Listen: Next in Tech | Episode 84: The bear bites M&A

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Eric Hanselman

Welcome to Next in Tech, an S&P Global Market Intelligence podcast where the world of emerging tech lives. I'm your host, Eric Hanselman, Chief Analyst for the 451 Research arm of S&P Global Market Intelligence. And we are here today to come back to the topic of mergers and acquisitions and a lot of the things that these crazy markets have been doing with them with returning guest, the Head of our M&A practice, Brenon Daly. Brenon, welcome back to the podcast.

Brenon Daly

Thank you, Eric. It's great to be back. I guess I didn't say anything to get me kicked off the show again not [indiscernible].

Eric Hanselman

Well, maybe we'll head down that road this time because things -- I mean, you had called it earlier in the year about how things were unsettled. And now we've gotten into the actual evidence of what's happened with deal volumes and really what's going on in the market. So where are we?

Brenon Daly

Yes. We -- last time we spoke, we were sort of, I guess, edging towards a bear market. Now we find ourselves deeply, solidly mauled by this bear market. And it has been a pretty dramatic change, both in terms of the rate of decline and also the depth of decline.

And just to put some numbers on that, last time we spoke, the Nasdaq was in the red over the previous 4, 5, 6 months, but not deeply so. Now we're at a point where the Nasdaq year-to-date has lost 1/4 of its value.

So what happens in the equity markets is directly correlated. Anybody who's been in the game for a while, you know that there is a long-standing correlation between what happens in the equity markets and what happens in the M&A markets.

And so what we've seen as these 2 markets have moved lockstep lower is that, that's been true both in terms of in the M&A market, valuations and activity. And so we're hitting low certainly compared to last year that we imagine things were just going to keep rolling out of 2021 and all up and to the right. And boy, it has been a jarring settle back into a new trajectory in the markets.

Eric Hanselman

Well, it's kind of like somebody shut off that natural gas pipeline.

Brenon Daly

Yes. This is not so much due to the European -- the conflicts in Europe and things like that, even on the...

Eric Hanselman

But -- yes. But we have these macroeconomic factors that are in play.

Brenon Daly

Certainly.

Eric Hanselman

And the fuel that was driving a lot of that activity is now cut way back.

Brenon Daly

Yes, because tech did lead. By and large, tech led the economy, certainly, the U.S. economy out of the pandemic recession, right? No other industry recovered anywhere near as quickly or as profitably as the technology industry. And so they sort of led on the way up, and boy, they are leading on the way down.

When you think about, I mentioned earlier, the Nasdaq down about 25%, that's twice the decline of the Dow Jones Industrial Average. So there's that discrepancy where tech is getting hit a lot harder this time around than the rest of the industries. And as we look back, the technology industry itself is no longer as healthy as it once was.

I mentioned this idea of sort of outsprinting other industries, right? If we think about rewind the tape sort of 2 years, technology really became almost indispensable in our lives, both personal and professional, during the pandemic, right? Certainly, the pandemic made us a lot more reliant on technology, and that got reflected in, of course, the valuations and the growth rates.

You think about a company like Zoom coming out of nowhere and just rocketing with tripling revenue quarter-on-quarter. You even think about a large-cap company like Microsoft. It came into the pandemic sort of 2019 was growing at about 12%. 2021, grew 20%. And right now, it's back to 12%. So we've seen this sort of round trip the sort of renormalization after this peak activity in 2021.

It really did, as the bear market started towards the end of 2021 back in November, it really shut down the M&A market. It was lights-out after that. It was just a matter of how far are we going to drop. And that's kind of what we're finding now.

Eric Hanselman

Yes. I was looking at some of that data and its big deals seem to have just gone away altogether.

Brenon Daly

Yes. Year-to-date, we are exactly at half as many $1 billion-plus transactions here in 2022 versus 2021. So this year, we've got in our M&A knowledge base, which is a product I oversee here for 451, have for about 1.5 decades year-to-date here, we have about 60 $1 billion-plus transactions. Last year this time, we had 120. So it really is a shift in sentiment.

And I think just to put a point on how much the environment has changed in 12 months, think about -- so as you and I are talking, Eric, Adobe announced the largest transaction, largest tech deal in about 4 months. It's a $20 billion purchase of Figma. And that deal, even with that boost, $20 billion, even with that boost, Q3, now there's still as we would record this, there's still about 2 weeks of the quarter left, but Q3 is going to be half the spending that we've seen for any other quarter over the past 2 years.

