When we started investing in search funds almost eight years ago, we thought that the retirement of the baby boomers would lie at the heart of our investment thesis, and that most companies would be boring B2B nichy service businesses that operate in profitable unsexy industries with a very low-tech component. Although this is still true for a big chunk of our portfolio (and we love these boring businesses!), 14 out of the 34 companies are software related businesses (Mapex, Infonetica, CarPro, CTAIMA, Motion VFX, Theia, dotCMS, Espiral MS, GHS, Labsoft, Nexti, Frotcom, and more recently Syonet and Velis).
The proliferation of software deals has been one of the overarching trends in the search fund community in recent years. Over the last decade software has become the largest industry category by far, and today almost one out two search fund deals worldwide is related to software/IT. In the US there is an increasing number of entrepreneurs and investors that focus almost exclusively on tech related businesses, somewhat creating a bifurcated market within the search fund community.
This bifurcation of the asset class is unlikely to occur in Europe in the short term. Due to the significant language and cultural barriers within different European countries -even more so in the SME space- searchers here typically focus on a single country or region, and the pool of software targets in each individual country is probably too small to justify an industry focused search limited to software. An exception in our portfolio are Helena and Ivar from Snowfall Capital, who ran a Europe-wide search focused on acquiring a vertical software company, and ended up acquiring Frotcom.
Why do software companies make for such a popular SF target?
It is easy to understand why software has become the largest industry category within the SF asset class:
- Software is indeed eating the world: Today, every industry runs on software, and the B2B industries traditionally targeted by search funds are not an exception.
- Great fit with SF economic investment criteria: a lot of software companies are growing recurring revenue asset light B2B businesses with 60%+ gross margins, consistently high ROTCs, negative working capital and virtually no capex, that provide mission critical solutions to customers who operate in growing end markets.
- Superior business model / potential for a home-run: Software companies often present a very attractive risk-return profile and great optionality due to the scalability and profitability of their business models. If you add to this a strong appetite in the private equity market for well-run software companies with more than €4m EBITDA -or more than €8m ARR- the result is a higher likelihood of achieving >10x returns.
- Owners often meet the "natural seller" test: Many founder-led software companies reach a point where the founder realizes that they need outside expertise to scale further, and that the weight of an almost instinctive preference for business as usual -derived form their entire net worth being tied to the business- is holding the company back. The founder becomes a "Chief Worry Officer" and the day-to-day burden associated with running a growing business prevents him from focusing on what they are really passionate about: developing great software products to delight their customers.
- Strong personal fit with searchers: A lot of searchers feel at ease in the more sophisticated (and often younger) working atmosphere that exists in most software companies, compared to other traditional search fund acquired companies. Moreover, cultural fit with the incoming CEO is a key priority for many software founders, and here search entrepreneurs often have a clear edge over other types of buyers. A strong personal connection is often built between the owner and the searcher during the deal negotiation. The founder sees in the entrepreneur a younger version of himself that is more likely to honor the legacy of what already exists, while being able to take the business to the next level of growth.
A different taste of chicken
Building a software search fund practice at Istria
At Istria we are very keen on backing software deals, and we've been focused on developing our own software muscle as investors over the last years to better support our entrepreneurs. We have invested so far in 14 software companies (out of 34 companies in our portfolio), and I personally sit in the board of three of them (Theia, GHS and as observer in CarPro). Developing a strong software practice will be at the heart of our Istria platform strategy in the coming years.
We believe that there is a unique investment opportunity in Europe today for this type of niche vertical software companies, especially in southern countries like Spain, Portugal, France and Italy. The proportion of software businesses in the €1-4m EBITDA range that are still founder-owned is high compared to other countries and access to capital providers is still very limited. Moreover, the lack of buyers and intermediaries with operating software experience in this micro-buyout segment reduces significantly the universe of prospective buyers, making it possible for searchers to acquire high-quality growing SaaS businesses at prices that, although they often exceed the traditional 4-6x EBITDA search fund target range, are still well below the 4-5x ARR multiples that we have typically seen in the US in recent years.