Nehal Raj leads TPG’s global technology investing practice.  Over the course of his career, Nehal has witnessed the evolution of the technology investing landscape, from the heady days of hardware to the more recent focus on recurring revenue software businesses.  Today’s technology investing universe is underpinned, among other factors, by a massive influx of capital across all stages of the company lifecycle.  In our conversation, Nehal reflects on this evolution, provides a glimpse into TPG’s unique approach to investing, and provides insight into how the market may continue to evolve.

RJ: Thanks for joining us today, Nehal.  We really appreciate you taking the time.  Maybe what we can do to kick things off is provide a little bit of background on yourself.  I think some of our audience will already be familiar with you, but always helpful to hear directly.

I’ve been with TPG for 12 years now and I lead our technology investing practice here at the firm.  I’ve been working at TPG within the technology group the whole time that I’ve been here.  Prior to that I was also in private equity investing at Francisco Partners, where similarly I was focused on technology and software — about 16 years between the two focused in this area.  Prior to that I was at Morgan Stanley doing M&A work in the technology industry down in Menlo Park.  The one industry I’ve always been a part of is tech.  I don’t know much outside of tech; it’s been a long time now in the tech industry.

RJ: Given that you’ve been exclusively focused on tech and have been investing in the area for a number of years, how have you seen the tech investing landscape evolve?

It has evolved quite a bit.  I remember back in 2002 there were only a handful of firms investing in technology at all in any large scale.  There were always the VCs but not many doing either large scale growth equity or buyout type deals.  Francisco was one, TPG was another, and there have been just a couple of other firms.  If you fast forward to today, 15 or 16 years later, it seems like everyone’s a tech investor.  Many firms that you would think of as historically “old line” firms like KKR, Blackstone, Carlyle, they’re all making big investments in technology today.  The main thing I would say that’s changed is tech investing has become much more competitive, just due to the sheer number of firms out there.  The other thing I’d say that’s changed quite a bit is that in the early 2000s tech investing was really all about hardware companies.  Companies like Seagate in the disk drive area or in the semiconductor area.  That was where all the big buyouts were happening.

Investing in software was not very prevalent at that time at large scale.  In fact, I remember whenever we would try to get a loan to invest in a software company the banks would balk and basically say, “Where are the fixed assets?”  They were investing to lend against the factories or the fabrication facilities that a disk drive company or a semiconductor company would have.  A software company, all they have is a bunch of engineers in a building and a code base.  There were no fixed assets to lend against.  It was very hard to even get capital.  That’s changed so much now.  Software companies today are the easiest ones to leverage because people just look at the recurring revenue and the cash flows.  The other thing that has changed is that the market for later-stage investing has gone from predominantly hardware-based investing to mainly software-based investing.  TPG has made that evolution as well.  In the late 90s and early 2000s, our name was really made around hardware deals.  Since I joined in 2006, the vast majority of what we’ve done is software.  And so that dynamic has definitely played out.

RJ: Are there particular niches or verticals within software that you focus on? Certain areas that you really like in the current environment?

We have a very theme-oriented means of sourcing deals.  At the beginning of every year we get our team together and we basically align on the four or five areas that we want to spend a lot of time on throughout the year.  These don’t typically change from year to year because most of these themes are multiyear, hopefully even decade long secular trends.  But we do kind of refresh and update them on an annual basis.

The four or five areas that we’re spending a lot of time on, in no particular order, are security software, the whole rewiring of the big data stack which can cover things like AI but also more legacy, big data use cases, healthcare IT, that’s another big area focus, the change in the fintech and payments landscape is a fourth.  And then a fifth one which is a newer theme for us is supply chains and the rewiring of the supply chain technology landscape.  Those are probably the areas where we’re spending most of our time right now.

RJ: When you’re going from the macro view of your five focus areas to the micro, company level view, are there certain characteristics you look for in terms of business fundamentals or how companies are operating which gives you conviction around a given investment?

That question is probably most relevant for our growth equity business.  What I see right now is many companies that are growing very well, 30%, 50%, 100% in some cases.  It’s hard to differentiate just looking at the financial statements of a company, between those or among those companies, they’re all growing very quickly.  Where we’re seeing more differentiation and where we’re focusing our microanalysis is on the unit economic level. Most companies in growth equity are generally making some level of loss — very few are actually profitable.  They’re making some level of loss, but it’s hard even to discern at different levels of loss making, who is actually more profitable than another.  What we do instead is look at everything on a unit economic basis where we can say for a given sale, how much are they actually making in gross margin and what are they actually having to pay on a variable basis to make that sale happen, which is usually some form of sales commission or sales efficiency metrics.  That’s where we’re seeing a lot of differentiation of business models.  Right now, I think the market is so hot that all companies, regardless of their unit economics, are trading according to their growth rate, with no consideration for how profitable they are on an underlying basis.