So basically, since we got back on our feet after that sharp and sudden drop in the first half of 2020, since we got back, we've been averaging about, give or take, $200 billion worth of spend. Right now for Q3, we'll probably be lucky to eke out even $75 billion of spend. So we are solidly cut in half in terms of spending levels.

Eric Hanselman

Yes. So this is not winter is coming. This is winter is here already.

Brenon Daly

Yes. And when you look at both the growth rates, profitability rates, operating margins, any metric you look at, it is going to be tough. You think about the guidance even now that technology companies were coming into -- earnings reporting season will be kicking off shortly here.

And you already think about some of the pre-announcements. And the overwhelming guidance, right, from these large-cap technology companies, which incidentally are the largest buyers in the market, they can afford to do these $20 billion deals when they can get away with it. But they've overwhelmingly been guiding lower for the final quarter and even continuing into 2023.

And as we all know, right, the technology industry and all industry valuations are predicated on growth rates. And right now, growth rates are coming down dramatically. Facebook, for the first time ever, in Q2 shrank, right? This is a company that reliably, reliably expanded revenue 50%, 60% year-on-year. And in the most recent quarter, they actually got smaller. So there is a big change in the technology industry right now.

Eric Hanselman

Well, it seems like that's going to change the face of potential acquirers and also narrow the potential exit paths for any of those folks who are out there in the market today.

Brenon Daly

Absolutely. And we're seeing a very distinct shift in the types of deals. So the overall deal flow, if we look at the transactions we've been seeing that are sort of 2022 prints versus 2021 prints, I mean, we were joking about this. I think last time when we spoke, and I said, "2021 was a year of, if you could think of a deal, you could probably get it done last year, honestly."

I mean, the equity markets were still favorable. Debt financing was readily available. Now certainly, both of those have changed quite a bit. The equity markets are your -- if you're even tracking to the market, you've lost 1/4 of your value.

The debt market right now, we've got another raise coming from Jay Powell and company in our central bank. So we started the year with a 10-year under 3%. Right now, I mean, we're going to be looking at 5%, 6%. So this is a dramatic uptick.

And what that does is basically makes acquisitions more expensive. And it certainly pushes the return hurdle, that threshold you have to meet to make money, and we do deals to make money. But it puts that threshold even higher because now suddenly, the debt is not as available as it once was. You can't use your equity or if you do use your equity as Adobe did this morning, it is discounted. Adobe's lost 45% of its value so far this year.

Eric Hanselman

And so you're coming -- right, you just can't bring that same value to the table, and you're paying with things that are costing you a lot more.

Brenon Daly

Exactly. And so that $1 of equity doesn't go as far. And that $1 of debt isn't anywhere near as available, and it's also more expensive. So that's on the currency side. That's on the payment side. But think about also the most important part is that sentiment, is that confidence to do deals, right?

If you think about from a Board of Directors' point of view, when they're all sitting around talking about, hey, do we go ahead with this multibillion-dollar transaction? Last year was, yes, we have the confidence. We have the growth rate to back this up. It's not going to cost us a lot, right?

That conversation has changed dramatically. The overwhelming sentiment now in boardrooms is, yes, now is not the time to pull the trigger on that deal. Let's see how 2023 shapes up. So that's what we're seeing is a lot of those larger transactions that would have gotten done in 2021 are not going to get done in 2022.

Eric Hanselman

Well -- and you've been writing some research on some of the ways in which that's changing the conversations that are happening around deals as well. That tension is starting to seep into the deal-making process.

Brenon Daly

Yes. It's pretty easy to do deals when the sun is shining. When storm clouds roll in and times get tough, suddenly, everybody is lawyering up. And everybody's fighting for that last dollar or that last term or when everybody is making money, what's a few dollars between friends.

But when pricing has become so under pressure right now, it's hard to get a deal done, then it's hard to get that actually seen through. I mean, you look at some of these cases that are landing in courts right now, I mean, by far, the largest social media transaction in history, right, is -- got a date with a judge in middle October to decide whether or not Elon Musk is going to be forced to buy an asset that he doesn't want. And buy it for...

Eric Hanselman

He's really indicated he's not -- yes.

Brenon Daly

And this is $45 billion of spend. This is not a couple hundred million. This is -- again, this is twice the size of the amount that Facebook paid for WhatsApp, for example, right? This is a mammoth transaction. And it's not the only one that's landing in kind of courtrooms or even retrading discussions or post-close negotiations. All of those are making it very unpleasant to do deals right now.

