mr. Coffee, the espresso whatever. You know there’s a dozen vendors and that’s sort of the TAM. In software, the problem is not only do I have multiple vendors, but I have a whole other dimension, which is I can solve this problem, most business problems, I could solve with paper and pencil. OK. Then I can solve it with email and Excel. OK. Then I can solve it with I’m going to write my own code. I’m just going to develop it myself. I’m going to outsource it to Infosys and they’re going to build it for EY. OK. They’re just going to build it for me. I’m going to go get a platform like Microsoft Power Apps or Force.com and I’m going to build it on top of a platform. Or, oh, I’m just going to go buy a purpose-built, commercial off-the-shelf application that does exactly what I need. Alright, in each of those categories, I got a bunch of vendors to choose from. So, I have this sort of multidimensional, there’s many ways to skin the cat and how I think about TAM is really complicated. Like, is it just the TAM of the vendors, the vended market, or is it really all the different ways to solve my problem is the TAM? And some of them are paper and pencil and human labor and at the other end is a commercial off-the-shelf app that I pay, you know, US$1,000 per employee per year for, or whatever the price may be. So, thinking about the market and the competitive landscape is really complicated, first. Second, pretty high gross margins, right? In the old days of software, you know, the first copy of the software cost a lot to build and R&D. And the second copy costs, at the beginning of my career we would distribute stuff first on quarter inch tape and then on CDs. It actually cost US$50 to burn a CD back then. So the cost of goods sold was actually US$50 and some postage, US$10 for the FedEx to send to the customer. Then, in the world, we started downloading software. It was virtually free. So, you had 99.9% gross margins often. Then, in the SAAS world, gross margins came back down to something in, you know, the mid-80s because you’re spending some of that recurring revenue towards running the infrastructure for your client, right? Whether that be in public cloud or in a data center, it actually started costing you something to deliver your monthly obligation of the software. So, very high gross margins. Second is the software is never done. OK, so unlike the coffee maker or even unlike an automobile, where every five years they might redesign it. The software is constantly evolving, right? There’s a major release every year; a minor release every couple of months. I’m fixing bugs regularly or, again, in a natural SAAS world, the product might roll out with new features every 30, 60, 90 days, more frequently. So, the product is never down. So that R&D expense, while gross margins are high, that R&D expense is also pretty high. Well, COGS is low, you might say. R&D expense is high because you constantly have to be evolving a software product. So, you have to look at it that way. So those are some of the characteristics that make software challenging, complex, but in our minds, more fun than any other sector.

Brown

What do you look for? And when you’re doing due diligence on a software company, what do you actually look for as key signs or key things that will help you determine that this is a viable company?

Vogel

So, the biggest thing is, and this is a great segue to the prior question, is the concept of technical debt. So, the biggest worry our clients have is that they acquire an asset and it has a ton of technical debt. So, what’s technical debt, and there’s a few definitions out there. Think of technical debt as deferred maintenance. So, when you buy a house or you buy a building, there’s probably deferred maintenance. The roof may have to be replaced at some point, the HVAC system may need to be replaced, the foundation may be crumbling. There are these hidden issues and they’re not really on the balance sheet. These are liabilities, but they’re not on the balance sheet. So, unlike real debt, OK, financial debt that’s on your balance sheet, this is obligations that you are signing up for that you may not know you’re signing up for and they don’t show up anywhere on the balance sheet and it’s really hard to find them and quantify them. All software has technical debt. If you built the software perfectly, you would be overengineering it. It’s like if you built the house to last 100 years, it would have cost three times more than you needed to and you would have overengineered it. But you have to make trade-offs when you’re building software. You have time to market. I have to get it out quicker. I need it to be fast. So, this is a trade-off between making it fast and making it extensible forever and making it extremely maintainable. So, architecture is making all these trade-offs and, as a result, just like you know private equity firms like to leverage their investments, having some debt is good. Having some technical debt is good. You need to have some, but you also need to manage it. You need to pay it down and you need to avoid accumulating too much technical debt over time because then you find yourself in a situation where every dollar goes into remediating technical debt and no money goes into building new features, and then competing with your competitors and differentiating your products in the marketplace. And that’s really the challenge that our clients are most worried about and where a lot of the time and product and technology diligence goes to understanding how much technical debt is being remediated and is the company going to be able to devote the required amount of resources that are going to grow their top line and not be mired in technical debt remediation.

Brown

And this is the diligence methodology that you pioneered? One that actually elaborates or one that actually assess the technical debt?

Vogel

Yeah, so I would say that our team was pretty instrumental in sort of institutionalizing product and technology diligence for private equity, for companies of substance, where there’s a lot of complexity and we needed to in a pretty short period of time be able to assess and quantify things that were going to matter for pretty substantive investments and acquisitions.

