Bright Spots in Software: Opportunities for PE Investors

By Viacheslav Romanov, Clark O’Niell, Ravi Prashad, and Vitor Falleiros

Software continues to eat the world. Despite a reduction in private equity (PE) transactions in 2023, enterprise software is attracting significant attention from PE investors. Investors are focusing on the growth story: what’s the real trajectory of these assets and what’s their competitive edge? Investors continue to face limitations in the data available for them for screening and due diligence of both private and public companies, which limits their ability to distinguish between promising and challenging segments.

For private companies in certain countries such as the US, the usual limitation is that financial and operational data is not available for outside analysis, and investors are using time-consuming processes to get access to private financial data. Public companies provide access to their financial (and some of operational) numbers, and private companies in such countries as the UK are also disclosing their financials, though this information comes with delays, and reporting of operational data is often limited. In the software industry, there is an additional limitation, as certain vendors operate in several segments, and segment splits are not available.

For this paper, we used a number of alternative data sources ranging from reviews to segment taxonomies to granular employee headcount data. By combining these data sources using our proprietary data sets and algorithms, and using data science to identify trends, we were able to account for many of these confounding factors and identify signals of promising investment opportunities.

For growth-oriented PE investors, we identified 23 segments that continued to grow in 2023 despite a challenging software market environment. For quality-oriented PE investors, we identified 16 segments that prioritized engineering talent while also showing attractive growth rates.

We picked the following five software industry themes from 2023 that were supported by identified growing segments:

• Generative AI
• Application Development
• ERP
• Simulation and Design
• Cybersecurity

Some of them are well known, with Generative AI being the core theme activating many segments, while others, such as ERP and Application Development, are more under radar.

How are growing segments found in a recessionary software market?

Analysts usually observe growth trends by looking at revenues from public stocks, but such an approach limits observations to mostly large companies and only a limited number of segments. That said, 2023 was the year when the multi-year growth in software came to an end.

The following are the challenges to monitor and analyze in terms of the growth of the software market by segment:

• There is a need for more revenue data for private companies in the countries where its disclosure is not required, as such companies represent the majority of players, especially in niche and emerging segments.
• Some software companies offer products in several segments and it’s unclear how to split revenue or headcount by segment given the absence of segment-specific reporting.
• Timely reporting of new information is necessary in order for changes in trends to be realized.
• Estimates-based market sizing used by analytics agencies involves a lot of assumptions, which means the resulting numbers used to calculate segment growth lack precision.

To overcome these challenges, we looked at alternative data sources in terms of headcount and reviews.

First, to look at the overall software market, we used headcount data, which is available for almost all companies, regardless of size. Based on our extensive access to alternative data sources, we have observed that total headcount growth is usually a good proxy for revenue growth. It therefore was useful to uncover revenue dynamics across all companies, including small and medium-sized ones.

Headcount growth data shows that software companies grew in 2019–2022, with a small break at the beginning of 2020 when COVID-19 started, and small to medium-sized businesses and mid-market companies led this growth. Then, a market correction began and segments of all sizes started to decrease headcount in H1 2023. This trend continued and the speed of headcount decrease accelerated by the end of 2023.

The start of 2024 shows a continuation of this challenging period, with January bringing new notable layoff announcements. Google announced the elimination of hundreds of roles in Devices and Services, with the majority of cuts coming from its augmented reality (AR) team, and dozens in Google X. Veeam is cutting around 300 employees after already cutting 200 employees last year. And the gaming segment is downsizing significantly, with Microsoft cutting 9%, or 1,900 employees, in its gaming division and Twitch cutting 35%, or about 500 employees.

Identifying growing segments in the market with such a declining trend is particularly valuable for investors.

Second, to split growth dynamics by industry segment, we used the number of product reviews as a proxy for each product’s share of revenue and/or headcount.

We received growth data for 168 segments comprising 13 th. vendors and compared CAGR for 2023 (correction period) with that of 2019–22 (growth period).

As previously mentioned, average growth experienced a significant slowdown; the median CAGR for 2019–22 was 7.6%, while the median growth in 2023 was only 0.2%.

Also, there was quite a diverse dynamic among segments for both periods. There were growing segments such as Data Labeling, which grew at 19% CAGR in 2019–22 and 5% for 2023. And there were segments such as Blockchain, which showed 15% 2019–22 CAGR but declined 6% in 2023. This dispersion is important, as it shows that there were enough segments (in the upper right corner of the chart above) that had grown fast and continued to grow in 2023 despite that challenging period in the industry.

There are still enough growing software segments

What growth-oriented investors told us is that they like to invest in companies whose business models show consistent growth in the face of industry cycles. To make such a determination, it’s especially important to use low-delay data when there are significant changes in trends, such as we are experiencing now, as such data allows us to determine that there is still growth.

