Wanted: Margin Growth in Software Investing

Expanding margins is almost always a part of a software buyout deal thesis.

Delivering on those projections turns out to be another matter altogether.

A proprietary Bain & Company analysis of 33 software buyouts shows that 31 of them (or 94%) projected a median 560 basis points of margin improvement over a five-year holding period. Yet, on average, actual margin growth badly trailed these models after five years of ownership (see Figure 1).

Figure 1

That discrepancy correlates closely with data breaking down the sources of return for software deals, according to CEPRES–DealEdge (see Figure 2).  

Why have software investors failed to deliver on this key component of value creation? The easy answer is that they haven’t had to. A decade or more of steady tailwinds from heavy technology spending, cheap capital, and steadily rising sale multiples has helped the software subsector achieve among the strongest returns in private equity for 15 years running. Ensuring that a company operated more efficiently was “nice to have” but not necessarily critical. Focusing on top-line growth in most cases has delivered great results.   

But relying on that formula in a much more challenging investing environment poses a real risk.

IT budgets, the key driver for software markets, have come under pressure across the economy, meaning robust growth is less certain for many software companies. At the same time, heavy competition for deals continues to keep technology valuations near all-time highs, despite elevated interest rates and financing costs (see Figure 3).

Figure 3

For buyers stretching to justify those rich multiples and find ways to prevail in competitive deal processes, underwriting a reliable path to earnings expansion is critical. And, in most cases, that requires a different approach to due diligence, one that integrates technical, commercial, and operating considerations in a holistic view of the target.

Getting the full picture

Software investors and their advisers tend to structure diligence as a series of discrete questions. From management interactions to adviser roles, the effort is siloed, as if market prospects, product attributes, IT architecture, and go-to-market capabilities had nothing to do with each other.

Most often, the diligence effort is skewed toward an assessment of what a target company can achieve more than how the management team might achieve it. Buyers lean in on factors like market growth, white space, competitive position, product efficacy, and customer feedback—critical elements in assessing growth potential and momentum. But viewed in isolation, they offer little insight into whether a company can reasonably expect to achieve that growth while simultaneously boosting earnings. That leaves buyers guessing how much it will cost to build the capabilities needed to achieve projected growth and whether the investment is likely to pay off.

Diligence that provides a unified, 360-degree view of the company’s potential addresses all the key interdependencies between strategy and operations. This changes the conversation from “What is this company’s growth potential?” to “Given what we know about its product, technology setup, talent, and commercial organization, what will it take to achieve full potential, and what are we willing to pay for that?”

Enabling profitable growth

This integrated approach was critical in late 2023 when CVC took a large minority stake in TOPdesk, an IT service-management platform headquartered in the Netherlands. TOPdesk had an especially strong leadership position in its home country, selling software that helps midsize companies optimize and simplify their IT service desks. It had good customer relationships and was gaining significant traction expanding into adjacent markets such as Germany.

What it needed was capital and operational support to enable the next phase of growth.

Commercial due diligence gave CVC confidence that TOPdesk had a large addressable market. But given elevated market multiples for software assets, the firm needed a clear assessment of what it would take to maintain momentum into the future.

While TOPdesk had already made its products more attractive to customers by migrating them to the cloud, integrated diligence found that key changes to its cloud architecture could allow for faster expansion, with greater economies of scale, especially with an important customer group: managed service providers. In addition, while existing customers were happy with the product (as suggested by a high Net Promoter Score^SM), a more modern user interface (UI) could accelerate new customer acquisition. So, the diligence team assessed how updating the UI could help the sales organization capture “new logos.”

This holistic approach gave CVC the necessary data and insights to underwrite these opportunities with confidence and prioritize the right roadmap to go after them. By quantifying the investment needed, the diligence enabled CVC to strike a partnership with the company to achieve sustained growth.

Targeting investment

The relationship between technical and commercial diligence also played an important role last year when a global firm took a majority stake in an enterprise resource planning (ERP) software company. Again, the big question in a high-multiple market was “How can we be sure this company has a promising next act?” In this case, the opportunity was catalyzing a new level of performance on the commercial side of the enterprise.

The company develops sticky, well-loved ERP solutions for businesses in a discrete set of traditional industries. Technical diligence showed that it had a well-thought-out plan for migrating products to the cloud and little “technical debt,” or required tech investment to enable its strategy. Commercial diligence confirmed that its strong position in a set of promising markets made its top-line ambitions achievable.

Yet an analysis of the go-to-market organization indicated that reaching those goals would likely require investment. The company had a strong group of long-tenured salespeople known for their hustle. But Bain’s OPEXEngine and measures from other sources showed that the organization’s productivity trailed rivals by as much as 30%. The diligence suggested that part of the issue was the company was spread too thin—it had too many products and not enough intelligence on which were truly profitable. At the same time, the sales team lacked a full set of analytics tools to focus the right sales play at the right time on the customers with the highest potential value.

In the end, the integrated diligence showed the buyer that there was a continued path to robust growth as long as it was willing to invest in accelerating the cloud migration, rationalize the product portfolio, and elevate the go-to-market organization with the tools and capabilities needed to take productivity to the next level. The potential was there to fuel growth at expanded margins, and, critically, the buyer was confident it had an actionable value-creation plan to get there.

Given the ongoing transformative power of technology, there’s no reason to believe that software growth is going anywhere but up over the long term. But valuations already reflect high expectations, competition for deals has never been hotter, and an uncertain macro environment continues to blur the shorter-term outlook. In short, investors can’t afford a growth-only approach to value creation.

The data is clear: Firms seeing top-tier returns already understand that winning deals and executing at a market-beating level requires an integrated process that not only underwrites revenue growth but also lays out a clear plan to achieve it profitably. What a company can capture at the top line is only half the story. How it gets there is the key to creating additional value through margin expansion.

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