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Software has been one of the worst-performing sectors this year amid a rising rate environment and geopolitical tensions overseas.
This comes as no shock to Orlando Bravo who helms tech-focused private equity firm Thoma Bravo. He says the mantra of ‘growth at all costs’ is over and that investors are slowly shifting their focus from momentum to fundamentals and profitability.
Bravo sat down with the Delivering Alpha newsletter to discuss what he thinks are structural problems in the software industry, the revaluation in tech, and the growing cybersecurity risk emanating from Europe.
(The below has been edited for length and clarity. See above for full video.)
Leslie Picker: There has been a massive shift in 2022, there’s just this macro change afoot. How does that impact what you do and what do you make of the recent revaluation in the [tech] sector?
Orlando Bravo: It was just a long time coming. I mean, we’ve been on a decade of tailwinds not only in the software industry, but in multiples. And what happened recently is that multiples of these growth stocks went from 20x to 10x. They got cut in half. Now why is that? Our theme and our thesis on it in talking to the big investors, sovereign wealth funds, big state pension plans, the original sources of capital, is that people are getting tired of being money-losing operations. They’re finally digging into the business models, looking at when profitability is going to come and discounting assets that have high growth, but no near-term prospects for profitability. So that correction is here and it’s happened and it’s in effect today. Now how does that affect our business? That is phenomenal on the buy side for our business because we are focused on buying the entire company, not in buying pieces of paper where you’re dependent on what others think. So it gives us an opportunity to do the one thing that we do really well and focus on which is to take these high-growth, innovative companies and put together an operating framework that allows them to be profitable as well and create profitable growth engines.
Picker: Would you say at this point in time that the sell-off is really priced in or do you think that valuations still have further to go before they’re at their intrinsic value, in your estimation?
Bravo: As a business owner, and as a participant in the private equity industry, it’s looking extremely attractive for groups like us, because once again, you can partner with companies and change their operational makeup by inspiring leadership. And these assets can produce big cash flow, not 20 EBIT/EBITDA margins, but 50% at growth and scale. So if you can price in your improvements, it looks extremely attractive. Now for the public markets, the problem is that once again, you don’t have control. So what is the bottom price on a revenue multiple when you’re unprofitable, especially when you miss your numbers? And now even more so if companies don’t beat and raise enough to surprise the street positively and they don’t have profitability to hold up your valuation, they are usually getting big negative surprises in terms of their share price.
Picker: What’s that tell you in terms of exits, though? Obviously on the buy side you mentioned tremendous opportunity. But what about the portfolio companies? You’ve been a massive dealmaker over the past few years, one of the most prolific dealmakers over the past few years, in all of private equity, not just tech. But what does that mean for the portfolio companies that you’re holding right now? Do you kind of wait a while for things to settle down before you look to do an IPO or to sell it? Or are you still seeing opportunities out there?
Bravo: What we do is we buy multiples of revenue, but we sell them on multiples of EBITDA. So we’re a fundamental seller as well and that’s how we model our investment cases in our companies. So if you have high cash flow, and you don’t get the right multiple on that cash flow, you can wait because you’re going to keep adding equity value, and you’re going to keep building a balance sheet that you can use for acquisitions. We are really not dependent on the market that we call ‘buy high and sell higher.’ We’re not in the momentum business, we’re in the fundamental business. What we’re seeing in private equity is private equity has not slowed down yet, in terms of buying companies on an EBITDA basis. And strategic buyers are sitting on their cash. And when they combine the number one player in a given sector in software, and that company does not have to be fixed, it does not have to be turned around, it’s highly profitable and can operate even as an independent business unit, that is still attractive to these corporate buyers.
The IPO is certainly a problem. And if you look at our industry, one of the challenges of private equity that the community doesn’t really talk about too much, is remember private equity needs to buy these public companies at a premium, call it 30% premium, and then you’re taking them public at a discount to the comps, call it a 20% discount. So the value that you have to create in between has to be so large for you to make your investment case work if you’re planning on taking it public later.
Picker: So if I’m understanding this correctly, then you are very hyper focused once you acquire a company on ensuring that it becomes profitable before you exit or at least close to that level of profitability before you do seek to exit. How do you do that, especially in this current environment with inflation and all sorts of labor issues in terms of acquiring and maintaining talent? It seems like it would be a tough job right now.