To address this demand, we split all the segments into three groups: “growing,” “normalizing,” and “correcting,” based on growth in 2023. We found 23 “growing,” 124 “normalizing,” and 21 “correcting” segments.

The list of “growing” segments allowed us to identify software industry themes for 2023:

1. Generative AI is the core theme that activated segments in two directions: first, in using Generative AI to build the next level of knowledge work automation tools such as Productivity Bots; and second, in big data preparation and management such as Data Labeling and Database Software.
2. Application Development is represented by several segments that benefit from continued innovation in the application development process.
3. ERP is driven by a trend toward modernization. A connected segment is HR Management systems benefiting from new vendors challenging incumbents.
4. Simulation and Design is driven by both the growth in functionality in the existing platforms that focus on virtual or physical design and a wave of innovators challenging established vendors.
5. Cybersecurity is a multi-year theme supported by continued cloud migration, remote work, and growing complexity in IT infrastructure.

Based on our IT Spending Pulse #6 of Q4 2023, in four of these themes, IT buyers are expected to have spend increase in the next 12 months. This forward-looking perspective supports the attractiveness of at least four identified themes for 2024: Generative AI, Application Development, ERP and Cybersecurity.

Deals and positive developments in individual companies highlight investors’ interest and growth in the identified segments.

2023 was a year when Generative AI received a lot of investors’ interest, and it’s not surprising that the year was kicked off by a $10 billion VC investment in OpenAI by Microsoft in January, which became the largest VC deal globally that year.

In the Data Labeling segment, a UK-based training data platform, V7, which had received $33 million in Series A investment in November 2022, increased its number of employees by 27% in 2023 after achieving 41% CAGR in 2019–22. Among other recent announcements for V7 were partnership withs AWS in October 2023 and Amazon SageMaker in November 2023 for labeling medical images in healthcare.

The bright spot in the integrated development environment (IDE) space is JetBrains — a Prague-based company specializing in development tools and whose clients include 90 of the Fortune Global Top 100 companies. The company is privately owned and has attracted no external investors. Bloomberg estimated its value at $7 billion in 2020. It was founded in 2000 and grew its headcount for many years; for instance, its 2008–19 CAGR was 16%. It has continued at a similar speed, with a 2019–22 headcount CAGR of 13% and growth in 2023 accelerating to 15% despite an industry downturn.

Another company in the IDE segment, Italian-based Arduino, raised $22 million in September 2023 to extend its Series B round of funding. The company has an electronics prototyping platform and a software IDE that is used for IoT and other applications. It grew its number of employees at 8% CAGR in 2019–22 and accelerated the growth to 9% in 2023.

HR Management Software is an example of a more stable and mature segment that continued to grow in 2023, largely driven by an increase in the importance of talent management and new vendors coming to the market to satisfy this demand. One of its players, ClearCompany, a provider of talent management software, was acquired in a leveraged buyout (LBO) by Gemspring Capital Management in September 2023. The company grew its number of employees by 12% CAGR in 2019–22 and kept it at 2% in 2023. It had been growing its installed base for the previous 10+ years, based on HG Insights data, which demonstrated a clear growth profile that led to the LBO.

HR niche player Darwinbox, based in India, drew interest into the segment from both global and local investors, raising $72 million in Series D funding in January 2022. In January 2023, it secured an investment from Microsoft and announced a collaboration in which it would integrate its platform with Microsoft’s ecosystem. It has also been included in the Gartner® Magic Quadrant™ for Cloud HCM Suites for 1,000+ Employee Enterprises. It grew its employees at 64% CAGR in 2019–22 but slowed down growth to 5% in 2023, which was expected in order to readjust its teams and strategy after such a strong growth period and investments received.

The growth of AI and machine learning (ML) has led to new demand for data storage and data processing, which is reflected in the continued growth in the Database Software segment. One of the largest beneficiaries of this trend is Databricks, which raised more than $500 million in its Series I round in November 2023. It also increased its headcount by 21% in 2023.

The Simulation and CAE segment was confirmed to be top of mind among investors and have considerable growth potential after the announcement that Synopsys will be acquiring Ansys in a $35 billion deal. The motivation for the deal is to build integrated silicon into system design solutions, which underscores that there is a place for product innovation in the segment.

Among 21 “correcting” segments, seven showed fast (≥10%) headcount CAGR in 2019–22. Some of these segments, namely Blockchain, On-demand delivery, Webinar, Augmented Reality, Live Chat, Help Desk, and Freelance Platforms had experienced high demand during COVID-19, overbuilt their teams, and are now adjusting them. Blockchain and Augmented Reality are also examples of segments that were growing fast before COVID-19 and then corrected; thus, these technologies haven’t yet reached their expected adoption rates.

