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Tech dealmakers eye more favorable backdrop for M&A after anemic year

Dealmakers are taking steps to prepare for a firmer M&A footing in the coming quarters after a comparatively anemic year for lucrative tech deals.

Cautious boardrooms, ‘sticky’ valuation memories and the higher cost of capital have weighed on the sentiment of both banks and investors, with prized US tech mergers and acquisitions volumes on track to slip by more than a third versus 2021, according to Dealogic data. At USD 4.4bn year-to-date, investment banking revenue from technology arms of US-based fee payers is also down around a third versus the same period last year in a further sign of continued stagnation.

But while the so-called flight-to-quality has helped to paint a worrying picture for corporates, private equity firms and their lenders, it has also offered the chance for many of the sector’s fastest-growing players to take a step back.

“In this low growth environment, investors are asking companies to go back to basics by focusing on profitability and margins,” said Avinash Mehrotra, Goldman Sachs’s Co-Head of M&A Americas. “The current tone in boardrooms is muted as it relates to inorganic or M&A growth, but we expect that to recover in the medium term, in the next couple of quarters or so.”

For both private and public companies, the story since the summer has been one bookended by cost adjustments and cuts to personnel. Management teams are being encouraged to be proactive, if not aggressive, in rationalization and rewarded for their ability to demonstrate a shorter time frame to profitability.

“The higher cost of capital has shifted investor attention to profitable growth versus the growth-at-all-costs approach we saw previously,” said Phil Drury, Global Head of Technology & Communications Banking at Citi.

The consequence is that many of the high growth, high cash burn stories that captivated investor interest during the coronavirus pandemic will continue to be punished by investors, according to Jason Gurandiano, RBC’s Head of US Technology Investment Banking. “These companies face the most challenging outlook as they look to recalibrate their models to weather the economic storm,” he said.

Reset and retest

Other tech verticals, such as mission-critical software, cybersecurity and digital infrastructure, offer a counterpoint. Long the golden children prior to the crack in the market, some of the year’s largest deals globally have come from these subsectors, including: Broadcom’s [NASDAQ:AVGO] USD 61bn deal for VMware [NYSE:VMW]; Thoma Bravo’s USD 6.9bn purchase of SailPoint Technologies; and Google’s USD 5.4bn acquisition of Mandiant.

That said, though put on a pedestal for valuation resiliency in souring markets, there will remain parties in those areas that – as in other pockets of tech – “need to continue resetting their valuation expectations,” said John Jansen, UBS’s Head of Technology M&A.

That’s a view shared by most advisers, even during a year that on paper is still set to be one of the strongest in sheer value terms in the last decade. With more than USD 500bn already doled out year-to-date on US software targets alone, tech as a percentage of total US M&A activity is approaching record levels, Dealogic data shows.

“Valuation memories are sticky. Boards and management teams will become more balanced and realistic in their views on valuation, but it will take time,” said Mehrotra, whose bank Goldman Sachs tops Dealogic’s M&A advisory league table globally. “The question really is whether the current valuation reset is the aberration or if it’s now the new normal.”

So, valuation ‘stickiness’ can stake a claim as being partially responsible for the drop-off in both M&A and initial public offerings. How to prevent further slides in valuations is something already at the top of the agenda for tech players of all sizes and, according to Jansen, will lead to more structured transactions that in some cases include requirements around minimum returns and increased liquidation preferences in the next year.

Buyers and sellers will likely fare best by remaining disciplined. Bid-ask discrepancies are narrowing, says Gurandiano, which “should set the stage for an active 2023.” The ability of private equity firms to offer deal certainty in terms of all-cash, over-equitized deals is “helping to bridge value gaps”, he said.

Financial sponsors – many of which have remained active in the booming take-private corner of the market – are increasingly looking to their own cash coffers to avoid spiraling borrowing costs and get deals over the finish line. Infrastructure investor Stonepeak, for instance, agreed earlier this year to acquire the Safety business of Apollo Global Management-backed [NYSE:APO] Intrado on an initial all-equity basis for USD 2.4bn.

Cash is king

Advisers say 2023 may well be the year that some of the industry’s best-capitalized players finally seize their moment.

“We’re expecting an uptick in consolidation driven by companies that don’t need to borrow and can fund acquisitions off their balance sheets,” Mehrotra said. “Those sitting on strong balance sheets and healthy cash positions are generally those which propel consolidation during periods of market stress, and that should be no different as we head into this more challenging GDP environment.”

Dhiren Shah, Citi’s Chairman for Technology M&A, noted “cash-rich acquirers” – many of whom were patient during 2020 and 2021 – are now active as they identify “attractively priced opportunities.” The next 12-18 months “may be a great period for large-cap companies to be aggressive on the M&A front,” particularly involving strategic assets that have been targeted for some time, he added.

Shaken by rising rates, the threat of a deep recession and the lasting impact of Russia’s war in Ukraine, the success of that period will largely depend on how far and how quickly confidence within the boardroom can be restored. 

“CEOs feel that the market presents asymmetric risk,” Gurandiano said. “Boards are willing to transact M&A-wise if the merits, economic or otherwise, are clearly articulable and definable. Boards are also more focused on reevaluating top ideas from the past that they know well and have proven-out merits versus exploring new avenues for growth in tangential markets.”

Even for some of Silicon Valley’s most established names, expect some focus on deals that are smaller and less ambitious in scope as management teams reassess corporate priorities. Tuck-ins and bolt-ons that offer vertical integration rather than horizontal product or portfolio extensions will continue to be rewarded by investors.

“With the challenges currently posed by the financing market, it will be another quarter or two until we begin to see a more favorable, albeit slightly unpredictable, dealmaking backdrop,” said Jansen at UBS. “For instance, we will likely continue to see more creatively-structured deals and those that are over-equitized or require refinancing at a later date.”

*Dealogic Revenue Data: Dealogic uses a proprietary revenue model to estimate investment banking fees across four key products: M&A, equity capital markets (ECM), bonds or debt capital markets (DCM) and loans. Fees derived from each of the three regions indicate fees generated by client fee-payers in those markets. All data correct as of 7 December, 2022.