Venture capital and private equity managers love subscriptions. But the model of selling products with a recurring fee is no guarantee of success.
Managers are still investing in subscription-model companies despite higher prices and the trouble that some, such as Blue Apron Holdings Inc., have had as public companies.
And investors appear to be on board.
Vista Equity Partners in March closed one of the largest-ever software funds, the $10.6 billion Vista Equity Partners VI, which started fundraising with an $8 billion target and no hard cap, according to a report to the Oregon Investment Council, a fund investor. Vista is focusing on high-growth software-as-a-service companies — or SaaS — with "high recurring revenues" as well as high customer retention, the Oregon report stated. SaaS companies license their software rather than follow the original model of selling it to customers.
The recurring-revenue model is a main feature of SaaS companies, which are prime investment targets for venture capital and private equity managers. Private equity SaaS deals grew 217% between 2010 and 2016, showed data from PitchBook Data LLC, a Seattle-based private equity research firm.
Vista's fund amounted to about 19% of the $56 billion in total capital raised by U.S. private equity funds in the first quarter, according to PitchBook.
Software touches many industries, and SaaS companies have attracted investor interest. Venture capital and private equity managers like the recurring revenue, which they believe make these companies less risky. What's more, recurring-revenue companies also sell for more on exit, which boosts returns.
"SaaS is a more predictable and reliable revenue stream than if you had to go out and sell the software — the perpetual license model," said Peter Fair, managing director in the San Francisco office of credit asset manager Golub Capital LLC.
Rohit Kulkarni, head of research at SharesPost Inc., a San Francisco secondary market private shares trading platform, agreed. "Any firm with recurring revenue is extremely attractive to investors," he said.
Typically, companies with recurring revenue models are valued much higher than companies without a subscription model, Mr. Kulkarni noted. He believes the higher valuations are warranted, especially for companies that have a captive base of customers paying monthly fees.
"The subscription model translates to greater visibility of revenues, less volatility," Mr. Kulkarni said.
In the first quarter, software companies using the SaaS model had revenue multiples of seven times, compared to 6.1 times for other software companies, according to a recent Golub Capital report. (Revenue multiples compare a company's enterprise value to its revenue, with managers prizing companies with the highest multiples.)
And the name of the game for private equity and venture capital managers is organic company growth. Companies with recurring revenues, especially in the software sector, make up one of the few areas in which private equity and venture capital executives see organic growth rather than growth through acquisition.
"If I had to think about what industry is going to generate organic growth, it probably won't be the car or airline industries, it would be software in its many forms," Mr. Fair said.