Private equity’s destructive role in chasing the golden goose of the EHS software industry
Around the time when Obama stepped into the presidency in 2009, the venture capital industry began investing aggressively in EHS and Sustainability (EHS+S) software companies, with some well-known names from Sand Hill Road pouring millions into startups like Hara, PlanetMetrics, C3, ENXSuite, and others. More than 100 startups were funded in less than 18 months in anticipation of the new administration implementing a cap and trade program. VCs were poised to profit from the inevitable market demand driven by the expected regulations.
Much of the VC money went into sales and marketing and buying research analysts’ ratings. Gartner named a few of these startups as “market leaders” and almost overnight, they became Silicon Valley “success stories.” But did they?
Today, all of these companies are either gone or have “pivoted” to different industries. Customers who signed up with them have nothing to show for their investments — they would have been better off staying with their spreadsheets than switching to these Gartner-proclaimed “market leaders.” Cap-and-trade never happened; most of those startups vanished before they could even show their software because everyone followed a herd mentality of chasing a single regulatory driver, a valid function for enterprise-scale carbon reporting, but limited unless linked to other EHS applications and automated financial (and ideally real-time) operational data. The industry — and the world — missed an opportunity to tackle a major problem in the race to address climate change.
There was a critical disconnect between what the EHS industry needed to move forward as an innovative force in the world of environmental tracking and risk mitigation, and VCs’ unrealistic return expectations, which hobbled any hope of these companies reaching a sustainable business model.
A VC’s main goal of harvesting the maximum potential profit from its investments is inherently one with a very short time horizon; as such, VCs tend to be short on patience for the type of development these startups needed to become viable.
We are now entering chapter two of this story, but with two notable differences:
- Venture capital has been replaced by private equity
- The investments being made today are not in startups, but in existing companies that, unlike the startups mentioned above, survived the crisis, but have since hit turbulent waters because their business models have not worked either.
What’s unchanged? Research analysts following this industry (only a very small handful are left after Gartner pulled out in 2014) are again naming winners and losers too early and confusing customers shopping for EHS software. You can probably bet that an EHS software company will not be in the upper-right quadrant of the research analysts’ ratings (green quadrant, magic quadrant, or whatever quadrant they call it) unless the company has received private equity funding (with at least a part of that funding being used to pay research analysts to “facilitate the rating”). Or, it is a part of a much larger organization that paid its dues through some other part of its business (such as SAP).
What is astonishing is that some industry research analysts, who are supposed to help companies understand the market and pick the best vendors, completely miss what is happening in the EHS software industry.
Behold the problem with letting VCs and rating agencies define the space: Analysts praise failures and describe the injection of private equity capital into EHS software companies as success stories, when in fact this money is not a lifeline to keep the ship from sinking, but a millstone around their necks that drives these companies to the bottom faster, just like their predecessor startups.
When you measure companies based on how much venture capital or private equity money it has raised over those that have bootstrapped their companies and prepared them for steady growth and a long life, you’re using the wrong metric for business viability.
Venture capital and private equity investments work well in industries positioned for explosive growth, especially when a company needs a lot of capital to scale up quickly as it may otherwise miss the market opportunity at hand. Many of those big returns have been with B2C software ventures.
However, there isn’t a one-size-fits-all approach just because we’re talking about another type of software, and trying to apply that lens to the EHS industry has stymied the industry’s ability to get viable options to customers.
Environmental and sustainability software is still a young industry that is growing slowly but steadily. It is not positioned for the explosive growth that we have observed over the last decade in the social media, search engine spaces, or other consumer oriented web software.
Some believe that raising money is a prerequisite for success and a successful “exit strategy.” A successful exit strategy is all about selling the business after building it to the level of success that it becomes attractive to other, more established industry players, to be acquired and expanded. At that point, the founders are rewarded for their hard work and the value they created.
What is happening now in the EHS software business, where company after company is accepting private equity funding, is the opposite of what the business definition of an “exit strategy” should be. For most of the EHS software companies that have fallen victim to private equity investments over the last 18 months, their exit strategies are not about getting the funding to grow and expand. Instead, they are a means for the owners to extricate themselves from a situation that is increasingly becoming more difficult and unpleasant, or to pay off accumulated debts.
Typically, these investments by private equity firms have resulted in majority ownership stakes in their acquired companies. By definition and depending on the fund size and investment strategy, a private equity firm will seek to exit from its ownership stake in three to five years ( see Intelex) to generate a multiple on invested capital of about 2 to 4 x and an internal rate of return (IRR) of around 20–30 percent. In today’s EHS software space, with an extended sales process that typically lasts from one to several years, obtaining these types of returns is simply not possible. For a typical Fortune 100 company, it takes about two years to select an EHS software vendor from the moment the management decides to do so. It takes another two to three years to implement the software. In some instances, this “process” can last a decade as the company management is more comfortable being in the process than actually committing to a decision. Another reason why it is not possible to obtain the desired IRR is that all acquired companies have high overhead structure because of the single tenant software architecture.
