Private equity challenges: How code quality impacts software valuation
In this article
Summary
For private equity (PE) professionals, software quality is a critical (upwards and downwards) driver of valuation and profitability in tech investments.
Without assessing software quality, PE firms risk overpaying, inheriting hidden risks/costs, and exposing themselves to legal and reputational damage—while missing opportunities to drive higher valuations and long-term portfolio growth.
Here’s why software quality matters to your bottom line:
- Maximize returns
- High-quality software drives higher exit valuations by reducing inefficiencies and proving scalability. Scalable software (code) supports growth and inspires buyer confidence, driving smoother integrations and stronger valuations.
- Minimize costs
- Poor-quality software often conceals technical debt, which on average accounts for 31% of the acquired codebase in M&A deals. Identifying these inefficiencies early reduces acquisition prices and lowers post-close expenses.
- Avoid breaches
- Poor-quality code correlates with cybersecurity vulnerabilities. Addressing these risks proactively prevents costly delays, legal fines, and reputational damage.
Integrating software quality assessments into your due diligence process reveals the true value of your tech investments. This ensures smarter acquisitions, better-informed decisions, and a streamlined path to ROI.
This article delves into the vital connection between software quality and valuation, offering insights to help you enhance your PE strategy, protect your portfolio, and maximize returns.
Private equity strategies and the need for IT due diligence
Investments in software assets have been a cornerstone of private equity (PE) portfolios for over a decade, peaking in 2021-2022 with over 500 deals exceeding $100 billion in value. Yet, as more recent dips in the number and value of PE tech deals have shown, value creation and growth in this sector can prove challenging.
One key challenge—and solution—lies in software quality, particularly the build quality of the source code. Traditional private equity strategies for asset valuation often fail to account for the complexities of software assets, offering “almost nothing” in terms of actionable insights when it comes to technology investments.
Without assessing software quality during due diligence, PE firms risk overpaying for underperforming assets, inheriting costly issues that inflate post-close expenses, and jeopardizing returns through hidden risks like poor scalability or cybersecurity vulnerabilities.
Let’s use a simplified analogy to clarify:
Imagine buying a car without looking under the hood. What looks like a high-performing engine could turn out to be riddled with problems.
And in case you think I’m fearmongering, I’m not; our research shows that software acquired through mergers and acquisitions (M&As) is often of significantly lower quality than the industry standard.
This implies that those systems tend to come with a two-times lower development efficiency and a considerably higher risk of defects and vulnerabilities.
Software in the context of PE tech investments
PE firms who neglect software quality during due diligence are exposed to hidden challenges that derail investment success.
For example:
- Unawareness of tech debt can lead to overpaying for software assets that require costly remediation.
- Uncertainty in security vulnerabilities increases exposure to breaches that harm operations, costs, and reputation.
- Scalability hurdles delay revenue growth, often requiring extensive reengineering to address underperformance.
- Open source and framework risks can result in lawsuits due to compliance failures with licensing agreements.
- Falsely advertised AI where a company claims to offer an AI product but merely integrates a generic solution like ChatGPT that competitors can easily replicate.
- Poorly implemented AI leads to unreliable outputs and increased error rates.
These overlooked issues can undermine deal value, reduce competitive advantage, inflate post-acquisition costs, and delay ROI.
The good news? Software quality assessments can avoid a lot of these headaches.
The true value of source code
Before diving into the challenges, let’s take a step back to understand the bigger picture.
When investing in tech firms with software intellectual property (IP), you’re not just buying a company—you’re buying its code.
How to estimate the value of source code?
Most investors are primarily attracted to the functionality of software systems. In tandem, traditional approaches to valuing software assets often prioritize functional requirements—essentially, “Does the software work?”
This is something we call the ‘Outside-in approach’.
However, looking from the outside in will tell only part of the story.
Valuing software also requires an inside-out view that will give you a much more detailed understanding, not just of its functional aspects but also its non-functional qualities.
Non-functional requirements govern the foundational aspects of software which determine just how valuable it actually is. The foundation of software includes:
- Maintainability: How easily can the source code be edited, altered, fixed, and upgraded?
- Security: How well are you shielded against data leaks and cyberattacks?
- Availability: How quickly can the software be brought back online following downtime?
- Scalability: How ready is the software to scale up in tandem with business growth and/or an increase in end-user demand?
Common challenges in PE tech acquisitions
The above-mentioned associated risks with software quality are critical during due diligence (DD). A thorough DD on software enables more accurate valuations and opens opportunities for value creation post-acquisition.
While high-quality code accelerates ROI and minimizes disruptions, it’s often overlooked during due diligence—dismissed as too costly or time-consuming.
This short-term thinking often leads to long-term setbacks.
Let’s explore some of the most pressing challenges when it comes to acquiring low-quality source code in PE tech investments.
1. Overpaying for assets due to hidden technical debt
Failing to conduct a thorough software quality assessment can have serious financial consequences. It often leads to significant overpayment for assets that fail to perform. The hidden culprit behind these inefficiencies? Technical debt—a pervasive issue that’s easy to overlook but costly to ignore.
Technical debt–a hidden consequence of rushed or poor-quality code, is more than just a technical inconvenience. It’s a hidden cost that can inflate acquisition expenses.
During our recent webinar on software economics, Jasper Geurts, Managing Director of Software Improvement Group Americas spoke to Hakan Erdogmus, Teaching Professor at Carnegie Mellon University’s Silicon Valley Campus.
Hakan Erdogmus aptly defined technical debt as “a financial metaphor for compounded future software asset costs,”. In layman’s terms, it’s the price you pay later for having cut corners.
