Validated software: why a regulated customer does not change supplier

Software installed inside a regulated manufacturing plant or a testing laboratory is validated before it is used. Validation is a documented demonstration that the system does what the operator says it does, under the procedures the operator has written, with test evidence retained for inspection. A mid-sized manufacturer spends between US$150,000 and US$600,000 and six to fourteen months validating a system it will then run for a decade. The customer pays that cost, not the supplier. It is the reason these customers do not change supplier.

The economics follow directly. Across the four companies the Private Equity division has examined in this niche since 2023, gross revenue retention ran between 96 and 99 per cent and net revenue retention between 104 and 118 per cent. Contract terms run three to five years. Price increases of three to five per cent are accepted without negotiation, because the alternative is a revalidation. The firm is not buying growth in these positions. It is buying a subscription that a regulated customer has already paid to keep.

Diligence is unglamorous and specific. The firm reads the validation package supplied to customers, the version currency of the installed base, the hosting arrangements and the support backlog. A supplier whose customers run four major versions across the estate has a support cost it has not yet recognised and a migration it cannot force. A supplier whose validation package lags the current version has customers who cannot upgrade. Both are repairable, both reduce the price, and the repair plan is agreed before completion rather than after it.

Hosting concentration is the risk the Third-Party Risk and Outsourcing policy exists for. Several of these suppliers run their customers' regulated workloads from a single facility with one operator. The firm requires a tested recovery arrangement in a second location within twelve months of entry, and it funds that work rather than asking management to find the money. In the position taken in December 2024 the requirement cost US$1.1 million of capital expenditure across two years, against US$21 million paid for a 62 per cent stake.

The Ethical Technology Charter applies to what the software does, not only to what the company earns. Proportionate automation means automation only where the error cost is understood. A system that releases a manufacturing batch without a human signature has an error cost measured in recalls. The firm will not hold a position in a supplier whose product removes the human sign-off from a decision of that kind. Since 2023 that test has excluded one company outright and required a product change in a second before entry.

Price discipline is what preserves the return. Suppliers below scale in regulated niches, meaning under US$15 million of recurring revenue, have transacted at four to six times that revenue in the processes the firm has seen. Larger assets attract buyers who pay for growth the firm does not underwrite. The firm buys below scale, funds the recovery and validation work, and sells to a strategic buyer who needs the customer list. Holding periods are modelled at four to six years, and nothing in the model depends on multiple expansion.

Published 2024-12-10 by the Private Equity division. Research is prepared for eligible counterparties and does not constitute advice.