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In the past five years of software investing, a volatile macroenvironment has created an unprecedented series of ebbs and flows. A period of breakneck intensity and investment was followed by a few challenging years. Now, investors are reflecting on the past and developing a more nuanced—and ultimately optimistic—view of software investment. In today’s environment, a significant volume of dry powder is still available, chief information officers (CIOs) have reopened spending, and rebalanced valuations have led investors to reengage on potential transactions.
About the authors
This article is a collaborative effort by Darren Handoko, Vish Narayanan, Alfonso Pulido, Kent Santin, and Varsha Verma, representing views from McKinsey’s Private Equity & Principal Investors Practice.
We have identified five key considerations to keep in mind as software investors prepare to engage with this new set of circ*mstances.
1. The slowdown of private markets in software is an opportunity for investors
Twenty years of continued multiples expansion is slowing down, with private equity multiples in software dropping significantly after years of steady growth (Exhibit 1). These factors, paired with a challenging deal environment and previously unrelenting valuations, have let dry powder pile up.
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2. Generative AI is driving waves of early disruption across software segments
Generative AI (gen AI) continues to be seen as a transformative factor in software, enabling both disruption and innovation, with an estimated $250 billion of potential spending on gen AI applications, according to McKinsey analysis (Exhibit 2). In the near term, traction will affect certain key domains, primarily high-impact software categories. Sales and service technologies, for example, are experiencing a near-term valuation boost driven by an active market for new requests for proposal (RFPs).
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3. Software buyers expect to increase spending—with caveats
Overall, CIOs are expected to continue to spend on software, accelerated by an increased dependence on and use of software to realize gains in efficiency (Exhibit 3). Vendor consolidation should remain the norm, except in areas with large amounts of innovation, such as data.
That being said, spending will likely not be even across software categories (Exhibit 4). According to data from McKinsey’s 2023 CIO Survey, spending in cybersecurity and data and analytics will likely increase as companies persist in developing their gen AI capabilities while continuing to secure their application and infrastructure stacks. The gen AI movement has also created positive spending expectations in categories in which gen AI use cases are anticipated to help businesses realize incremental results, according to McKinsey survey data. This is particularly true in sales, supply chain, customer service, and industry-specific applications. Meanwhile, spending on human capital management and finance is expected to remain more stagnant.
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4. Investors are rethinking their software investing approach
A slow 2023 delayed capital deployment, leading to accelerated sales processes for “long-in-tooth” hold periods (Exhibit 5). Continued fragmentation is expected within certain domains (for example, data) that will create headroom for thematic investments, with investors also exploring long-term bets, carve-outs, and take-privates.
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5. The last mile has high potential for value creation for software companies
Software companies contemplating exiting in the next 12 to 36 months could consider proactively implementing improvement initiatives. There is a wide disparity between top and average performers in realized value creation for software companies, with some companies creating a five- to tenfold increase in enterprise value (Exhibit 6). This is mostly being accomplished through targeted revenue, M&A, and operational improvements (Exhibit 7).
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From our conversations with more than 100 investors and their portfolio companies in 2024, we are seeing enthusiasm for and commitment to applying these five engines of software value creation. With that said, investors and software companies are considering a few levers to be disproportionate priorities in 2024: pricing and packaging, go-to-market effectiveness (including the rejuvenation of new logos, renewals, sales force coverage, and channel strategy), cloud “FinOps” to tackle the complexity of cloud adoption, R&D effectiveness and productivity (in particular, by extending current initiatives with the infusion of gen AI), and M&A.
Darren Handoko is a consultant in McKinsey’s Bay Area office, where Alfonso Pulido is a senior partner and Varsha Verma is an associate partner; Vish Narayanan, who leads McKinsey’s software private equity work, is a partner in the New York office; and Kent Santin is an associate partner in the Seattle office.
The authors wish to thank Tejas Shah and Joshan Abraham for their contributions to this article.
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