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Unpacking Private Equity’s Interest in the Work-for-Hire Industry

Private equity firms have traditionally been hesitant to invest in gaming due to its unpredictability and hit-driven nature. However, as the $200B-plus gaming market continues to grow, more IPs have proven their staying power, and the industry turns toward more recurring revenue models, these investors are now starting to take notice.

While most private equity firms are still getting comfortable with investing directly in content, there has been active interest in the software and services surrounding gaming. There has been a flurry of private equity activity in the work-for-hire space. Consider:

June 2024: EQT is in advanced discussions to acquire Keyword Studios (#1 player in the space) for £2B.
October 2022: Emona Capital’s $20M minority investment in Amber Studio.
September 2021: BPEA’s $150M minority investment in Virtuos.
March 2021: Phoenix Equity Partners investment in Universally Speaking.
October 2019: NorthEdge Capital’s £47M investment in Catalis.

In today’s digest, we’ll provide an overview of the work-for-hire industry, discuss why investors are drawn to the space, highlight some of the risks, and offer our predictions on how this could shape the industry.

Market Overview

The work-for-hire industry generally consists of seven core outsourcing services: game development, testing and quality assurance, player support, art, localization, audio, and marketing. According to Keywords Studios, the market opportunity is a whopping $38B, with roughly 35% outsourced today, and is set to grow at an 8% compound annual growth rate over the next five years.

Keyword Studios Pre-production — *Source: Keyword Studios 2023 Investor Presentation*

Outsourcing adoption varies, but at a high level, audio, localization, and quality assurance are generally outsourced (with a greater than 70% penetration), while the other work is still largely handled in-house. However, as games become increasingly complex and specialization increases, publishers and developers are turning to work-for-hire studios for help across all lines of work.

Outsourcing also provides access to talent in low-cost regions and helps reduce a fixed headcount. This has helped publishers and developers look past some of the coordination challenges and potential quality control issues that come with outsourcing.

The confluence of gaming's continued growth, increasing development spending, and outsourced penetration has driven double-digit annual growth for the large players in the work-for-hire industry over the past decade.

Keywords Studios- Organic Growth — *Source: Keywords Studios Company Filings*

What’s Drawing Private Equity to this Segment?

In addition to the aforementioned tailwinds, there are a couple of other reasons why private equity investors are being drawn to this space.

First, the work-for-hire industry is fragmented and ripe for consolidation. Keywords Studios, the top player in the space, holds only a 6% market share, and the majority of the market is still occupied by many small competitors. Large players hold strategic value through revenue diversification, the capacity to undertake larger projects, and revenue synergies from cross-selling multiple services to customers. As a result, they trade at significant premiums compared to their smaller competitors. For example, EQT’s recent bid for Keywords Studios valued the company at 16 times its earnings (EBITDA), while Keywords Studios has been acquiring smaller competitors at five to seven times its earnings.

Over the years, private equity firms have made a killing by consolidating industries with similar characteristics — buying up small players at a discount and selling the combined businesses at a premium. Investors seemed to have identified an opportunity to repeat the same playbook.

Keyword Market share — *Source: Keyword Studios 2023 Annual Report*

Second, the industry allows investors to participate in the massive gaming industry without direct exposure to content risk. Work-for-hire studios provide services throughout multiyear game development projects, and in the short term, their revenues are largely independent of whether the game becomes a hit. The increasing lifespan of games also provides a long tail of earnings from supporting content add-ons. These characteristics provide revenue visibility and help investors get over the hump of investing in a historically unpredictable industry.

Finally, there’s a strong buyer appetite for these businesses. Ultimately, private equity firms are looking to sell the companies they acquire for more money, and the work-for-hire industry is drawing interest from strategics (like Tencent), private equity investors, and public markets. A recent example would be Sumo Digital, a work-for-hire studio (with a small portfolio of “owned” IP games — only 18% of its revenue) that first entered private equity ownership in 2014 and was sold at a return of 4.4 times in two years for its first investor. The next buyer was another private equity firm that went on to publicly list Sumo Digital at a £145M valuation and eventually sold its remaining stake to Tencent at a mouthwatering £900M in 2022 (over 50 times the EBITDA).

While some of these mind-boggling numbers were likely enabled by gaming’s COVID-driven highs and the zero-interest phenomenon, they’ve clearly gotten private equity firms salivating.