A discernable pattern of churn
In 2015, within days of a private equity firm buying Enviance, an EHS software vendor, it did what private equity firms frequently do: It indiscriminately cut a lot of jobs, including domain experts and key managers who had built the company. That’s life in the private equity world, where layoffs are part of the playbook. Many customers were shocked, and some are still looking for their exit strategies. But where do they go after they already invested in one company with a questionable future?
Private equity firms acquire companies that are often underperforming or on the brink of failure. Historically, they made money by buying troubled companies, restructuring them through layoffs and other cost-saving moves, then reselling them. A private equity firm is only a middleman and a temporary owner of the companies in which it has no interest to grow other than to sell as soon as it finds a buyer who is willing to pay more than they paid.
We can assume there’s no difference between the EHS business sector and other industries for why they have been targeted by private equity; it follows that the EHS software companies that have been acquired are troubled companies, even if rating firms have called them market leaders thanks to some creative interpretations of the facts. Why are private equity firms so aggressively investing in this uncertain industry? The reason is that they are all in financial trouble, and private equity firms are hoping that they can act as a catalyst for the consolidation of some companies to create a market leader that could be sold to one of the majors when the market takes off.
Enablon, Enviance, Intelex, Medgate, and many other EHS + S software providers that have sold themselves (or a large portion of themselves) to private equity firms are in this compromised position.
After some years trying to roll up the market, IHS gave up because the task is not simple, space is complicated, and the market is not opening or growing fast enough. Rumor has it that Enablon, or its private equity owners, is aggressively shopping for a round-two investment. It is becoming hard to manage multiple instances of implemented software and customers are noticing it.
I believe these companies had no option other than to put themselves up for sale as they never reached profitability and simply ran out of money and could not keep their operations afloat. Conversations with employees from many of the already acquired companies suggest that all struggled with cash flow and profitability issues before being put up for sale.
What is conspicuously missing here is a lack of strategic buyers, companies that are well established in their vertical markets and could use this unique market situation to expand their domain offerings, that is, companies like Oracle, SAP, and IBM. Of all the major players, only SAP showed an interest in this space with two notable acquisitions, Clear Standards in 2009 and its subsidiary TechniData America in 2010. Both of these followed the VC hype of the time. With their non-existent cloud strategy, neither acquisition took hold in the marketplace, and for all practical reasons, SAP is not a major player in the EHS space.
The failures of EHS software companies are not attributable to the size of the addressable market. Even non-believers in climate change agree that companies need to keep track of their emissions and consumption and eventually be taxed on them (if for no other reason than to control their operational expenses). Almost everyone agrees that the EHS and Sustainability Software market will one day be huge, perhaps bigger than anything we have seen so far, but the market will not take off like a hockey-stick-shaped curve, nor will it be served by vendors that built their software on the wrong software foundation (i.e. single tenant or ASP). Instead, the market will eventually reward those companies that are patient and who have a well-thought-out strategy for scaling their business to meet current and future customer requirements, not private equity firms that will need to cash in on their investments in three to five years.
Additionally, customer requirements will not be looking for one-vertical applications like incidents, carbon, or water management, but rather offering a software platform that integrates energy and environment-related sustainability and compliance attributes into the enterprise- or supply-chain-scale systems of records, such as ERP solutions. This complements the emerging market for building information management systems, especially when combined with analytics or business intelligence layers.
One of the biggest drivers of the EHS and sustainability market in the coming years will be the convergence of climate change, water, and energy crises. All of these elements must coexist along with compliance activities in an integrated, highly scalable, and real-time software platform that only a modern, multi-tenant cloud architecture offers.
If we consider how long it will likely take to get the necessary regulatory framework in place, it’s clear that only those companies that have the fortitude to stay in business over the long run will be poised to reap the benefits of the regulatory changes once they go into effect. We will not be able to rely on “sexy” environmental startups to fulfill this crucial role, nor on a tired group of companies stuck in 1980s software technologies: They won’t have the depth of knowledge in the industry to be able to respond in a quick and meaningful way to the demands facing the industry, so their ability to turn a profit will be moot.
The bubble to the rescue?
In 2009 Matt Taibbi wrote an article in Rolling Stone magazine, “The Great American Bubble Machine,[1]” in which he described five market bubbles that happened from 1929 to 2009. He predicted that the next, bubble number six, will happen, and it will be engineered around climate change. He said “Cap-and-trade is going to happen. Or, if it doesn’t, something like it will.” And private equity investors know this. It almost doesn’t matter who wins the White House in 2016; climate change is real, and governments around the world will have to deal with it.
With this prospect looming on the horizon, private equity firms are hoping that they will combine some of the existing companies, repackage them to create a $100M company, and sell it to one of the major software vendors.
Unfortunately, that is not the path forward for viable EHS+S companies to establish useful software products to serve the needs of the global business community. Members of the EHS+S industry who shook hands with the private equity devil are no better off for all of the money thrown at various companies.
What the industry needs is time to develop the right software on the right platforms, rather than getting swept up in the Silicon Valley greed machine. These companies need to get out from under the watchful gaze of the VC and private equity players looking for ways to harvest money from them and get back to work on ensuring the maturity and long-term viability of their products.
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[1] The Great American Bubble Machine, BY MATT TAIBBI April 5, 2010