Brown

OK. And in order to do that, I’m imaging[MOU1]  that, from what I understand of your team, you’ve got deep talent. You’ve attracted ex-CIOs, you know, a lot of the people that you talked about that have technology degrees, how do you not only attract the right talent, but also train them and continually upskill them given how quickly technology’s evolving?

Vogel

It’s multifaceted. You’re right. Like early on, recognize the need to build a team of really strong mostly serial CTOs, pretty experienced people. And what we have done is combine that team with the team of _[MOU1] So that’s a pretty senior/older team and then we have a young team of people that come out of top schools and pretty interesting software companies at the early parts of their career, usually with technical backgrounds, computer science degrees, product development, product management and sometimes solutions engineering. And then you marry this together. So, you marry real experienced people who love working with young people and it sort of keeps them energized and motivated and the young people love learning from the more experienced people. And it’s wound up being, you know, a pretty good formula for our success. And like all good things, you know, we stumbled into it and it was better to be lucky than good. But we came up with the right formula and it’s been working well for us.

Brown

So your secret sauce then is people, essentially, and a passion for technology?

Vogel

Yeah, yeah. I think we’re definitely a people business and there’s no doubt that our success is 100% attributable to our great people.

Brown

Cool. And so if we think, then, so you guys now have done the diligence and you’ve helped PE make the decisions around where to invest, if I think about traditional PE, it’s all about value creation once you’ve made that investment. Where do you think the value creation levers are typically when you have a software company, given what you’ve described so far?

Vogel

Yeah, so that’s a great question. I mean, a lot of the companies that our clients acquire are thinking about heading towards, in the middle of some form of tech transformation. So, helping them get that right with the right cost structure and the right risk mitigation is pretty important. So, they might be moving to the cloud, they might be taking an on-prem product and making it SAAS. Often, they’re, a constant theme is two plus two equals five. Those secret evaluations are through the roof. So, in order to make the math work, it’s not uncommon for our clients to look for synergies and acquisitions and scale that they could build in the companies. And when you take two or three things, putting them together in a cohesive way is nontrivial, you know. Which products do you keep, how do you consolidate, do you consolidate, what’s the impact to customers when you do that? A pretty common thread is the asset in some of these companies is the stickiness of the customer base, right? [MOU1] So, people always talk about recurring revenue, but why is revenue recurring? You know, contracts are rarely, you know, more than three years. So, it’s not contractually recurring, it’s that customers have products that they like and they’re sticky and they don’t want to move. So when you, if you radically change the platform such that the customer has to go through pain to stay on your products because you went from v5 to v10 or v5 to next-gen, is a common thing. If that was hard for the customer, they would say, you know I might as well go to RFP because it’s going to be painful either way. You want to avoid that. We’re often tasked with helping our clients come up with ways to remediate the technical debt, modernize the software. But in a way, that’s behind the scenes, under the covers and does not cause friction with existing customers. And that’s way easier said than done. So, a lot of the value creation is that, it’s like a going forward technology road map that optimizes the trade-offs between modernizing, adding capabilities and being low friction for existing customers.

Brown

So the way you’ve just described how technology companies and software companies are evolving, feels like it’s more of a long-term play. And when I think of PE investments, they’re typically short term.

Vogel

Yeah. Well, they’re becoming shorter term, right? I mean, you know, probably when we started this four to eight years was the average, five to eight was the average hold and then you’ve seen a lot of this stuff flip. Like, you know, we’ve been doing this since. We’re seeing things for the third time that we worked on in 2014, 2014, 2017, 2020. And that’s pretty unheard of, like two flips in three years each. But at the same time, we’re also seeing some of the best investors in the world decide that they want to hold companies for 10 or more years, and sometimes that’s a fund to fund. Like they sell it from Fund 6 to Fund 9 because their limited partners see value in holding software companies over the long haul and I think everybody can advise the decisions that are made when you’re long-term oriented. So, all of that comes to play, I think, even in the short-term scenario where someone’s thinking of halting it for years. They also know that the company has to look right upon sale. So you still have to make 5- and 10- and 15-year decisions, right, because it’s not uncommon to be having a conversation. It’s not just about like what we do with a company, but you can’t sell the company while there’s a major investment. You know if I were purely maximizing cash flow and not let’s say sale value, you might say, OK don’t remediate the technical debt, maximize cash. But I know that I can’t sell something that has all this technical debt to the next player because they’re going to say they got a major overhaul on their hands and that’s going to impact exit valuation. So you wind up having to take a 6-, 7-, 8-, 10-year lens to something, even in the case where you might have a client that says we’re flipping this thing in 3½ because usually whoever they’re flipping it to is a pretty smart investor themselves and the next five years has to make sense as well. So, we don’t really see ourselves in too many situations where we’re optimizing for the short term.

