Orlando Bravo, a private equity investor in the tech industry, claims that the approach of prioritizing growth above all else is no longer sustainable.

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This year, the software sector has been one of the poorest performers, with a rising interest rate environment and geopolitical tensions abroad contributing to its poor performance.

Orlando Bravo, head of tech-focused private equity firm Thoma Bravo, states that the "growth at all costs" mentality is no longer applicable, as investors are increasingly prioritizing fundamentals and profitability over momentum.

Bravo discussed with the Delivering Alpha newsletter his views on the structural issues in the software industry, the revaluation in tech, and the increasing cybersecurity threat originating from Europe.

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What is your take on the recent revaluation in the tech sector, given the significant shift that has occurred in 2022?

Orlando Bravo: The recent correction in multiples of growth stocks, which went from 20x to 10x, is due to investors becoming tired of money-losing operations. They are now focusing on when profitability will come and discounting assets that have high growth but no near-term prospects for profitability. This correction is great for our business because we focus on buying the entire company, not just pieces of paper, and we excel at taking high-growth, innovative companies and creating profitable growth engines.

Do you believe that the sell-off is currently priced in or do you think that valuations still have room for adjustment before they reach their intrinsic value?

As a business owner and participant in the private equity industry, it is highly attractive for groups like us to partner with companies and transform their operational structure through leadership inspiration. These assets have the potential to generate significant cash flow, not just 20 EBIT/EBITDA margins, but 50% at growth and scale. If we can price in our improvements, it becomes highly attractive. However, in the public markets, we lack control. The question is, what is the bottom price on a revenue multiple when we are unprofitable, especially when we miss our numbers? The problem intensifies if companies fail to meet and exceed expectations, resulting in negative surprises in their share price.

What does the number of exits tell you about the portfolio companies you're holding? Although you mentioned tremendous opportunity on the buy side, how does this impact the portfolio companies? As a prolific dealmaker in private equity, particularly in tech, what do you do with the portfolio companies you currently hold? Do you wait for things to settle down before considering an IPO or sale, or are you still seeing opportunities?

Our investment strategy involves buying multiples of revenue and selling them on multiples of EBITDA, making us a fundamental seller. We model our investment cases based on this approach, and if a company has high cash flow but doesn't receive the right multiple on that cash flow, we wait until equity value and balance sheet growth occur. Private equity has not slowed down yet in terms of buying companies on an EBITDA basis, and strategic buyers are sitting on their cash. When they combine the number one player in a given sector in software with a highly profitable and independent business unit, it is still attractive to these corporate buyers.

The challenge of private equity is that it must buy public companies at a premium of 30% and then sell them at a discount of 20% to the comps. This means that private equity firms must create significant value in between to make their investment case work if they plan to take the companies public later.

To clarify, you are highly focused on making a company profitable before exiting or getting it close to that level of profitability before seeking to exit. Given the current economic climate with inflation and labor challenges, how do you manage to achieve this goal, particularly when it comes to acquiring and retaining talent? It seems like a challenging task at present.

We appreciate the recognition and feel that we have earned it as a company that owns all the problems. We cannot outsource these problems, as people change their minds and want to change jobs. As leaders, we need to inspire our team to continue doing great innovative things while maintaining growth curves. Our firm's secret sauce is our ability to talk to leaders and inspire them to make positive changes with the existing management team, while maintaining discipline and operational cadence to produce more margin and grow faster.

Unlike most of the world, we believe that growing a business does not require losing money or investing negatively in P&L. For companies with over $100 billion in ARR, the more profitable they are, the faster they should grow, as they have more money to invest in sales and R&D. We work with our leaders to implement this strategy and embrace it, which de-risks innovation and allows companies to continue innovating for a long time without disruptions to their business models or dependence on outside capital for growth.

Do you believe that the mantra "growth at all costs" is not the current reality?

The "growth at all costs" approach has ended, and those who continue to invest and operate in this manner will be caught off guard. The focus has shifted to business economics, and it's time to consider the basic question: how can a company create a large output with limited societal resources? This is a structural problem in the software industry, and groups like us are working to address it.

What is the impact of the geopolitical situation in Russia and Ukraine on the technology sector? Is there any value that technology can offer as we evaluate the situation abroad?

The digital transformation of the world is an irreversible trend that has accelerated in recent years, as businesses and individuals have had to adapt to remote work and new communication and transaction methods. This has led to increased adoption and use of existing technologies, creating a new step function in the world of going digital. As a result, industrial companies and financial institutions are now embracing digital transformation, with some even rebranding as technology companies. However, this shift also exposes the world to increased cybersecurity risks, and the importance of cybersecurity is more crucial than ever, especially in the current geopolitical environment.

What is your opinion on the ability of cybersecurity companies to protect organizations in the U.S. and the West from foreign actors seeking to harm them, such as banks or defense organizations?

We were the first private equity group to develop a large portfolio in cybersecurity, and today we have $6 billion in revenue. If we combine all of our cybersecurity companies, we are the largest cybersecurity company in the world. Three months before the invasion, we saw a huge spike in DDoS attacks mainly coming from Russia. Now, we see a 10x increase in DDoS attacks emanating from Russia. These attacks are at scale and complicated, and even the best cybersecurity technology experts in the U.S. don't know how they pull them off. It is crucial for corporations worldwide, especially in the U.S., to have a strong cybersecurity posture, which requires a significant investment. It involves pulling together various products and buying the best product in each cybersecurity area. Free products are worth what they are, and corporations should not invest in them. A poor cybersecurity posture can lead to disastrous consequences, so it is essential to invest in infrastructure appropriately.