Olivier Wolf, TMT Transaction Advisory Services leader at EY; and Eric Sanschagrin, head of TMT Transaction Advisory EMEIA, discusses how the tech sector is fuelling IPOs in the UK.
Technology vendors accounted for roughly one third of the £2.8bn in total proceeds raised in UK IPOs during the second quarter of 2018, according to EY’s latest IPO Eye. Although far from the purple patch of 2014-15, which saw a number of tech-focused businesses come to market in rapid succession, tech listings are now fuelling the London IPO market.
That’s quite a notable performance given the broader political and macro-economic outlook, as well as the tendency for IPO volumes to seesaw in tandem with investor confidence and market sentiment. At the same time, global M&A volumes in the technology sector have been running at an average of more than $350bn over the 2015-2018 period, an increase of more than 100% over the 2011-2014 period. We estimate that software accounted for more than 50% of technology sector deal volumes over recent years, while hardware-centric sub-sectors such as semiconductors and communication systems have become increasingly marginalised. Based on data compiled by EY, the average multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) paid by acquirers for software vendors has been creeping up steadily; where the norm over a decade ago may have been to value software vendors at high single digit multiples of EBITDA, the last twelve months have witnessed many transactions at EBITDA multiples in excess of 20.
While the software business model has always displayed attractive features for investors such as low capital intensity, high margin and potential for strong revenue and earnings growth, a number of more recent trends have driven this upward tendency in valuation multiples:
Recurring revenue models with low customer churn: Software vendors, particularly those providing software as a service (SaaS), achieve a higher proportion of contractually recurring revenue. This compares with what software vendors relying on term or perpetual license sales were used to in the past and investors are justified in attributing higher value to recurring cash flow.
Market with sustainable and resilient growth potential: Software sits at the very heart of the digital transformation sweeping through the majority of traditional industries at the moment. This is creating conviction among investors that demand will remain sustainable, strong and resilient to potential economic swings.
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Broadening appetite from strategic buyers: Market participants across all sectors are embracing technology to get closer to their customers via a better web presence. They are also bringing greater levels of efficiency and automation to their business processes using robotics, artificial intelligence and the Internet of Things. Through this they are becoming potential acquirers of software companies, tilting the M&A supply/demand balance.
Private equity invasion: If growing appetite for software from more traditional industrial participants has driven M&A interest higher, this pales in comparison with the impact private equity has had on the sector in recent years. While only a limited number of specialist firms used to invest in technology, nowadays almost all generalist private equity firms have identified technology – and software in particular – as a core area of focus, adding significantly to the supply/demand imbalance.
This positive investor sentiment towards software is reflected in the current strong IPO window. But history tends to repeat itself and IPO windows open and close with little notice, driven by shifts in market sentiment.
With continuing geopolitical uncertainty, it is understandable that institutional investors are jumping on the bandwagon while the market is open. Regarding current valuation levels however, the factors driving multiples higher appear permanent in nature, so while a reversal of trend is likely at some point, the days of single digit EBITDA multiples do not appear likely to return any time soon.