Software M&A - the engine of tech enablement and transformation as the outlook for M&A brightens

However, the resulting valuation premium for growth was not sustainable. Increasing interest rates, inflationary pressures, regulatory uncertainty as well as the changing competitive landscape — all contributed to the unwinding of this valuation premium and the correction of software valuations to a level slightly higher than pre-pandemic valuations.

As we move into next generation technology, businesses that can genuinely prove AI product enablement will command a valuation premium that should accelerate growth.

Chart 1 and Chart 2 reflect software valuations in the public markets; the pricing correction has not been as severe for private companies and mid-market transactions have continued at a good pace.

^{Source: S&P Capital IQ
Notes: Top 100 software companies by size (enterprise value). The top 100 companies were assessed each week and, based on each company's trading revenue multiple in that month, the 100 companies were split into 10 deciles i.e. decile 10 being made up of 10 companies with the highest Enterprise value (“EV”)/last twelve months (“LTM”) Revenue multiple.}

Assessing performance and valuations

A key metric for assessing the performance and valuation of software companies is the Rule of 40 that states that the sum of revenue growth rate and free cash flow margin should be equal to or greater than 40% to identify high performing businesses.

At the peak of the market, there was a large divergence in the Rule of 40 metrics across the 100 largest software companies. The Rule of 40 was heavily skewed towards growth with companies being rewarded by investors for pursuing growth at all costs, as shown in chart 3. What we now see is significant convergence across the peer set, with formerly high growth businesses now taking a big hit on valuation multiples as a result.

Chart 3

^{Source: S&P Capital IQ
Notes: Analysis is based on top 100 software companies by EV, at each of the specified dates. Flexible peer groups and quintiles have been assessed based on the LTM revenue multiple at each point in time. Bubble size reflects the company's LTM revenue multiple.}

We note that there has been a decline in the number of companies that meet the Rule of 40 as growth expectations have moderated somewhat.

UK vs. US market

When comparing the UK and the US software market, it is commonly thought that US companies are awarded and trade at higher valuations, although this is more likely driven by the companies’ size rather than the operating territory. Given the comparatively larger size of the US market, companies based here typically have access to a larger market which is reflected in the potential growth opportunity. In the UK, on the other hand, only two software companies out of Top 10 by Enterprise Value (Sage and Darktrace) have consistently displayed a valuation of above £1bn.

Mid-market software companies (with EV from £100m to £1bn) in the US and UK did not observe the same price premium for the largest global software companies in 2021-2022, but traded at more stable valuation multiples over this period. Additionally, mid-market valuations across the two territories have tracked much more in line with each other.

UK companies are increasingly expanding into the US market, for example Sage, Access and Iris. This reflects a more active expansion strategy as historically such expansion was largely driven by inbound investment from the US and other global investors.

Chart 4

^{Source: S&P Capital IQ
Notes: 23 US publicly listed companies with the EV in the range from £100m to £1bn were considered.}

Transactions

Deal activity in the software sector shrunk between Q2 2022 to Q3 2023. Higher interest rates and inflation as well as global geopolitical uncertainty have led investors to be more cautious, to apply greater scrutiny and to challenge investment decisions. Mega deals in particular have been more difficult to execute, driven by costly debt financing and a drop in valuations, both of which are deterring sellers from coming to market.

Despite this, we saw some large software deals complete in the UK over the last 12 months, including Blackstone’s acquisition of Civica for $2.5bn in November 2023, Leonard Green’s acquisition of Iris Software for $4.0bn in December 2023 and Thoma Bravo’s acquisition of Darktrace for $5bn.

Deal activity in the UK mid-market is broadly in line with levels observed over the last three years and shows signs of gaining momentum. UK corporates continue to pursue their buy and build strategy, including Clearcourse (acquired Harbour Assist and GOb2b in October 2024), Software Circle (acquired Link Maker Systems in July 2024, Be The Brand Experience in May 2024 and ARC Technology in February 2024), Iris Software (acquired SwipeClock in May 2024 and Blue Octopus in September 2023) and Access (acquired Paytronix Systems in November 2024 (announced), Hire Ara AI and Tradify in October 2024 and QikServe in September 2024).

Following the pandemic, large software companies, particularly in the US market, were significant beneficiaries of the valuation uplift; however, at the mid-market level, valuations of UK and US companies did not diverge that much. A lower level of volatility at the mid-market level also meant that mid-market software transactions continued at a reasonable rate whilst larger software deals pretty much dried up for a while.

As valuations have now moved back more in line with historical levels and inflation moderates, the need for transformational M&A continues and sponsors need to deploy capital and exit investments. Momentum is building in deal flow, including a return of larger deals and software will continue to be one of the main drivers of deal activity in the market and of transformation in the wider economy.