Starting with a sell-off in public technology stocks (trading “FAMMGA” is no longer a winning strategy), the outbreak of war in Europe, upcoming midterm elections in the US, out of control inflation, rapidly rising interest rates, rotating COVID19 shut-downs in China rippling through the supply chain, escalating prices at the pump, threats of war in the Taiwan straits, and increasing regulation by enforcement, all while the world has otherwise seen a return to “in real life” activity after two years with minimal in-person events, have had sweeping effects from the gas station to the grocery store to capital markets to technology M&A activity.
We have previously examined how 2022’s volatile events have negatively impacted technology startup valuations and venture capital investment, but how is this impacting tech M&A activity? Common sense would tell us that with falling tech valuations, tech acquisitions would be on the rise. But is that actually the case?
A recent analysis by Jahani & Associates took a deep dive into the impact of the economic downturn on M&A and whether it has actually led to a spike in activity. What they found was significant growth in global M&A transactions in terms of capital deployed in the first half of this year – a 67% increase over the same time last year (from $1.14 trillion to $1.91 trillion). They point out that we don’t yet understand the full effects of a recession (it is generally accepted that the US has only officially been in a recession since summer 2022), but their data shows firms have been taking advantage of those lower valuations and utilizing 2021 profits to make acquisitions.
Below are some of the additional highlights from their report:
- Median deal size increased from $19 million and $24 million in 2021 Q1 and Q2, respectively, to $31 million and $43 million in 2022 Q1 and Q2, respectively.
- This highlights an increased appetite for acquisitions despite economic downturns, as roll-up strategics become increasingly aggressive leading to larger deal sizes. Challenging business conditions would drive the supply side demand while lower valuation would lead to an increase in demand for acquisitions.
- Capital deployed in cross-border M&A deals by USA-based companies increased by 59% from 2021 H1 ($69 billion) to 2022 H2 ($169 billion). Deal count grew consistently by a 13% increase between 2021 H1 (706 M&A transactions) and 2022 H1 (813 M&A transactions).
- The data suggest significant growth in cross-border M&A activity by USA-based companies. The degree of competition in domestic markets as well as more affordable valuations in international markets will continue to drive future cross-border transactions.
Looking more carefully at M&A activity in the tech sector, however, tells a different story. According to data taken from S&P Capital IQ, Pitchbook and MergerMarket, overall tech M&A activity was down by more than 40% at approximately $450 million in the nine months ended September 30, 2022. And this despite some blockbuster transactions like Adobe’s $20 billion acquisition of FIGMA and some major private equity buys.
But there are reasons for optimism as we look into the post-election cycle:
- Whoever wins the mid-terms, taming inflation and more thoughtful regulation should become priorities of the new Congress, and regulators should pivot to enabling rather than blocking digital assets, web3 and new capital formation.
- As inflation subsides, interest rates should stabilize, making acquisition financing more predictable.
- Dry powder has accumulated at historic levels within private investment funds, public companies and SPACs, and investors will seek to take advantage of better times to put these funds to work.
- Private equity firms who have been waiting for better financing and other conditions to prevail should bring their better-performing assets down from the higher shelves and to market.
- Sellers who have been holding out for better days will capitulate, and clearing the backlog should enable good trades for strategic and financial buyers
- We expect buyers and sellers to structure acquisitions with rollover equity / stock consideration to offer selling stockholders upside (note that unless these equities are publicly traded, there may not be an avenue available for selling stockholders to cash out their equity).
We are already seeing sellers offering seller financing to buyers to hold the line on valuation in the face of a clearly higher cost of capital in the capital markets. We expect private equity buyers to increase their use of liquidation preferences at multiples greater than 1 times, participation rights, pay-in-kind dividends and forced redemption clauses to bridge valuation and risk gaps. We are seeing more earnout and deferred payment structures to protect capital invested but also expected return on capital invested.
The impact of hot war, cold war, geopolitical instability, another pandemic outbreak, or natural disaster can never be predicted, but there is reason to be optimistic. To get ready for a running start in 2023, we expect that buyers and sellers will put their best feet forward by:
- Cutting expenses within portfolio companies and securing additional bridge financing (whether equity or debt) to create an 18-month runway of cashflow.
- Identifying and cultivating commercial relationships with potential buyers and targets to mitigate risk.
- Building pipelines of targets through top-down strategic targeting and bottoms-up, opportunistic leads from the grass roots.
- Doing more detailed prep work in advance of launching a process in either direction, such as building a modernized valuation model that takes new market conditions into account, showing profitability in addition to growth, preparing a virtual data room, scenario-planning answers to difficult diligence questions, advance “quality of earnings” reviews and more 360 degree consultation with potential counterparties and ecosystem parties.
From a legal perspective, some of this prep work should include a detailed look at your company’s revenue and commercial agreements:
- Examining whether contracts can be extended on a streamlined basis, automatically, and for extended periods.
- Removing the ability to terminate for convenience.
- Updating force majeure and material adverse effect provisions to make sure that sources of recent volatility and potential future sources on the horizon would protect you from liability.
- Ensuring that the restrictive covenants therein (if any) are not disproportionately burdeonsome.
- Structuring revenue as subscription-based with seat licenses limited in scope.
- Auditing compliance with existing subscription-based contracts and recovering past fees and negotiating future fees.
- Extending debt maturities, securing new committed credit lines of all types.
All of this requires a strategy, proper planning and forward-thinking, proactive advisors who are all in.
No one can predict the lasting effects of an economic downturn for certain and whether tech M&A activity will ebb or flow. We continue to see economic conditions evolving daily. However, current economic conditions present the ideal buyer’s M&A market. So, looking into 2023, we could continue to see an increased appetite for acquisitions as valuations stabilize at lower levels, inflation subsides and interest rates taper off.