Eric Hanselman

No, a lot of difficulties in the environments all together. One of the things I wanted to clue our audience into is this is a lot of what you're going to be talking about at the 451Nexus virtual version that we've shifted to virtual capabilities and are going to be kicking off at the beginning of November. So this is -- you're going to be leading off our program for us.

Brenon Daly

Well, I will miss my trip out to Vegas, but I do understand why we moved it online. And I have to say, I hope I have a little bit more bullish environment to talk about in -- by the time we actually get Nexus going.

I mean, right now, it certainly feels as if we're bouncing along the bottom in terms of sentiment and activity. And I mentioned July was the lowest monthly spending total that we've seen since we came out of the pandemic, right? So that's a 2-year low in July, and it was virtually nothing.

I mean, $13 billion, which is about 1/4 of what we would expect to see at a typical month. So we really bottomed out in July, had a little bit of an uptick in August and kind of dipping a little bit but still above where we were at the nadir in July here in September.

And as we record this, we saw a few more days, a few more deals to get done and so on. But it certainly feels like we're kind of in for a period of kind of bouncing along the bottom simply because there doesn't appear to be any catalyst. And if we think about sort of the macro economy, it's probably going to get a little bit worse before it gets better.

Eric Hanselman

So this is not something where there's a backlog that, hey, we clear the quarter, and a lot of those deals didn't get done that have been sort of sitting, cooking for a while are going to happen where people are going to be holding off for a bit yet?

Brenon Daly

Exactly. And there will not be a -- there's typically seasonality to the M&A market, where we see a big, big push in Q4, particularly late November, sort of around Thanksgiving period, getting deals done before many businesses shut down for -- effectively shut down for that final week of the calendar year. So we typically see a lot of big months in October, November and even early December. That's just the way the season breaks.

Typically, also, for those of you who follow the IPO market, you'll see also a similar sort of seasonality where fall, particularly post Labor Day as we find ourselves now, that tends to be the period where a lot of roadshows get kicked off, maybe some pricings in a healthy year. Now obviously, this year, we have -- nobody is on the road, nobody's selling new equity because the IPO market is effectively dead right now.

Eric Hanselman

Well, I guess, presumably, that's one of those things that people are back from the beach suddenly realizing what -- they came back from that lovely vacation to suddenly realize that, wow, things were not all that great. And it wasn't the deal that they were waiting to get started on.

It, in fact, is the point at which now they're trying to figure out what can you do, how do you do it, if it didn't even get done. And maybe they get driven by the end-of-the-year sort of pressures to start doing something as we get towards the end of the year. But it sounds like what you're saying is that deal volume, even so, is still going to be relatively low.

Brenon Daly

And certainly, as we look ahead to what I'll be talking about at Nexus, I think the trends or 2 of the trends that I will be highlighting during that presentation, again, that will be in early November. So I don't imagine much will change between now and then.

But if we think about sort of representative transactions, I mentioned the $1 billion-plus transformational transaction from 2021. Here in 2022, it's a much different-looking transaction. It's -- I'm out here in San Francisco, so my sort of frame of reference is Silicon Valley.

And so when I think about deals this year and particularly a trend line that's going to be accelerating on well beyond Nexus and even into 2023 is this idea of soft landing. So these are deals where a start-up that was basically living from round to round from their venture investors. And suddenly, that next round that is sustaining the business is no longer available.

And we've seen that if we look at our Cap IQ venture cap investment totals, they're down anywhere from 30% to 40%. So that's a lot of dollars being held back. And as a consequence, the start-up community is starting to feel that winter a little bit early, right?

They're feeling the pinch of that capital infusion that they had been running their business along with the idea that, hey, that's -- that B round or that C round or even a later-stage round is just going to be available because that's how the game works. Well, it's -- no longer works that way.

And so instead, you're seeing these soft landings which are, call it, a little bit bigger than an acquihire. So it's maybe acquihire plus product. But it's, again, basically looking for kind of a home. If you think about -- you're sort of a nautical person. But if you think about choppy waters, you look for a safe harbor, right?

And waters are pretty choppy out there, particularly in start-up land. So they're coming into the safe harbors of big-cap public companies who -- they may get roughed up a little bit. I mentioned Adobe being almost cut in half year-to-date, but whatever happens in the broader economy, like Adobe is still going to be standing on the other side of whatever recession, inflation.

