Breakingviews: 2024’s biggest US software LBO has some good omens

Squeezing money-losing but fast-growing software companies for profit is an ideal private equity pitch. Problem is, banks shy from offering return-boosting debt when profit isn’t involved. As Vista Equity Partners and Blackstone close in on one of the year’s largest buyouts, they will likely tap private lenders for loans based on revenue, rather than cash flow. That’s bitten Vista before. This time, though, there are reassuring signs.

Vista and Blackstone are discussing a $56-per-share offer for Smartsheet, a developer of collaboration software, Reuters reported on Monday. At nearly $8 billion in equity value, it would be the year’s largest U.S. private equity software buyout, according to LSEG data, though slightly shy of TowerBrook Capital Partners’ deal for most of R1 RCM, after including debt.

Smartsheet fits a certain mold: it snags customers on recurring subscriptions, spending heavily to chase growth. Marketing spend is set to hit 42% of revenue this year, Visible Alpha estimates show. For private equity, whose forte is budget discipline, the question becomes how much the top line will suffer when it starts slashing costs. But the basic playbook is aided by Smartsheet’s “net retention” rate of 113% – meaning that clients signed up in one year, as a whole, are spending more the next. Right now public markets are uneasy with the trade-off between growth and cost-cuts. So for LBO shops, there’s an opportunity.

Assume Vista and Blackstone get 30% of the deal’s value, net of cash, in debt. If revenue growth stays steady, EBITDA margin climbs from this year’s expected 19% to 25%, and Smartsheet sells in five years for a market-standard 6 times sales, returns would be around 20%. That’s fine, not amazing, but there’s room for more cutting, too.

Of course, buying a money-losing company is inherently risky, making banks leery. Private lenders like Ares Management or Blue Owl Capital have filled the gap. During Covid-19’s boom, they offered a spate of loans backed by companies’ recurring revenue, betting that buyers can excavate cash flow from steady subscriptions. So far, those deals haven’t produced many blowups – even if, of 109 recurring-revenue loans surveyed by S&P Global in June, 76% were rated in the diciest rungs for default risk.

There’s an exception: Pluralsight, latterly owned by Vista, had to hand over the keys to lenders in August. Various factors soured that deal – not least that Pluralsight is less enterprise software, more online education temporarily boosted by Covid-19. Still there might be light at the end of the tunnel for deals with less thesis drift. Thoma Bravo, a serial acquirer in recent years, is preparing an initial public offering for Sailpoint Technologies, acquired in 2022, Bloomberg reported. That exit would at least provide a reasonable path to tread.