The internal books of the world’s largest private equity firms are currently carrying a fiction. This isn't a matter of simple accounting errors or minor fluctuations in the market. It is a systematic, multi-billion-dollar disconnect between what these firms claim their software portfolios are worth and what the public markets would actually pay for them. John Zito, the deputy chief investment officer at Apollo Global Management, recently voiced what many in the industry have whispered for two years. The marks are wrong.
In the world of private credit and buyout shops, a "mark" is the estimated fair value of an asset. When interest rates were pinned to the floor, these marks climbed steadily upward, fueled by the belief that enterprise software was an unstoppable engine of recurring revenue. But as the cost of capital spiked, the public markets corrected. High-growth software stocks saw their multiples slashed by half or more. Curiously, the private side didn't follow suit. While the S&P 500 and Nasdaq reflected the new reality of expensive money, many private equity portfolios remained frozen in 2021 pricing.
This gap has created a dangerous imbalance. If the underlying assets are worth significantly less than the reported net asset value, the entire fee structure and exit strategy of the private equity model begins to crumble.
The Mechanics of the Valuation Ghost
The primary culprit is a reliance on stale comparisons. Private equity firms typically value their holdings by looking at "comps"—publicly traded companies in the same sector. If Salesforce or ServiceNow is trading at fifteen times revenue, a private firm might argue their smaller, unlisted SaaS company is worth twelve times.
The problem arises when the public comps drop to six times revenue, but the private firm maintains its twelve-times valuation based on "fundamental long-term performance." This is often a polite way of saying they don't want to admit a loss to their investors.
There is also the issue of the "denominator effect." As public stocks fell in 2022 and 2023, the percentage of total assets that pension funds held in private equity shot up. This wasn't because they bought more; it was because their public holdings shrank. To avoid being forced to sell private assets at a discount to rebalance their portfolios, many institutional investors have been complicit in keeping valuations high. They don't want the write-down any more than the fund managers do.
The Problem with Recurring Revenue
For a decade, the term "recurring revenue" acted as a magic spell. It convinced investors that software companies were safer than bonds. The logic held that once a company integrated a piece of software into its operations, the switching costs were too high to ever leave. This supposed "stickiness" justified massive debt loads used to fund buyouts.
However, the reality of the current economy is testing that stickiness. When companies are forced to cut costs, they realize they are paying for twenty different SaaS subscriptions they don't actually use. We are seeing the first real "SaaS recession," where churn is increasing and new customer acquisition costs are skyrocketing.
If a software company is no longer growing at 30% annually, it shouldn't be valued like a growth engine. It should be valued like a utility. But utilities don't return 20% to limited partners.
Why the Exit Ramp is Blocked
The end goal of any private equity investment is an exit. This usually happens through an Initial Public Offering (IPO) or a sale to another company. Both of these exits are currently blocked by the valuation gap.
- The IPO Deadlock: If a firm carries a software company on its books at a $5 billion valuation, but the public market is only willing to pay $3 billion, the firm cannot go public without "down-marking" the asset. This creates a massive hole in their reported performance metrics.
- The Strategic Sale Stall: Big tech companies like Microsoft, Google, and Oracle are the natural buyers for these software firms. But these giants are currently under intense regulatory scrutiny. More importantly, they aren't interested in overpaying for a competitor's inflated portfolio.
This has led to a rise in "continuation funds." This is a practice where a private equity firm sells a company from an old fund to a new fund managed by the same firm. It is essentially moving money from the left pocket to the right pocket. While this generates a technical exit for the old investors, it doesn't solve the underlying problem. It merely kicks the valuation can down the road.
The Role of Private Credit in the Crisis
The explosion of private credit has added another layer of complexity. Many of these software buyouts were funded not by traditional banks, but by private lenders like Apollo, Blackstone, and HPS. These lenders provided "unitranche" loans—expensive, flexible debt that allowed private equity firms to bypass the stricter requirements of the syndicated loan market.
As long as valuations remained high, these loans looked safe. But as the "marks" are questioned, the debt-to-equity ratios of these companies look increasingly precarious. If a company was bought with $1 billion in debt based on a $2 billion valuation, and the real value is now $1.2 billion, the equity is almost wiped out. The lender is now effectively the owner of a struggling software company.
The Intelligence Trap
There is a new narrative being used to defend these valuations. It suggests that every software company is now an "AI company." By sprinkling a bit of machine learning onto an existing product, firms are attempting to reclaim the high multiples of the previous era.
This is largely a smoke screen. Adding a chatbot to a legacy ERP system does not fundamentally change the unit economics of the business. In fact, the costs of running these AI models—often referred to as "compute costs"—can actually compress margins. Instead of the 80% gross margins typical of software, AI-heavy products often operate with margins closer to 50% or 60%. Investors are beginning to realize that the AI revolution might actually make software less profitable in the short term, not more.
Looking for the Bottom
How does this end? Usually, it ends with a "clearing event." This is a moment where a major player is forced to sell a high-profile asset at a massive discount, setting a new, lower benchmark for everyone else.
We are starting to see the cracks. Secondary markets, where investors sell their stakes in private equity funds, are currently trading at discounts of 20% to 30% to the reported net asset value. This is the market’s way of saying it doesn't believe the official numbers.
The firms that will survive this period are those that move first to adjust their marks. Admitting a 20% loss today is better than being forced into a 50% loss two years from now when the debt matures. But the incentive structure of the industry works against this. Fund managers are paid based on the value of the assets they manage. Lowering the value means lower fees and a harder time raising the next fund.
The Concrete Impact on the Economy
This isn't just a game for billionaires and pension funds. When private equity firms overpay for software companies and load them with debt, those companies are forced to prioritize debt service over innovation. They lay off engineers, cut customer support, and raise prices on their users.
The "valuation gap" eventually manifests as a "quality gap" in the software we use every day. If your work tools feel buggier and more expensive than they did three years ago, you are likely feeling the effects of a private equity firm trying to squeeze a return out of an overvalued asset.
The industry is currently holding its breath, waiting for interest rates to drop enough to make the old valuations look reasonable again. But hope is not a financial strategy. If the "marks" don't come down to meet reality, reality will eventually come up to claim the marks.
Watch the secondary market pricing of software-heavy funds. When the discount there narrows, it won't be because the market got more optimistic; it will be because the private equity firms finally stopped lying to themselves about what their companies are worth.