Teams that fail to identify tech debt during due diligence risk overpaying for assets that require expensive remediation to achieve performance goals. Without clear visibility, investors are often blindsided by these inefficiencies after the deal closes.
And this happens more often than you may think. Did you know that more than a third of the code volume in software acquired in M&As is considered technical debt? That’s a staggering figure—one that emphasizes how common this issue is.
The question then becomes: how can you uncover these hidden challenges?
Without a proper software quality assessment, it’s impossible to tell whether a system’s source code is clean and efficient, or the opposite.
2. Cybersecurity risks
Our research has revealed a direct correlation between poor-quality code and an increasing number of cybersecurity vulnerabilities.
Cybersecurity failures can lead to expensive downtime, legal liabilities, and reputational damage that undermine your asset’s value and harm the credibility of the portfolio company you acquire. Identifying and addressing vulnerabilities early ensures investor confidence and operational stability.
Performing IT Due Diligence to get insights into software quality helps private equity investors to identify vulnerabilities before they become cybersecurity risks, thus lowering entry valuation and better preparing post-close management teams for value creation (i.e., by identifying vulnerabilities and how to solve them to avoid costly failures further down the asset lifecycle).
3. Unforeseen scalability hurdles
Scalability is a critical factor for tech assets in growth-focused portfolios.
Hastily developed solutions often lack the flexibility to scale effectively, resulting in bottlenecks as user demand or operational complexity increases.
Scalable software is essential for meeting growth targets and supporting market expansion, ensuring your asset can grow in step with portfolio demands—without incurring operational bottlenecks that erode returns.
4. Open source and framework risks
The regulatory landscape for software assets is increasingly complex.
Compliance issues with open-source libraries can expose your portfolio company to fines, lawsuits, and operational disruptions, turning an asset into a liability.
By conducting a software composition analysis you can:
- Identify license issues contributing to IP risk
- Reveal security vulnerabilities in open-source software
- Show whether open-source packages are outdated and obsolete
Identifying and addressing compliance gaps early ensures your investment won’t face IP challenges, operational delays, or reputational fallout. It also provides leverage to negotiate lower valuations, protecting your capital.
5. False advertising of code quality or AI capabilities
In tech-driven PE acquisitions, sellers may overstate a software system’s capabilities to inflate its perceived value. Without a thorough software quality assessment, investors might purchase a system that underdelivers promised functionalities.
Key risks include:
- Misrepresented AI capabilities.
- Unmet scalability claims.
- Hidden dependencies on people, documentation, and technology
- Lacking competitive advantage
Without assessing the source code quality and code architecture, it will be difficult to tell.
Spotting misrepresented capabilities during due diligence ensures you avoid overpaying for overhyped assets. Alternatively, it can reveal hidden opportunities to secure high-value assets at a discount.
Benefits of assessing code quality in tech acquisitions
Code quality is integral to accurate asset valuation and long-term value creation in private equity investments. Traditional valuation methods, like public or multiples-based approaches, often fail to capture the nuances of software-driven businesses. Without assessing the quality of the underlying source code, these methods risk significantly misjudging an asset’s true worth.
Here’s how code quality assessments directly impact valuation.
1. Avoid eroding asset value post-acquisition
Hidden risks like technical debt, compliance issues, or cybersecurity vulnerabilities can erode asset value and stall ROI. By identifying and mitigating these risks early, PE firms can:
- Establish a triaged roadmap for addressing critical issues.
- Avoid costly surprises that diminish the asset’s value over time.
This proactive approach not only protects valuation but also ensures smoother operational management post-acquisition.
2. Have a smoother post-acquisition integration
For PE firms looking to integrate software into an existing portfolio, quality assessments provide critical insights into compatibility and portability. Knowing where architectural flaws lie ensures:
- Faster, more cost-effective integration.
- Minimal disruption to ongoing operations.
3. Maximize exit valuation with demonstrable software quality improvements
By actively improving software quality during ownership, PE firms can position assets for maximum valuation at exit.
Consider software quality improvements such as:
- Reducing technical debt.
- Enhancing compliance and security.
- Scaling the system for broader market demands.
These enhancements not only increase buyer interest but also validate higher valuations, supported by demonstrable improvements.
4. Demonstrate resilience and scalability to potential buyers
A comprehensive software quality assessment does more than evaluate an asset’s current state—it also highlights its future potential.
Demonstrating strong, scalable architecture commands higher valuations by boosting buyer confidence and showcasing operational resilience.
Whether the goal is to exit or integrate the software into an existing portfolio, proving resilience and scalability enhances perceived value.
Conclusion
Software is a strategic asset for private equity firms.
Assessing risks associated with software investments is a proven strategy for maximizing returns, controlling costs, and minimizing legal and reputational risks across the asset lifecycle—from initial valuation to post-acquisition growth to exit.
By conducting thorough software quality assessments during due diligence, PE investors can:
- Avoid overpaying for assets riddled with technical debt and hidden vulnerabilities.
- Mitigate risks associated with poor scalability, cybersecurity, and compliance.
- Ensure smoother integration or build stronger value-creation strategies.
Whether the goal is to scale the software, improve operational efficiency, or achieve a lucrative exit, looking into software quality early unlocks significant opportunities for value creation.
By investing in software quality early, PE firms can protect their capital, accelerate ROI timelines, and ensure assets deliver sustainable growth and value.
To learn more about how software quality assessments can transform your investment strategy, follow our blog or explore how we can help you mitigate risks and maximize value in your tech acquisitions.
