Private Equity + Enterprise SaaS
Smartsheet’s Take Private and Why Private Equity Buys SaaS Companies
Smartsheet Acquired by Private Equity for $8.4B Billion
Last week, on September 24th, Smartsheet announced that it had entered into a definitive agreement to be acquired by Blackstone and Vista Equity, in an all-cash transaction valued at ~$8.4B. The $56.50 / share offer is a ~25% premium to the undisturbed closing share price on July 17th (when media reports of an acquisition first surfaced) and a 16% premium to the highest closing price over the previous 12 months. The acquisition price is also a ~35% discount to SmartSheet’s all-time high in 2021 and represents a reset of valuation expectations for the company.
Why Does the Acquisition Matter to the SaaS Sector?
If the deal does go through, it would be the largest private equity acquisition of a software company this year. This acquisition comes on the heels of other recent announced PE-backed software acquisitions, including:
Permira’s announced acquisition of Squarespace for $6.9B in May
Bain Capital’s announced acquisition of PowerSchool for $5.6B in June
TPG and CDPQ’s announced acquisition of Aareon for € 3.9 billion
And it’s not just an acceleration of large deals in 2024. According to Pitchbook data, Q1 2024 had the highest technology M&A deal volume by financial sponsors (Note: I’m using “private equity” and “financial sponsors” interchangeably) in the past three years and the momentum has continued until Q2 and Q3.
Financial sponsor backed M&A was stalled in 2022 and 2023 due to rising interest rates, recession fears, and a valuation gap between sellers and buyers. With interest rates coming down, public market valuations coming down and SaaS companies resetting valuation expectations, the announced acquisition of SmartSheet is another sign that private equity’s appetite for acquisitions broadly, and SaaS specifically, is opening back up.
This matters not just for SmartSheet. According to Battery Ventures, over 1,000 software unicorns were birthed in the past 10 years and these firms will need sources of liquidity and paths to an exit.
There are generally three paths for companies to get an exit - an IPO, acquisition by a strategic (i.e., competitor) or acquisition by a financial sponsor.
IPO
IPO markets are closed for private companies in the U.S. and there are no clear signs of the public markets thawing in the next six months. More importantly, with only 200 public software companies and 1,000 software unicorns, there isn’t sufficient appetite from public market investors to support a large volume of IPOs.M&A: Strategic vs. Financial Sponsors
Strategic acquirers (e.g., competing firms) have been inward focused as valuations have come down and as efficiency has been the top priority. While I expect strategics to be active in acquiring companies with AI capabilities, I expect strategics to be a relatively less important source of exits for SaaS companies. Over the past three years, data from PitchBook indicates a trend towards financial sponsors driving an increasing proportion of tech exits as compared to strategic acquirers.
I expect financial sponsor M&A to be important not just for companies like SmartSheet that are generating over $1B in ARR, but also to SaaS companies starting at $10M+ ARR.
Why is SaaS Attractive to Private Equity Firms?
A couple of decades ago, private equity firms didn’t invest in software or technology companies because there was a fear that innovation and disruption was too rapid and would lead to unstable cash flows. Investors such as ThomaBravo and Vista Equity have shown that software applications and infrastructure can be surprisingly sticky and have good investment characteristics. SaaS companies are attractive to private equity firms for the following reasons:
Recurring revenue. This stability of revenue limits downside and also allows private equity firms to use (some) debt to finance the acquisition
Growth rates. SaaS companies operate in rapidly growing markets, especially compared to other industries private equity firms invest in
Gross margins. SaaS companies have limited cost of revenue and can relatively easily generate 80% gross margins, resulting in attractive operating leverage in the business.
Innovative founders. Private equity firms believe that SaaS companies are run by founders who are great at innovating and creating great products. These founders aren’t nearly as good at creating highly profitable companies. The combination of innovative founders and PE funds with a proven operating playbook can drive improved profitability and lead to meaningful value creation.
How Do Private Equity Funds Generate Outsized Returns?
In May 2016, Vista Equity Partners acquired Marketo for $1.8B, at a ~64% premium to the company’s share price. Despite the rich premium, Vista believed that Marketo was being undervalued by the public market which was overly focused on profitability concerns. In the two years post acquisition, Vista revamped product development and focused on the enterprise segment, to support revenue growth. Additionally, the Vista team executed it’s operational efficiency playbook to make the company profitable within two years. In September 2018, two years after the original acquisition, Marketo was sold to Adobe for $4.75B, a $3B return (>2.5x) in 2 years!
Vista’s acquisition and eventual sale of Market touch on some of the levers that private equity funds use to generate outsized returns:
Operational improvements. Funds have tried-and-tested playbooks to improve EBITDA margins over a short period of time. Despite the median public SaaS company having operating margins of ~15%, private equity funds target EBITDA margins of 40%+.
Revenue. Accomplished through levers such as:
Pricing: Increase pricing, more discipline on discounting deals
Upsell: Introduction of new SKUs (Premium, Enteprise), upsell to additional products
Market expansion: New geographies, new customer segments
Cost. Accomplished through levers such as:
Headcount: Reduced spend on management, hire outside of Silicon Valley, offshore talent
R&D: Cut RoI negative projects
S&M: Reduce spend on inefficient S&M channels
IT: Reduce spend on underutilized SW tools
Multiple expansion. Multiple expansion can occurs through various means including purchasing an undervalued asset, benefit from a lower interest rate environment at exit or roll up a number of small companies (smaller companies generally trade at a discount).
Financial leverage. While taking on debt is a critical component of private equity in other industries, due to the high multiples in SaaS, debt ends up being a less important lever for driving financial returns.
Closing Thoughts
On one hand, IPO markets are frozen and strategics continue to sit on the sidelines with respect to M&A. On the other hand, there are over a 1,000 unicorns and a cambrian explosion of profitable SaaS companies in the $10M to $50M revenue range. This is setting up a ripe environment for financial sponsors to be an increasingly active source of liquidity for private SaaS companies.