Apollo's Zito Sounds Alarm on Private Software Valuations, Citing Disconnect with Public Markets
John Zito, Deputy CIO of Credit at Apollo Global Management Inc. ($APO), has issued a stark warning regarding software valuations within private equity portfolios, asserting that "all the marks are wrong." His comments, delivered at a recent industry event, underscore a growing unease among some of Wall Street's most influential figures about the persistent disconnect between public and private market asset pricing, particularly in a sector that has long been a darling of growth investors. The pronouncement from a senior executive at one of the world's largest alternative asset managers signals a potential reckoning for private market participants who may be holding onto valuations that no longer reflect current economic realities or public market comparables.
Apollo's Warning Shots
Zito's candid assessment highlights a critical issue for private capital: the often-lagging adjustment of internal valuation models to external market shifts. For years, private equity firms capitalized on an era of ultra-low interest rates and voracious demand for technology, fueling a boom in software acquisitions. These companies, characterized by recurring revenue models and high growth potential, frequently commanded premium valuations based on future earnings projections. However, the Federal Reserve's aggressive rate hiking cycle, which has pushed the benchmark Fed funds rate to a 22-year high of 5.25%-5.50%, has fundamentally altered the landscape. Higher discount rates inherently reduce the present value of future cash flows, making long-duration assets like growth-oriented software businesses particularly vulnerable to revaluation. Zito's remarks suggest that many private equity firms may not yet have fully accounted for this paradigm shift in their internal portfolio marks.
The Shifting Sands of Software Valuations
The private equity software boom was largely predicated on robust revenue growth and expanding profit margins, often fueled by readily available cheap capital. Firms like Vista Equity Partners, Thoma Bravo, and Hellman & Friedman have built vast portfolios of enterprise software companies, betting on the sector's resilience and mission-critical nature. Yet, the macroeconomic environment has grown more challenging. Corporate spending on new software licenses and upgrades is facing headwinds amid inflationary pressures and uncertain economic outlooks. Publicly traded software giants, often used as benchmarks for private valuations, have already experienced significant multiple compression. The Nasdaq Composite ($COMP) has seen considerable volatility, and while the broader tech sector has rebounded in 2023, many software stocks remain well below their late-2021 peaks. For instance, the S&P 500 Information Technology sector ($XLK) saw its valuation multiples contract sharply in 2022, with many high-growth software companies trading at significantly lower enterprise value-to-revenue multiples than during the peak of the pandemic-era tech rally.
Public vs. Private Discrepancy
The crux of Zito's concern lies in the divergence between publicly observable valuations and the internal marks used by private equity funds. While public software companies such as Microsoft ($MSFT), Oracle ($ORCL), Salesforce ($CRM), and Adobe ($ADBE) have been subject to the daily scrutiny of the market, private assets are typically revalued less frequently, often quarterly, using models that can be less sensitive to immediate market swings. This "mark-to-model" approach, as opposed to "mark-to-market," can create a lag, especially in periods of rapid economic change. Data from PitchBook indicates that while the pace of private equity software deals remained robust through early 2022, the average valuation multiples began to show signs of cooling by late last year. However, the full extent of this adjustment may not yet be reflected across all fund portfolios, leading to what Zito describes as "wrong" marks. This discrepancy could pose challenges for limited partners (LPs) who rely on these valuations for their own portfolio reporting and asset allocation decisions, potentially leading to a "denominator effect" where public market declines make private allocations appear disproportionately large.
Broader Implications for Private Capital
Zito's comments extend beyond just software, touching upon the broader health of private markets. The ability of private equity firms to exit investments, either through initial public offerings (IPOs) or strategic sales, has become significantly more difficult. The IPO window, effectively shut for most of 2022 and remaining largely closed in 2023, has removed a key liquidity path. Strategic M&A has also slowed, as potential buyers face higher financing costs and greater economic uncertainty. This constrained exit environment means that private equity firms are holding assets for longer, increasing the pressure to maintain realistic valuations. Should Zito's assessment prove widespread, it could trigger a wave of write-downs across private equity portfolios, potentially impacting fund performance and future fundraising efforts. Institutional investors, including pension funds and endowments, are keenly watching these developments, as they grapple with the implications for their own long-term investment strategies.
What to Watch
Investors and LPs will be closely monitoring several key indicators in the coming months. Firstly, the next round of quarterly fund reports from major private equity players will provide critical insight into how firms are adjusting their valuations. Any significant write-downs could signal a broader trend. Secondly, the trajectory of interest rates will remain paramount; a sustained period of higher rates will continue to pressure valuations. Thirdly, the M&A landscape for software companies, both public and private, will offer clues about investor appetite and realistic exit multiples. Lastly, the performance of publicly traded software companies, particularly those with similar growth profiles to private assets, will continue to serve as a bellwether for the sector's health. The current environment demands a rigorous and realistic approach to valuation, and Zito's warning serves as a timely reminder that even in private markets, the laws of economics eventually prevail.