However all of those macroeconomic pressures work themselves out over the next 6, 12, 18 months, Adobe is going to be there, just like Microsoft is going to be there. IBM, there's no question, right? Whereas the actual survival of a lot of these start-ups is no longer guaranteed because that capital is no longer guaranteed.

So that's making for a lot of kind of thinning the ranks in the venture portfolios. It's -- again, record venture investments last year, maybe too many. And so now we're kind of winnowing the herd for start-ups. So that's -- and that's a trend, again, as the longer we go out, the more capital they burn through, the more they're going to look to just kind of wind down business.

Eric Hanselman

Well, I'll shift back to my aviation geek metaphors, and let's say people are looking for things that are within gliding rain.

Brenon Daly

Yes. Yes.

Eric Hanselman

And trying to figure out if they're not going to have more fuel, where can they make that soft landing.

Brenon Daly

Yes.

Eric Hanselman

And that circle gets narrower and narrower the lower down you get.

Brenon Daly

Yes. The other M&A trend, and I'll try and mangle and extend your metaphor, is the glide path. You glide a lot further if you aren't carrying as much weight, right? And so the -- another type of deal that we're seeing is a lot of divestitures.

A lot of companies, right, particularly tech companies that have had outsized growth rates and outsized valuation because, again, valuation is predicated on growth. So particularly in 2021, I mentioned the spike that obviously Zoom had, but just generally speaking, I mean, companies that were maybe teens growers were suddenly 20% growers last year.

There was just indiscriminate tech spending almost. And so they got away with having underperforming assets in their portfolio. And now the macroeconomic conditions, I mean, we've had 2 straight quarters of no growth for our GDP, right? So writ large, we are flatlining.

That puts the pressure to find growth back on to companies. So they're doing a very deep and thorough review what's working, what's not, what's going to work, what's not going to work. And if it's anything that's not working or not going to work, they're getting rid of it. They're shedding assets.

And again, those of you in the game know that like a divestiture on a good day is kind of a 1x trailing sales maybe. If it's a superb asset, 2x trailing sales, which would kind of get you close to a market multiple almost in terms of that. So again, those are a lot of tough deals that are still probably going to come as long as the economy continues to find itself in sort of stagflation.

Eric Hanselman

Yes, which we find ourselves. Well, we see it even in sort of the camp in which I keep one foot in the information security markets, things are a little gloomy there as well.

Brenon Daly

Yes. And what's fascinating about the infosec market, if you think about it, is just the huge consolidation of the large vendors, right? Like we saw -- I mean, Mandiant just closed. It's now a Google property, right? This was a breakthrough company in the last decade, right? So you see how short...

Eric Hanselman

Talk about finding a safe harbor.

Brenon Daly

I mean, you see how short these cycles are. Even for emerging technology, you go from best-in-class start-up and new when you go IPO, and then you're a part of -- you're a division out of a larger holding company inside a decade, it's a -- usually, that would take like 20, maybe 30, in the old days, 40 years to play out in here. It's just basically from IPO to sale inside a decade, that's a phenomenal pace of corporate life cycle.

Eric Hanselman

Well, many things that are feeling pressure. I guess we'll see what happens in the month that we've got between now and 451Nexus and see what we can bring to the virtual stage when you get up there.

Brenon Daly

That's right. I hope to have a little more sunshine to talk about.

Eric Hanselman

Well, maybe there'll be happy tunes to play and a little more sun. But yes, we'll -- I guess we'll see when we get there. Well, thank you, Brenon, even despite all the gloomy outlook. Hey, telling it like it is for where the market sits today.

Brenon Daly

Yes. Yes. It's a glass half-empty kind of day, but that's all right. Yes. Well, I'm looking forward to seeing you, and hopefully, a fair number of our listeners can join us on -- at virtual Nexus here in just a couple of weeks. And yes, we'll connect again there.

Eric Hanselman

Sounds like a plan. Well, that is it for this episode of Next in Tech. Thanks to our audience for staying with us. And thanks to our production team, including Caroline Wright, Caterina Iacoviello, Ethan Zimman and our intern, [ Michael Asaolu ], on the Marketing and Events teams and our studio lead, Kyle Cangialosi. I hope you'll join us for our next episode, where Melanie Posey is going to be coming back to do the formal introduction of 451Nexus in its virtual form. I hope you'll join us then because there is always something Next in Tech.