We’re seeing big differentiation between companies where, maybe you have three different companies all growing 50%, but vastly, vastly different levels of unit profit.  Some are able to do it with a sales model that’s just more efficient than others.  Some have much less variable cost associated with their business model.  In an environment where all of those businesses are trading for the same multiple then the logic would hold that the ones that have the superior unit economics are actually relative value investments right now.  Conversely, there’s probably others that you’d rather be short.  That’s the level of analysis that we’re having to get to in our growth equity business to be able to differentiate.  Because the market right now, I think as a whole, is not differentiating very well between those.

RJ: Maybe switching gears a little bit to The Rise Fund. It’s really interesting to see how more firms are getting into the impact space. The Rise Fund seems to be one of the more high profile examples and I think it was recently announced that John Kerry is joining.  If you wouldn’t mind, could you talk a little bit about The Rise Fund and what you’re focused on there?

The Rise Fund came out of a couple of things, one was a knowledge that many of the investments that we were already making for TPG were in companies that had a social impact to them.  It’s just we didn’t call it that.  We did those investments out of our growth fund or out of our buyout fund.  What we noticed is that many of our LPs want to do the right thing in terms of investing in companies that have that kind of social impact.  But historically the alternatives were to invest basically in these concessionary type funds that were investing behind impact, but we’re doing it on a low return, almost non-profit sort of basis.  It was really blurring the lines between an investment fund and a charity fund in that sense.  We had the view, based on our historical deal experience, that social impact can actually be collinear with returns and that you don’t need to make a tradeoff between the two.  In many cases if you’re choosing the right companies you can actually have some of the companies that have the best social impact, also have the best return profile.  What we’ve promised our investors is that we would have a similar return profile in The Rise Fund as we would in all of our other private equity funds and that there wouldn’t be a big difference like there is for other funds.

When we first raised the fund, I don’t think any of us were totally clear as to what proportion of different sectors would fit into that fund.  We all kind of had a sense for what social impact meant, or what type of companies that played into it.  What’s surprised me so far is just how many technology companies and how many software companies are actually helping to create the social impact that we’re looking for.  Some of our larger investments in The Rise Fund are actually software companies.  The first deal that we did for The Rise Fund is called EVERFI, which is a SaaS business that is surveying the K-12 and higher ed markets with sponsored software that helps with things like financial literacy for underprivileged students in public schools or things like prevention of sexual assault and alcohol abuse in higher ed.  It’s really a way to teach students in both high school and college settings about certain life skills that they otherwise wouldn’t get or would get in a very manual sort of way like reading a student handbook or something like that.  EVERFI is able to provide that in a SaaS platform that’s very engaging for students.  It has a software business model, it’s growing nicely at 30 plus percent a year, strong economics.  It has all the things that we would look for in a traditional software growth equity investment, but it happens to be a company that’s creating big social impact.  It’s a really great example of the type of stuff we’re looking for.

Another example is C3 IoT which is an IoT startup that’s run by Tom Siebel.  That was an investment we initially made out of our growth fund.  Then we were asked to lead a subsequent round of financing.  What we learned in that interim period between making the first investment and second one is that many of C3’s use cases were actually having a social impact.  They have a big IoT effort around energy management.  They do all the analytics for smart meters and grids, both in the US and Europe, and a lot of the output of that helps companies and countries really help manage their energy usage in a much more efficient way.  That has huge social impact obviously.  Another emerging use case with C3 is in the healthcare area where they’re helping big insurance companies make sense of all the data that they have, both from their claims history as well as from patients in the field using sensors.  The aim is to create, effectively, what looks and feels like preventative maintenance for healthcare for human beings, which also has really big social impact potential.  Long story short, we ended up making our second investment in C3 out of our social impact fund, Rise.  It’s really surprised me, when you look at things through this lens, just how the companies that are having social impact are actually achieving it through a technology and software driven business model.

RJ: That’s really helpful.  Truly fascinating to see this shift towards taking advantage of the fact that investors and increasingly also family offices want to allocate a portion of their portfolios to social investment.  Nehal, that I think covers it.  I really do appreciate you taking the time.  Before we sign off, is there anything that we may have left out that you’d like to share with our audience?

No, I think that covers it.  The only other observation I’d make is that it feels like we are closer to the top of a cycle, given that we’re eight to ten years into an expansion.  As we all look for private equity investments, at least here at TPG, we’re really focused on the deals that are in sectors that will continue to grow through an economic cycle.  I would just encourage you, as you are talking to others, it will be interesting to see how many firms are focused on that aspect of where we are in the cycle and how that’s likely to play out.  I know internally we’ve been very focused on finding companies with real secular growth that should be cycle resistant in that sense.  If there’s any other trend that I’m seeing in our business, it is a real focus on that.  It will be interesting to see how that plays out in the coming years.