Software is eating the search fund world

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?

The type of software businesses that are attractive to search entrepreneurs and investors are very different from the horizontal software companies described by Marc Andreessen in 2011 in his famous WSJ piece. Searchers typically acquire founder-led vertical software companies that provide a tailored solution for a very specific set of business customers in a small niche (ideal TAM is somewhere between €300m and €1b). These companies are mostly bootstrapped businesses that were profitable almost from day one and never received a VC dollar, and they are typically located far away from traditional VC hubs.

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

Through the years, we have learned that, although vertical software companies can be very capital efficient and profitable businesses, there are some challenges associated with investing in software business when backing first-time search fund CEOs.

In most small businesses there is what Brent Beshore refers to as an "everything-tastes-like-chicken" layer of business, that is very similar across industries: developing a strong sales and marketing engine, implementing systems and processes, hiring good people and building a strong culture or financial optimization. Small business owners are often less knowledgeable about this "business of business", and typically will be very good at only one or two of these areas. Successful search fund operators -with the support and pattern recognition skills of their experienced board of investors and operators- will figure out how to improve most -if not all- of these areas as part of their search fund playbook.

Vertical software companies have their own "everything-tastes-like-chicken" layer of business (the chicken taste metaphor was actually coined by software investor Robert F. Smith from Vista Equity Partners). However, it is a different kind of chicken. Running a software business is more complex than running most traditional businesses. Regular business metrics often fail to capture the key factors that drive performance in software companies and a different set of knowledge, skills and experience is necessary to be successful operating this type of businesses.

If transitioning into a first-time CEO role is overwhelming for most searchers, doing so in the more complex environment of a software company can be daunting. Most searchers don't have a software background and the entrepreneur will need to learn at the same time both about the vertical that the company is serving and the software playbook.

Under these circumstances, the search fund investor group -and in particular the role (and composition) of the board- becomes an (even more) critical subject. The definition of search fund investing as "low maintenance private equity" does not apply when executing complex software deals. Putting together a strong investor board with a combination of software operating experience and a track record investing in software businesses can make a big difference for the outcome of the investment. The use of "operating partners", special board members that are willing to spend long hours with the CEO helping with critical operational challenges, can also be extremely helpful for a first time CEO.

In Europe the investor community is still at an early stage of development and even the strongest cap tables often lack relevant software operating and investing experience (even in the US there is a scarcity of software operating experience). This talent gap at the investor level makes it harder for search CEOs to address some of the recurring challenges that most software businesses face (development of a B2B software sales engine from scratch, recruiting for critical roles like product management or customer success, etc.). Some US investors have played a critical role bringing frameworks and best practices for software investing, but there is a growing need to develop a strong Europe-based software chapter within the search fund community.

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.

SF Thoughts

Musings of a European Search Fund investor