Brown

And that’s probably a distinct difference between an investment in a technology company vs. an investment potentially in a product. Because, like you say, your coffee machine is there. There’s your product, you turn more products. But you’ve got the R&D that needs to happen for tech companies, otherwise you’re dead in the water, right?

Vogel

Exactly. And some of this is the results of the valuations of the last 24 months. Everybody has to underwrite growth. They can’t just underwrite cash flow because they’re paying crazy numbers. You know, they’re paying 20 times EBITDA on everything and you can’t get there just on underwriting cash flow.

Brown

And so, what do you say? I mean, technology is changing at such a fast pace. What role do you think PE’s going to play in shaping the technology sector for the next, you know, call it 5, 10 years?

Vogel

I mean, I think a pretty significant role. I mean, the last six months notwithstanding, tech IPOs had slowed a little bit. There’s lots of trade-offs on whether you want to be public or private. I mean, I am very appreciative of our clients, not just because they’ve been good to us, but I really do think they are all, they’re company builders. This notion that private equity guys are cut and slash — we just don’t see it, or we don’t see it in tech anyway. They’re company builders and, as I said, they need to grow companies in order to be successful. They can’t just milk the cash. They tend to make long-term decisions. And you know, if I’m a software executive, boy would I rather be in a private company without the quarter-to-quarter lens that’s required where I can make longer-term decisions — one that’s owned by private equity vs. a public company where every quarter matters and you know you don’t always really have the liquidity, right, for lots of reasons. So, because of all of those things, I think you’re seeing more and more management teams, CEOs, founders, see the benefits of being parked with private equity. You see many that have gone public and have decided to go private again because of that, because some of the virtues of being public weren’t all that they were cut out to be in terms of liquidity and availability of capital and other things. Private equity has a trillion bucks plus the leverage on that of dry powder and it’s looking more and more towards tech to deploy that.

Brown

So, I guess from a technology company’s perspective, very clearly, access to capital is hugely important. And I guess from a private equity perspective, technology companies are hugely profitable. So also, win-win.

Vogel

The only downside is the valuations, right? But let the markets take care of that. I think that folks that have been investing in technology have, seem to have the IOR to justify what they’ve been paying. And you can see record funds being raised, which is the proof is in the pudding.

Brown

Do you have any recommendations maybe for those PE firms out there looking for some really attractive potential targets? What would your words of advice be for them?

Vogel

They’re all pretty smart, so I don’t know that they’re going to get a lot of advice from me. I do think that staying long-term focused is pretty important. The PE firms and the portfolio companies that we’ve been involved with that have kept the long-term lens have done the best. There’s some bellwethers out there in our client base and in our clients’ portfolios. I eluded to some of these funds that are holding companies for more than 10 years. Some of these companies are getting to the size and stature of the large-cap public software behemoths because of that, particularly in enterprise software. Like nobody’s going to get to the size of a Google over there in the software economy, software-enabled services area. But in sort of the software, there are now private companies that are getting up there that have products that are up there in the leagues with the SAPs and Microsofts and Oracles of the world because they’re able to build to that scale.

Brown

Fantastic. And so, Jeff, before I let you go, are there any other trends that you’re seeing that you think might be shaping the technology sector and PE investments over the short to medium term?

Vogel

So that’s a good question. And I think it’s pretty relevant right now and some of this is as a result of COVID, but I think something that we’re seeing that should lead, in my opinion, to some good things, and it touches on the public vs. private, we have seen some hybrid-type deals. So, what do I mean by that? I mean some private equity firms that used to be majority-control investors starting to do minority slices. We’re seeing some PIPEs (Private Investment in Public Entities) — so public companies needing some capital, taking on a large private investor that’s going to own a slug. You start seeing hybrid. You start seeing some of the great practices and detail management and reporting and strategy expertise from private equity starting to permeate maybe some public companies or two or three PE firms that normally wanted to be sole or control investors partnering with each other. So, a little more of this cross-fertilization and crossover happening. There’ve probably been times in history where we saw a little bit of this before. But in any event, we’re seeing that now and I do expect that to continue and see some more things that looked a little strange to us in the previous months, but we’re now starting to see more regularly. And I think that’s going to be mainly a good thing for both the public and the private markets.

Brown

Excellent. Well, thank you. I look forward to seeing all of those transactions unfold. I think it’s going to be exciting times in the sector.

Vogel

Same here. Thank you, Winna.

Brown

Thanks Jeff.

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