Risks

Over the past couple of years, we’ve seen numerous reorganizations and cost-cutting measures across the gaming industry. Many of these private equity deals were struck at the peak of the COVID boom, and investors likely underestimated the cyclical nature of the gaming industry.

For context, Keyword Studios’ organic growth fell from 19% in 2021 and 22% in 2022, to 6% in 2023. Anecdotally, we’ve heard that other players in the industry fared worse, with many reporting layoffs in recent months (like Sumo Digital laying off 15% of its employees).

Although some of these investments aren’t off to hot starts, the growth tailwinds discussed above endure. The competitive playing field for gaming continues to rise as existing live-service titles make it harder to grab players’ attention, and consumers expect large amounts of content in their AAA games. Large publishers are also facing pressures from their investors to resume growth and push earnings higher. These forces have led to ever-increasing development budgets (whether sustainable or not), and if this spending pattern persists, the work-for-hire industry will continue to benefit.

Another headline risk is the potential impact of AI tools on the work-for-hire industry. They are already having an influence on areas such as art, audio, customer support, localization, and quality assurance. Given that many of these tools are still in their early stages of development and adoption, it’s hard to assess their effectiveness, cost efficiency, and whether all large publishers/developers can get comfortable around the legal risks. Regardless, these tools will increase competition and have a deflationary impact on service lines that can be automated. Work-for-hire studios that have higher exposure to the services discussed above are probably looking to proactively adopt artificial intelligence tools themselves or diversify into higher value-added services (like outsourced development or co-development).

Ultimately, advancements in efficiency and tools have not reduced overall development spending. Instead, they have pushed developers to build bigger and more complex games. Similarly, even if AI lives up to its potential as an efficiency tool, spending is unlikely to drop precipitously. AI tools will drive up competition within existing categories and push large publishers and developers toward larger and more ambitious projects that their less-resourced competitors can’t undertake. In the near term, the work-for-hire industry will be negatively affected by some of these advancements. However, in the long term, these teams also stand to benefit from the efficiency gains and quality improvements that will come from adopting these tools.

Predictions

The influx of private equity capital will likely drive a continued wave of consolidation in the work-for-hire space. For example, Virtuos used BPEA’s $150M investment to accelerate its buy-and-build strategy, and has acquired or invested in at least four other work-for-hire studios since 2022.

Similarly, EQT will likely look to accelerate Keywords Studios' M&A strategy (30 acquisitions in the past five years) by increasing leverage, which would be challenged by investors in public markets (with 0.4 times the net leverage today). Other scaled players in the space, like Sumo Digital (four acquisitions in the past five years) and Amber Studios (built through a series of mergers), are also active acquirers. The growing number of buyers in this space will drive up valuation multiples across the industry and be a nice liquidity event for owners of work-for-hire studios with strong reputations.

It’s worth noting that acquisition-driven growth isn’t a straightforward endeavor, and the gaming industry has recently witnessed firsthand the aftermath of overzealous M&A (e.g. Embracer Group). Even Keywords and the broader work-for-hire space haven’t been immune to questionable dealmaking.

Private equity firms' frequent use of leverage to accelerate growth could also backfire, and employees often pay the price of management’s missteps. Ultimately, not all of these roll-ups will succeed, and studio owners who are looking to sell should do their proper reverse diligence on their acquirers.

Conclusion

Private equity's interest in the work-for-hire sector stems from its similarities with other industries where prior investments have thrived. The most important of these are the large industry size, notable growth prospects, industry fragmentation, and strong exit optionality.

However, there are also challenges to navigate, such as recent cutbacks in the gaming industry and the looming threat of AI. Nonetheless, private equity investors have been able to get comfortable with those risks and have deployed significant capital into the space.

Outside of the work-for-hire industry, we’re starting to see green shoots in private equity interest on developers, especially those with evergreen titles generating recurring revenues. Recent deals include CVC and Haveli’s acquisition of Jagex from Carlyle Group and Haveli’s investment in Behaviour Interactive, the studio behind Dead by Daylight.

Growing private equity interest provides an alternative path for publishers and developers to stay independent and receive growth capital without having to run the venture capital treadmill.

We are already starting to see private equity firms with dedicated focus on games (Like Haveli Investments, Emona Capital), and more will likely follow over time. We’re hopeful that this influx of capital can help support growth for the industry overall.

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