Downward Pressure on Vertical Software

The economic contraction from the coronavirus pandemic has already hurt business around the globe, and a lot more pain is coming. However, it isn't going to be evenly distributed. Certain industries – notably hospitality, energy and retail – have already been walloped pretty hard and appear likely to get roughed up even more.

Much of that has already registered in the more-visible public markets, with stocks of companies viewed as more exposed to the coronavirus outbreak selling off harder than others. (In the first three weeks of March, energy providers in the S&P 500 Index shed 44% of their value, compared with 'just' 18% in the overall index and only 7% among consumer staples, according to S&P Global Market Intelligence.) Similarly in the debt market, S&P Global Ratings has been busy trimming the outlook for issuers such as hotel chains, retailers, airlines and other industries that have been decimated by the outbreak.

In the more-opaque private markets, where pricing isn't as immediate or immediately apparent as on Wall Street, sector-specific discounting hasn't really shown up. But it is undoubtedly coming. Trend lines don't stop at the edge of PE portfolios.

That's important because PE portfolios are stuffed right now with more companies that sell industry-specific software than at any other time in history. So-called vertical software vendors have been some of the hottest targets for buyout shops in recent years. PE firms did more than four times as many vertical software deals in 2019 as they did at the start of the decade, according to 451 Research's M&A KnowledgeBase. Why the unprecedented attraction to this niche market?

Even horizontal software products, which can be implemented by a wide range of companies across numerous industries, generally have financial characteristics that get buyout shops seeing dollar signs, such as strong retention rates and rich margins. Those are bankable assets. Vertical software has all of those advantages, plus they almost always encircle their businesses in a 'moat,' a concept popularized by public-private investor Warren Buffett.

Because vertical software providers serve individual markets, they tend to specialize. The applications often conform to particular industry regulations or workflow idiosyncrasies in a way that generic, off-the-shelf software can't. That tends to make vertical software even more sticky to its users, which results in higher renewal rates than horizontal software, as well as opening the way to incremental upsells of high-margin new offerings.

All of those financial characteristics appeal to buyout shops, which, in turn, paid up for them during their specialty software shopping spree. (The M&A KnowledgeBase shows they handed out a lavish 7x trailing sales for the vertical software vendors they picked up last year.) Of course, not all of the vertical software companies are serving sectors of the economy that are going to get drubbed during the recession. But those that do get hit are likely going to get hit hard enough to force PE firms to change up their playbooks for the software sector.