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Recessionary dealmaking: As a downturn looms, M&A will take a hit

The drumbeat of recession grows louder. What will that mean for mergers and acquisitions?

Dealogic data shows dealmaking has waxed and waned as the economy expands and contracts. The correlation is extremely tight: as gross domestic product rises, so does the total value of dealmaking. When it falls, M&A spending declines.

The recession of 2001 led to a 50% year-on-year drop in deal value that year; the Great Recession led to a 38% decline in 2008; and the mini downturn at the start of the pandemic led to a 18% drop in 2020.

The data suggests M&A is a coincident indicator with recessions.

It means that if the US enters recession later this year, M&A – which has been in a steady decline since its 2Q21 peak – should drop even further in 2023.

Some leading indicators suggest a recession is likely in 2H23, according to Michael Darda, chief economist at Roth MKM.

The fastest rise in interest rates in four decades has set off several phenomena that historically presage economic crisis. First, a broad-based inversion of the Treasury yield curve – when short-term interest rates rise above long-term rates –almost always signal recession 12-14 months later, Darda says. The yield curve first inverted last July, which means the US could enter recession this summer or fall, he says.

Tightening lending standards, weak money supply growth, and a slide in the residential real-estate market also point to a forthcoming recession, argues Darda. The Federal Reserve’s focus on tightening until we see sustained weakness in inflation and employment figures – both either coincident or lagging indicators – means a “hard landing” is now unavoidable, he argues. The failures of Silicon Valley Bank and Signature Bank are a sign of things breaking.

“I would expect M&A to dampen as we go into a recession,” he says.

Shrinking, profitably 

What type of transactions will still get done? Typically, in times of uncertainty deals get smaller.

As borrowing costs ballooned, the number of USD 5bn-plus deals in North America nearly halved to 56 in 2022 from 105 in 2021.

Meanwhile, the proportion of smaller deals soared. Sub-USD 500m deals accounted for 91% of all transactions in the year to date, up from 85% during 2021’s easy money-fueled frenzy.

James Furey, of Furey Research Partners, thinks small cap stocks are about to outperform bigger companies over the next decade. Small caps are currently inexpensive relative to large caps, and they tend to do better in difficult, inflationary or deflationary environments, as they did in 1975-1982, he says.

Silicon Valley’s “exorbitant privilege” is also coming to an end, he adds. For years, driven by cheap money, surging valuations, and a confidence from the confluence of a deflationary environment, globalization and low interest rates, tech firms had the currency to make accretive acquisitions. Now, soaring inflation and interest rates combined with collapsing stock prices have hurt their ability to do deals. Dealmaking going forward should be much more balanced with a focus on cash-flow positive deals, Furey says.

One company’s preparation 

How have companies been preparing? Ryan Steelberg, CEO of Veritone [NASDAQ:VERI], says his software company has been planning for the coming recession with some cost-saving moves implemented last year. Those measures have included cutting headcount from 740 at its peak last year to 650 now. It is also divesting its non-core energy group. While that divestiture is not material to revenue, it will allow Veritone to focus on three areas: media, entertainment and advertising; government and legal compliance; and the HR eco-system. The company is now acquisitive again and is looking at legacy business models it can automate or augment with its AI technology. “With some of these valuations becoming a little better, [an acquisition is] dependent on the opportunity.”