No one can predict the lasting effects of an economic downturn for certain and whether tech M&A activity will ebb or flow. However, current economic conditions present many aspects of the ideal buyer’s M&A market.
While pundits have predicted a recession in the United States for well over a year, the U.S. economy has been growing at a steady clip since the third quarter of 2020. Following historical stimulus programs to bring the economy out of a pandemic-induced trauma starting in March 2020, culminating in the falsely named “Inflation Reduction Act” of 2022, inflation reached double digits. Unemployment is at record lows, and labor markets remain stubbornly tight. The Federal Reserve has been coordinating a historic tightening of monetary policies, raising interest rates by 500 basis points in less than a year, while shrinking its balance sheet and ending “quantitative easing” as we knew it.
Unsurprisingly, asset allocation has moved away from equity and other high-risk products given the higher cost of capital, and into higher returning debt products. This translated into a 20% fall in the S&P 500 in 2022. Also, the Dow Jones US Technology Index and NASDAQ fell by 35% and 33%, respectively, in 2022. Year to date in 2023, the stock market has been relatively flat, and the market for new issues has been tightly shut.
So where did all of the M&A transactions disappear to?
To answer that question, we have to put it in context:
- As of the date of this writing, the Fed has made a 10 consecutive rate increase, bringing it above 5%, a first in over 15 years.
- The regional banking crisis, beginning with the failures of Silvergate, then Silicon Valley Bank, then Signature Bank and now First Republic, have shaken the business community’s confidence in the banking system and bankers’ appetite to extend credit.
- Inflation is still running hot at approximately 5%—although this has gone down by nearly half, this is still far from the Fed’s target inflation rate of 2%
- Geopolitical uncertainties—the war in Europe continues on, together with fears of an outbreak of war in other parts of the world, coupled with their collateral damages, e.g., the energy crisis in Europe
- Global supply chains are in flux, never having recovered from COVID measures, and now responding to active war in Ukraine and cold war with China
How have events impacted tech M&A activity? Conventional wisdom would tell us that with falling tech valuations, tech acquisitions would be on the rise. But is that actually the case?
Effects on M&A Activities
According to a recent law.com article, M&A activities in Q1 2023 saw a 44% decrease from Q4 2022, after experiencing a 37% fall from H1 2022 to H2 2022.
Looking to other data in the tech industry specifically, according to data taken from S&P Capital IQ, Pitchbook and MergerMarket, in the nine months ended Sep. 30, 2022, overall M&A activity was down by more than 40%.
Industries appear to have been affected by the economy to a varying degree. For example, while tech M&A was been down, M&A in the healthcare vertical has thus far in 2023 seen a 60% YoY increase in terms of dollar value.
M&A Outlook
We are cautiously optimistic as we look forward:
- With inflation dropping precipitously, and in the face of a regional banking crisis, the Fed has pressed pause on further tightening.
- After 17 months of a closed IPO market, regulators may pivot to enabling rather than blocking new capital formation.
- A realignment of regional banks may lead to some lending after the pause we have seen in 2023.
- As inflation subsides, interest rates should stabilize, making acquisition financing more predictable and encouraging investors to deploy their dry powder.
- Dry powder has accumulated at historic levels within private investment funds and public companies, and investors will seek to take advantage of better times to put these funds to work. According to a recent Forbes article, dry powder for PE globally is estimated to be $1.3T, and that of VC globally is estimated to be $580B.
- 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 stock to offer selling stockholders upside.
- Certain verticals, for example AI and cloud solutions, have remained resilient due to growth and development.
- Current strong dollar could make foreign targets more appealing to US buyers.
- Tech companies’ valuations are showing trends of stabilization.
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.
Practical Ideas
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. We expect that buyers and sellers will put their best feet forward by:
- Evaluating and controlling expenses within portfolio companies and securing additional bridge financing (whether equity or debt) to create a longer runway of cashflow.
- Identifying and cultivating commercial relationships with potential buyers and targets to mitigate risk, both strategic and financial.
- Building pipelines of targets through top-down strategic targeting and bottoms-up, opportunistic leads from the grass roots.
- Frontloading 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, as well as cleaning-up various house-keeping matters
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/or for extended periods.
- Exploring pricing and timing of payments, including multi-year revenue deals with upfront cash.
- Revisiting the ability of either side to terminate for convenience.
- 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.
Conclusion
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 many aspects of the ideal buyer’s M&A market. So, looking ahead, we could continue to see an increased appetite for acquisitions as valuations stabilize at lower levels, inflation subsides and interest rates taper off.
Reprinted with permission from the May 17, 2023 edition of The National Law Journal© 2023 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or [email protected].