Comment: Navigating industrial software investment

Heading into 2024, investors keen to capitalise on this momentum should pay close attention to two factors shaping industry dynamics: supply chain risk and the transformational impact of artificial intelligence (AI) on the industrial software sector. These trends are indicative of an unpredictable and changing landscape and will be key to understanding the market moving forward.

Industrial software: A strong sector with robust M&A activity

Compared to the broader technology ecosystem, vendors within the industrial software sector have been relatively successful in maintaining valuations during the most recent period of volatility. This software is key to end markets, especially in an environment of global supply chain pressures and decreased demand for goods in the face of inflation.

Unique to industrial software, the sector has been able to maintain an ingrained baseline of activity driven by active strategic buyers looking to make acquisitions. The data speaks volumes: the top 10 players in the market have engaged in nearly 100 acquisitions since 2020. This dynamic, paired with the strong financial health of vendors, has propped up the sector and driven EBITDA multiples to a near six-month high.

Navigating supply chain risk

But despite its overall strength, the sector is not free from risk. Inflationary pressures, geopolitical tensions, onshoring, and additional tariffs are placing significant pressure on global supply chains. With this in mind, investors are increasingly prioritising technologies that can provide insights and visibility into the supply chain whilst being able to adapt to potential disruptions.

Supplier concentration is a key risk on investors’ radar and an important focus area for sector end customers. Peak supply chain pressures driven by COVID-19 - which have only recovered as of 2023 - illustrated the necessity of diversification, particularly for manufacturers and other supply chain stakeholders. To address these challenges, there has been a technological shift towards the development of systems that can support rapid changes to the supply chain through advanced capabilities in monitoring and data-driven insights. This shift is reflected in a changing trade landscape, with notable headlines like Mexico overtaking China as the United States’ top trade partner.

There is also a risk that supply chain software workflows are becoming too commoditised, leading to reduced profitability and increased competition amongst companies offering similar solutions. Meanwhile, users are focusing on ensuring efficiency and coordination within a given technology system (i.e. tech stack) to maximise operational impact and are finding value in a suite of complementary solutions.

Investors, cognisant of this environment, are gravitating towards high-value-added, differentiated platforms. We see a focus on solutions that optimise management and mitigate operational risk alongside a preference for vendors that are difficult to replicate or replace. Sustained investment in technology across the supply chain to address end-market risks and improve financial efficiency is set to continue.

The transformational impact of AI

AI is continuing to have a transformational impact on every sector, and investors in technology are factoring it into their assessments. This is particularly acute in industrial software, where we see companies increasingly looking to expand their capabilities.

AI is unmatched in its power to support optimization - a key value proposition at the core of many industrial software use cases. In manufacturing, well-defined use cases of AI include predictive maintenance, quality control, and optimisation of line workflows. For supply chains, AI refines forecasting and logistics operations, offering tangible cost savings and improved customer service. For example, successfully implementing AI-enabled supply-chain management has enabled early adopters to improve logistics costs by 15 per cent, inventory levels by 35 per cent, and service levels by 65 per cent.^[1]

Investors are drawn to companies integrating AI into their workflows to enhance efficiency and competitive advantage. Venture capital and private equity firms, for example, are actively seeking opportunities in this space. In July 2023, O9 Solutions, an AI-powered platform for integrated supply chain planning and decision-making for the enterprise, raised $116m of growth equity from KKR and General Atlantic, placing them at $3.7bn post-money valuation. Activity in this space has boosted valuations for AI-driven industrial software firms, with investors willing to pay a premium for those effectively leveraging the technology’s capabilities.^[2]

But the use of AI can pose material downsides for companies, particularly when it comes to safeguarding data privacy, addressing ethical concerns, and managing workforce implications. Organisations will need appropriate operational governance to mitigate these challenges, and we will increasingly see investors looking for those that can do so sufficiently.

Industrial software has shown that it can weather the storm and remains a relatively good bet for investors. But, as with any sector, it is not without risks and change. Investors interested in this space will be keeping an eye on vendors that are able to bolster operations within the supply chain and mitigate risk. AI is likely to play a significant role in this and investors will reward those able to effectively navigate the technology.

Tim Macholz is a director in Houlihan Lokey’s global Technology Group

[1] https://www.mckinsey.com/industries/metals-and-mining/our-insights/succeeding-in-the-ai-supply-chain-revolution#/

[2] https://technode.global/2023/07/21/indias-o9-solutions-raises-116m-investment-at-3-7b-valuation/