Bravo: I really appreciate that. We feel like we earn it and when you own a whole company, which is what we do, you own all the problems. You can’t outsource the problems. People change their minds. People want to change jobs. You need to inspire your leadership. Customers change their point of view. Their product problems, their sales problems, distribution problems. We live those every single day. The way we do it, we do it in a unique way in private equity, in software, which is we make big positive changes in the companies we buy but we look to do that only with the existing management team. And that’s the secret sauce of our firm…we have a way of talking to leaders and inspiring them to continue to do the great innovative things that they’re doing that are going very well and not interrupt the growth curves of these companies, while implementing an approach where of discipline and operational cadence that allows the company or those businesses to produce more margin while they grow faster.
We are different than most of the world. We do not subscribe to the view that in order to grow, you need to lose money or invest negatively in your P&L. These companies, once you have over $100 billion of ARR – annual recurring revenue – the more profitable you are, the faster you should grow, because you have more money built in from your operation to invest in sales, which is tactical and more money to invest in R&D, which is more long-term and strategic. And we really work with our leaders to put this motion in place and understand that and embrace it so that they can build these long term profitable engines. And what that does, is it de-risks innovation. That way that companies can continue to innovate for a long period of time without having big disruptions to their business models. Or if capital dries up, they’re not dependent on outside capital to continue to grow, grow their business.
Picker: So the mantra ‘growth at all costs,’ do you think that’s not the way the world is right now?
Bravo: That is over. ‘Growth at all costs’ has ended and whoever is still investing and operating in this way, is going to be surprised. It’s changed and it finally has come after a long period of time of just investing behind a total available market and around momentum growth. People are now finally looking at the business economics. And think about it, it’s so basic. How could you create a company, and a large company over time, where the societal resources that you use for production way exceed the output? It just, it cannot last and that’s a bit of a structural problem the software industry has now and groups like us look to fix that.
Picker: How does [the geopolitical situation in Russia and Ukraine] affect the technology sector? Are you seeing a value that technology can provide as we assess what’s going on overseas?
Bravo: The world has become digital and that is now, talking about technology, that is an irreversible trend. And we are at the beginning of that trend. In the last two years when we all had to work from home, when companies needed to do business differently, communicate with their customers differently, transact differently, people began – business leaders in society as a whole began - to use technology that has existed for a long time. But their minds were opened to actually absorb that technology and use it differently. And that created another step function in the world of quote-unquote going digital. Now you see industrial companies trying to go digital, either acquiring and or changing their businesses. Financial institutions, some of them call themselves a technology company with a financial services business model, and that is the trend. Therefore the world is a lot more exposed to cybersecurity risks. And now we are in – yesterday, some news came out starting to talk about it – that we’re also in a technology war. And the importance of cybersecurity as the world goes digital, and especially now, given the geopolitical environment and in essence of war, the importance of cybersecurity is huge.
Picker: You own a plethora of cybersecurity companies. You do have a good sense of the pulse of the technology as well as the premium that investors are paying here for these types of assets, especially as their value-add becomes ever more present. What would you say about just the ability to defend our organizations here in the U.S. and in the West against foreign actors that may be seeking to harm, whether it’s banks or other entities here, our defense organizations here in the U.S.?
Bravo: Thoma Bravo has been in cybersecurity since 2008. We were the first private equity group from a control standpoint to develop a large portfolio in cybersecurity, and today we have $6 billion in revenue. If you put all of our cybersecurity companies together, which make us in total, the largest cybersecurity company in the world. One of the things we saw is three months before the invasion, a huge spike in DDoS attacks – denials of service – mainly coming from Russia. And of course now you see a 10x increase in DDoS attacks emanating from Russia. These attacks are at scale, they are complicated, and even the best cybersecurity technology experts in the U.S. don’t quite know how they pull them off at this scale. So it is so important now that corporations all over the world, and especially in the United States, have a strong, what we call, cybersecurity posture, which is difficult to have because it requires a big investment. It requires pulling a number of products together and it’s also really important that these corporations of any size – you can be a large company or you can be a very small company – buy the best product in each cybersecurity area. Do not buy free product. Free product is worth what it is, it’s free, and that is what it’s meant to be. You do not want to be in a bad cybersecurity posture when you did not invest in your infrastructure appropriately.