Commentary: A growth-focused paradigm in private equity investing

Historically, when people thought of software and technology investing, they thought of venture capital. There's a reason for that, since venture capitalists drive significant innovation through investing in startups and companies of all sizes. Private equity, on the other hand, has been something entirely different: a vehicle for short-term growth and bottom-line improvement in later-stage, older companies, but little else.

That was then. Today, based on changes in the market and the growth and size of companies, investors must pioneer a new approach across the investing spectrum. Over the last five years, we've seen a shift in tech investing, and it's reaching a tipping point in 2019. Not only is growth front and center in private equity deals, but the old way of cutting costs to boost profitability hurts investments in the long run and curtails innovation.

The new private equity paradigm takes a leaf from the VC playbook, centered on making an investment a better business — not just a more profitable one for investors. By diving deeply into business practices, bringing subject-matter expertise to the table, and looking holistically at how to grow — and sustain — a company's top line, PE investors can realize robust returns while simultaneously improving businesses for the long term.

The new private equity playbook for technology investing has a few axioms.

Historically, the investment thesis for a private equity single-digit-growth-low-margin buyout involved cutting costs, increasing prices, and consolidating locations and headcount. These actions boosted EBITDA in the first year of the investment to support a quick recapitalization and payback of the initial investment to lock in a strong internal rate of return. EBITDA maximization was paramount; investment in future growth was a lower priority.

Today, PE-style target investments are no longer sluggish growers but high-growth assets, borne out of the ubiquity of software as the underpinning of business transformation. Many companies sustain growth over 20%, tapping into demand for horizontal and vertical software, and benefiting from cloud deployment and recurring revenue software-as-a-service business models.

The market has shifted so that tech-focused private equity investing is no longer synonymous with slow growth. Rather, it's simply a control transaction into a high-growth asset, requiring therefore, a different value creation strategy.

In the prior cost-cutting approach focused on short-term EBITDA maximization, growth was secondary. Today, growth is a core thesis; giving a highly scalable business a chance to blossom, and through data-driven investing in innovation, can realize much higher returns, improve profitability and catalyze further disruption — if investors give it a chance. Profitable growth yields top-line scale and bottom-line improvement without needing to focus solely on expense reduction.

Savvy investment requires an executive team with growth expertise focused on delivering value to customers. It's essential to employ talent with deep know-how — whether in digital marketing, DevOps, cloud infrastructure, cybersecurity or vertical domain expertise. The rise of the chief product officer as a key executive, for example, reflects the need for product portfolios that target different audiences with distinct business needs. Likewise, the recently elevated chief customer officer focuses on customer success to yield high retention and renewal rates.

When the entire private equity remit was improving EBITDA and cutting costs, building a sustainable business was less important. Today, success is amplified through innovation: investing in the first few years of an investor's hold period to building new revenue streams, new sales and marketing infrastructure, and entirely new markets. As companies tap into a larger total addressable market and get pricing leverage through market share and brand equity, this can reap much larger benefits in the longer run for investors and the company itself.

Inorganic growth, executed effectively, has a step-function impact on scale and reach. In today's private equity landscape, however, M&A cost synergies are not the driving motivator for acquisition — growth and scale are. Revenue cross-sell across customer bases, acquiring new customers, new products and new geographies, as well as access to scarce talent resources, can create businesses with greater resiliency and less dependence on single-product portfolios, or underlying market dynamics.

Companies that equip their organizations to collect the right business metrics can react in real time to shifts in customer net promoter scores, (i.e., a scale for measuring customer experience), sales team productivity, customer acquisition costs by channel, customer usage and logons. Data facilitates incremental improvements in sales close rates and revenue retention rates.

With cloud-based data and common systems collecting information across portfolio companies, this data is a significant asset for investing in growth equity. Data insights let investors examine what's worked across the portfolio and troubleshoot challenges; they also increase transparency and open up an opportunity for best-practice sharing across the portfolio.

Driving profitable scale is at the heart of this new approach to private equity investing. In the new model, it's not uncommon for investors to double headcount throughout a hold period, overhaul and complement existing talent to help an organization reach its goals and invest to broaden product portfolios. Smart investors should not be afraid to do so through effective partnerships with recruiters and operating practitioners who have hands-on expertise running a business. Increasingly smart investors deploy an in-house team of operations experts to disseminate best practices across the portfolio, helping companies navigate sustained, rapid growth.

It's 2019 — time to open our eyes and strategies to meet an ever-evolving business landscape. Investors who follow this paradigm will be better for it — and so will their investments.

Deven Parekh and Hilary Gosher are managing directors at Insight Venture Partners, New York. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.