AI Disruption Fears Prompt Scrutiny in Booming Secondary Market

Growing fears that artificial intelligence will disrupt traditional software business models are now spilling into private markets. Investors are demanding larger discounts—up to 20%—for technology-heavy private equity portfolios, a shift from the 5% they previously sought. This increased caution reflects the broader market unease sparked by new AI capabilities that threaten to upend long-standing enterprise software models.

The rise in skepticism has led to a slowdown in secondary transactions involving buyouts and private equity portfolios. Firms like Thoma Bravo and Vista Equity Partners have had to reassure investors about the resilience of their software holdings. Blackstone Inc.'s head of secondaries, Verdun Perry, noted that buyers are now willing to offer lower prices in anticipation of future volatility.

Private equity managers are responding by conducting more rigorous due diligence on their software holdings. They are running deeper financial and operational scenarios to assess how AI might affect exit timelines and returns. This added scrutiny is particularly pronounced for portfolios with a high exposure to software and IT investments.

Why Did This Happen?

The fear is rooted in the rapid advancement of AI tools, which are now capable of replicating many functions traditionally performed by enterprise software. Tools like Anthropic's Claude CoWork and AI coding agents are reducing the need for subscription-based models, challenging the core revenue structures of software companies. This has sparked a re-evaluation of the long-term viability of many private equity-backed software investments.

Software's previous appeal to private equity came from its high margins, predictable revenue, and sticky customer bases. However, the rise of AI is compressing profit margins and forcing companies to pivot to outcome-based pricing models. Investors are now concerned about whether these changes will lead to less predictable cash flows and lower overall returns.

How Did Markets React?

The secondary market for software-focused private equity is showing signs of stress. Some investors have paused planned portfolio sales until they can better assess AI-related risks. This has led to delays in the closure of continuation funds, which are used to extend the life of private equity funds that struggle to exit via traditional methods.

In public markets, the sentiment is also shifting. The Nifty IT index has fallen to a two-year low, with analysts downgrading major Indian IT companies like Infosys and HCL Technologies. In the U.S., enterprise software stocks have seen sharp corrections, with companies like Intuit and ServiceNow losing significant value. These moves reflect broader concerns about the ability of software firms to adapt to the AI-driven transformation of enterprise IT.

What Are Analysts Watching Next?

Private credit lenders, which have heavily financed software companies in recent years, are also under scrutiny. Lenders like Ares Capital have been forced to explain how AI risks are factored into their lending strategies. While many still see software as a resilient sector, the increased scrutiny is leading to tighter underwriting and more conservative lending terms.

Analysts are particularly focused on how private equity firms handle the transition. Some have suggested that software companies may need to restructure their business models to stay competitive. For example, moving from seat-based pricing to usage-based or outcome-based models could help retain customers in an AI-driven world.

The coming months will test whether private equity and private credit can adapt to the changing landscape. As AI continues to evolve, the ability to reassess portfolio risks and adjust strategies will become increasingly critical for investors.