AI, frontier tech, and hardware grab the headlines while services fly under the radar.
The genesis of Silicon Valley and the lure that it holds started in hardware. But you wouldn't know it today as the venture capital industry has increasingly turned to software for returns.
It's hard to blame them. Software produces the biggest returns and scales more easily than other business models. Buoyed by this upstream focus, private equity also turned to software as the industry matured and "ate the world."
Kyle Harrison recently argued in this well-written piece that hardware could be on its way back to popularity in Silicon Valley. He correctly warned that venture capital runs the risk of treating hardware like software, which could be a disaster.
Nonetheless, some venture investors have turned their attention to hardware because it's:
a) viewed as the next big thing as a result of on-shoring, the energy transition, and space and;
b) the belief that software will become more accessible due to AI, and thus, competition will grow exponentially over the next decade.
The latter could come to fruition. But, and I can't overstate this enough, building the software is only ~25% of the battle. Once software is built, that product needs to be sold and implemented. As a company grows, hiring, strategy, and execution all increase in importance. If everyone can build software, domain expertise will become the differentiator.
Kyle's piece inspired me to write about another business model I've been thinking about for a while that could grow in importance over the next decade: services. It's a sector where private equity has done well and where smart firms are playing today. It's also a model where distribution and knowledge moats can be fortified by rapidly creating and leveraging software to expand margins.
The energy transition is complex. How do I plan for an electric fleet? Do I need to build my own microgrid? How big should my onsite battery storage be? What data do I need to measure my emissions? Where's the best place to put new transmission and generation?
These questions are highly complicated and customer-specific, while the solutions are opaque. They require the customer to have a high degree of trust in the person solving the problem for them. Software can solve many problems, but human trust isn't one of them.
Some of the best private equity firms have already leaned heavily into this strategy. Oaktree Capital has a history of rolling up EPC firms. At the same time, Summit Partners and Blackstone have purchased several construction services companies. Other PE firms are rolling up HVAC technicians and electricians.
These investments fit the private equity playbook perfectly. The localized offices have built loyal customer bases within their specific region. Once combined with other firms, they can share back office systems and operations. Finally, they usually have a specialized skill in high demand with short supply.
Like hardware, service businesses have to be capitalized appropriately. No matter how digitally-enabled it may become, investing in a services business can’t be done at a 10-20x NTM revenue multiple. They also need to be profitable much earlier, if not from the beginning, as they are ultimately valued on EBITDA and FCF multiples. But, these constraints don’t preclude the businesses from being good investments, far from it.
Services have also held up well in a rocky market for energy transition stocks. Over the last twelve months, infrastructure services have grown 29%, in line with the Nasdaq, while outperforming the S&P 500 and CLES by wide margins. This surprised me, but it makes a lot of intuitive sense:
The IRA and Build Back Better reward deployment
Global infrastructure is aging or being replaced by better solutions
The revenue growth of these firms is now in line with software after the recent pullbacks
Traditionally, service businesses haven't received the same level of attention and hype as their hardware and software counterparts. But many enduring service businesses are out there, including in seemingly mundane areas like tree trimming.
The energy transition will create more of them in the next decade, and even if they don't grab attention, they'll grab returns for the investors who find the right ones.