The US Economy Is Strong, The Stock Market Is Steady, So Where Did All The M&A Deals Go? – Corporate and Company Law

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:

1. Examining whether contracts can be extended on a streamlined
   basis, automatically, and/or for extended periods.




2. Exploring pricing and timing of payments, including multi-year
   revenue deals with upfront cash.




3. Revisiting the ability of either side to terminate for
   convenience.




4. 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.

Originally published in The National Law Journal, May
17, 2023

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.