Investors seeking high-quality growth should look at software segments that are prioritizing engineers

Other groups of investors would like to invest in companies with robust business models that have high barriers to entry and low sensitivity to economic or industry cycles. Our experience indicates that these investors care about top-line growth and competitive differentiation — in other words, they look for high-quality growth.

Our analysis shows that proxies for these different factors are different pools of employees — specifically, engineers and salespeople. Analysis of public software companies’ financials shows that a high ratio of engineers to salespeople leads to higher total shareholder return and return on capital, which in turn are top financial indicators for investors.

This data-science-driven logic is supported by the fact that ownership of unique IP and products is a way to build a strong competitive position and command margins in the market, while a high share of sales employees may lead to continued pressure on margins.

Here’s why we looked at headcount structure and growth of engineering and sales teams separately. Among the analyzed companies, the average share of engineers was 35% and quite uneven by segment, showing that companies were using different strategies in forming teams.

What is also relevant to analyze is change in engineering headcount vs. change in sales headcount. In a downturn, it’s important to protect engineering teams despite the need to cut costs and overall headcount, as they are core for long-term investment returns. When a company’s engineering team is growing fast, it must also be investing in the future by building new products. If a sales team is growing faster, the company should be focusing on monetization its existing products.

The following chart chows our analysis of changes in engineering and sales teams in 2023, by segment:

Segments that grew engineering teams faster than average for the same growth in sales are below the trend line. Examples of such segments include those whose business model depends on complex algorithms and clearly requires strong engineering teams, namely Generative AI, Database Software or DS and ML Platforms.

Analysis of growth of engineering and sales teams allowed us to identify 16 growing segments that prioritized engineers. Below is the list, ordered by headcount growth in 2023:

Four of the resulting segments are part of the 23 “growing” segments, and 12 are from the “normalizing” group. This demonstrates the known compromise: higher quality may lead to slower growth. The Cybersecurity theme represents four of them. Let us highlight here some deals and developments in these segments that support their attractiveness:

In Email Security, French Vade is focusing on threat detection and response and received $30 million in VC investment in May 2022. It March 2024 it was acquired by German Hornetsecurity Group, a cybersecurity company backed by SG Equity, TA Associates and Verdane. Vade claims to protect 1.4 billion mailboxes globally and is positioned as a leader in G2 Grid® for Cloud Email Security and for Email Anti-spam. It grew its employees at 15% CAGR in 2019–22 and continued at the same rate in 2023.

In Identity Management, Nord Security, based in Lithuania and developer of the well-know NordVPN tool, received $100 million in VC investment in November 2023, which doubled its valuation to $3 billion over its previous round in April 2022. It grew its employees by 66% CAGR in 2019–22, but slowed down growth to 13% in 2023.

SpyCloud, a US-based vendor in the Web Security segment, focuses on protection of digital identities and received $110 million in its Series D round in August 2023. This investor interest is supported by its headcount growth: 40% CAGR in 2019–22 and 29% in 2023.

Some segments demonstrated clear protection of engineering while implementing cuts in sales, including the following:

• Product Management: growth in engineers in 2023 by 6.2% while cutting sales by 0.6%.
• DS and ML Platforms: continued growth in number of engineers by 2.1% in 2023 while implementing a 2.9% cut in sales.

The next step is to analyze companies in promising segments

Investing in a downturn requires separating weak segments from those that continue to grow despite challenging market conditions. Our analysis allowed to systematically look at segments of mostly private software companies, including small ones, estimate their growth, and identify 23 segments that push growth and 16 segments that offer a balance between growth and quality.

These two lists of software market segments can help PE investors in software to focus their target screening efforts and identify the following:

• Big-enough targets for growth investments or buyouts
• Targets for bolt-on acquisitions for portfolio companies
• Ideas for new, in-demand products for portfolio companies

The next steps should be screening and analysis of individual companies in the identified segments.

BCG’s PIPE and X teams use advanced analytics to uncover hidden trends in tech markets, and this post is just one example of our work. Our extensive alternative data resources and ring fence of data scientists and proprietary analytical tools allow us to find answers to due diligence questions for targets in different segments from different countries.

This analysis was designed for high-level identification of growing and promising segments of software companies using only two alternative datasets with categorization, reviews and headcount data.

There are other steps that could be taken to address PE investors’ questions regarding screening and due diligence phases, including the following:

• Diving deep into company levels and identify growing high-quality companies
• Looking at the quality of growth: staff attrition, etc.
• Evaluating strength of engineering teams by looking at job history and career traction for key team members
• Evaluating companies’ competitive position by looking at their software installation bases
• Evaluating product quality by text analysis of reviews