It wasn’t so long ago that private equity investors were convinced the slide in tech dealmaking would reverse itself by mid 2024. Stable, if not falling, interest rates would combine with aging portfolios and the industry’s mountains of dry powder to prod the market forward again.

It hasn’t turned out that way.

While deal markets bottomed out in the year’s first half, private investors continue to wrestle with heavy uncertainty about when central bankers may finally ease rates. That, coupled with choppy growth prospects for many software-as-a-service (SaaS) companies, has left buyers and sellers at odds over valuations, resulting in a waiting game. Until we see a meaningful reversal in rates, it is unlikely that tech dealmaking will regain anything like its former momentum.

What we do know already, however, is that investor expectations have shifted during the downturn in ways that have clear implications for how tech assets will have to be managed in the months and years ahead.

Tech investors have historically driven outsized returns in private equity through revenue growth and multiple expansion (see Figure 1).

But in a higher-rate environment, multiple expansion is no longer a given, and investors are looking for a more balanced “Rule of 40”—the oft-used valuation formula suggesting that growth rate and profit margin should add up to 40% or more (see Figure 2).

Figure 1

Historically, revenue growth and multiple expansion have largely driven private equity returns in technology

Figure 2

Valuations today are rewarding a Rule of 40 that balances growth and cash flow

The importance of healthy growth isn’t going away, but assets that exhibit strong growth prospects and robust cash flow are the ones rewarded with premium valuations in today’s market. Consider EQT’s recent acquisition of supply chain specialist Avetta, which sold for $3 billion (including debt), or 24 times its $125 million in projected 2024 earnings before interest, taxes, depreciation, and amortization (EBITDA). 

The renewed focus on profitability is hardly surprising. While dealmaking has slowed, the market is no less competitive. Many of the multi-sector funds that rushed into the software space during the post-Covid-19 boom remain in the hunt, ensuring that prices for any quality asset remain high. Avoiding the buyer’s curse means underwriting the kind of performance necessary to justify those prices. And for the many maturing software segments where penetration curves are flattening, that requires identifying ways to displace existing products, not just selling into whitespace. That in turn dials up the importance of investments in strong R&D and go-to-market capabilities funded out of cash flow.

The investors with a clear advantage in this environment are those adept at boosting EBITDA through operational improvements. Doing so without compromising growth is easier said than done, but the firms getting it right follow a clear set of principles:

Invest (and cut) strategically. Portfolio companies need to match underlying demand and revenue growth targets at a segment or product level. They also need a clear understanding of where they have a unique right to win and what it will cost to get there. Leaders know where and how to rightsize without cutting into muscle. Lower revenue growth targets for a given product line, for instance, might mean rebalancing maintenance vs. new product expenses in R&D to optimize spend. Supporting margin targets by simply asking each function to cut 10% of costs is almost never the right answer.

Follow the money. Go-to-market and R&D are typically the areas of biggest spend for most software companies, making them obvious targets for rightsizing. “Hunting” vs. “farming” accounts, for instance, require different skills and compensation structures, so striking the right balance can point to savings. Fewer projected implementations for a given SaaS product also might signal fewer service requirements.

When one large private equity firm recently set out to combine two promising SaaS companies in the services space, it saw clear openings to cut costs by eliminating overlap in the commercial functions. Doing that without compromising growth, however, demanded the hard work of evaluating the combined pool of customers to understand each one’s full potential and how best to go after it. 

Working from a deeper understanding of customers and segments, the new management team designed the right product initiatives and go-to-market motions to focus sales and marketing on the deepest pools of revenue—effectively creating growth vs. just chasing it down. The strategic rightsizing not only captured $30 million in cost synergies, but it also helped the company identify $7 billion in untapped market whitespace while tagging 100 existing accounts primed for cross-selling. The new company emerged leaner, but it was also significantly more effective.

Get going on generative AI. It’s easy to get lost in the hype surrounding these potentially transformative technologies. But the PE investors gaining the most traction recognize a couple of important things. First, they are accelerating plans to use generative AI tools to boost operational efficiency and effectiveness in areas where there is already evidence of measurable benefit—functions like software development and customer support. Second, they are exploring how to enhance or reimagine product offerings but are realistic about assumptions of near-term revenue uplift. AI needs to be part of long-term strategic planning for any software business, both in terms of offensive and defensive moves. Right now, though, it is critical to get moving on piloting and deploying these technologies in the areas that will pay off today.

Tackle change management head on. Shifting a company’s focus from all-out growth to an emphasis on cash flow and growth inevitably involves the kind of cultural transformation that demands careful management and communication at all levels. When private equity-backed companies miss their objectives, it is often because a gap opens up between those in the boardroom making plans and those closer to the front line expected to execute them. Many organizations will need to change how people work and how they approach the business. They will also have to reevaluate talent based on the imperatives in new value creation plans. A clear strategy to mobilize the organization is critical to success.

Our crystal ball is no better than anyone else’s when it comes to predicting when tech dealmaking will regain its momentum. But we can say this with confidence: The winners in the next upcycle won’t just focus on revenue growth. Instead, they will help portfolio companies build the capabilities that produce profitable growth sustainably.