A Due Diligence Checklist During Recessionary Environments for Private Equity Investing in Tech

A Due Diligence Checklist During Recessionary Environments for Private Equity Investing in Tech

Economists and financial experts can continue to debate whether we are either approaching or currently in a recession. While the uncertainty factors—interest rates and inflation, growing reports of a slowdown in enterprise spending, an increase in company-announced layoffs, currency risks—are real, barring a significant exogenous event (e.g., geopolitical, environmental, macroeconomic), deal activity will continue and the market will remain competitive for high-quality companies.

There are still resilient industries with bright spots that will keep investors interested. Additionally, well-capitalized companies may now be challenged with achieving growth targets, which may make M&A more necessary to help drive continued company expansion.

However, deals in this environment will necessitate investors adjust their current process to navigate current market conditions more successfully. Stax provides a checklist to help private equity investors prepare evaluations of deals during periods of economic uncertainty.

Secular Over Cyclical Growth

Investment theses that are underpinned by a secular growth story, whereby a company’s growth is driven by underlying technological and demographic trends, independent of business cycle fluctuations, are more advantageously positioned. For example, digital transformation, cloud computing, cybersecurity, and automation (e.g., workflow, industrial tech), are durable growth trends that will prevail over current economic conditions. These end-markets continue to drive new advancement and disruption and allow them to better withstand short-term pressures and stand out relative to the broader market.

Mission Criticality

More than likely, organizations may be forced to grapple with budget cuts. Within organizations’ tech stack, those solutions that serve as a “system of record,” acting as the authoritative source of truth for a business, will be more insulated. Conventionally, finance applications (e.g., ERP) have been prioritized as the system of record, but organizations have expanded the term to applications such as HR, CRM, and operational software. Understanding where solutions rank within a company’s tech stack will help determine the degree of volatility that a target business may experience.

Solve for Q

Without question, Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are important metrics to evaluate the health of software and SaaS companies, viewed as an indicator to assess the reliability, predictability, and growth of company revenues. However, as a company’s growth may come under pressure, it may not be clear what’s driving the change in ARR/MRR performance, price compression (P) or a change in customer demand (Q). Unpacking a company’s performance to evaluate quantity (Q) of demand (e.g., customers, contracts, etc.), will help validate the stickiness and value of a company’s products and services to its customer base.

Evaluating Pricing Power

Similarly, an examination of a company’s pricing power (P) — the extent to which a company can raise prices over and above costs — will help provide insight into the strength of a company’s unit economics or potential for margin compression in the wake of a downturn. Historically, companies that possess brand strength, market share, and/or companies that are more geographically diversified are able to maintain pricing power. However, investors must consider a long-term perspective of a company’s pricing power.

A longer-term historical analysis of pricing trends may be particularly important as the Covid-19 pandemic and cost inflation have enabled companies to pass through price increases. Examining whether companies have taken a more measured and strategic approach to pricing or whether current market conditions have led to an exploitation of power, will help provide guidance for investors on whether a company can maintain margins in a more challenging market.

Find the A and B Customers

Not all customers are equal in value. Investors should complete a market segmentation to identify a company’s most profitable customer segments which will help investors understand customer opportunity risk. Once top segments have been identified (A’s and B’s), a voice of customer analysis can help discern what customers care about, alignment of a prospective company’s value proposition to its customer base, and identification of additional needs can be addressed by the target company. These insights can help investors understand the runway for growth within a company’s existing customer base, particularly when the pace of new customer acquisition may be slower in a more challenging economic environment.

Without question, diligence processes have always possessed a rigor unto itself. However, current economic conditions will likely reshape strategic considerations. Investors need to more proactively embrace and adjust their current processes in response and the checklist offers up additional factors to consider for validation and pressure-testing a company’s positioning in the face of challenging macro conditions. In turn, these insights can be utilized to help identify attractive investments in an otherwise unsettled market.

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