Rising interest rates and increased scrutiny have forced tech companies and the tech M&A market at large to get smaller.
|
After a flurry of pandemic-era tech deals related to digitalization trends, financial buyers and strategic buyers like Microsoft Corp., Alphabet Inc. and Meta Platforms Inc. have recently stepped back from doing larger deals that would require significant financing. Deal totals for the first five months of the year at almost $76 billion are just one-fifth of the total recorded for the same period of 2022, according to the 451 Research M&A KnowledgeBase.
Financial and strategic buyers are grappling with the realization that deals that made sense when debt was cheap no longer work.
"We saw a big surge in global M&A announcements in 2021. And so some correction there was inevitable. And when you combine that with rising rates ... the M&A pipeline is very, very thin," said Nick Kraemer, head of ratings performance analytics at S&P Global Ratings.
Record debt and an earnings recession
The market uncertainty comes at a time when the tech sector is more highly leveraged than ever, according to S&P Capital IQ Pro data. US publicly traded companies in the technology sector ended 2022 with $904.66 billion in debt, up from $219.39 billion 10 years earlier.
With issuance of new debt slowing, the record capital that had been stockpiled when cash was cheap is starting to diminish as sector growth slows, Kraemer said.
"Now we're in a period that some might call an earnings recession," Kraemer said. "I think there's a big risk that you're going to see interest rates either stay high or keep rising longer after that pivot point in growth."
The rapid pace of interest rate hikes has also created a deepening divide within the tech sector, according to David Tsui, technology sector lead at S&P Global Ratings.
On one hand, you have larger tech companies like Microsoft and Apple Inc. that are well-capitalized and have strong cash reserves that can be used to make acquisitions, regardless of the capital market environment.
On the other, you have often smaller companies that have more strains on their balance sheet. "Those are the ones that really are hurting from the rising rate environment," Tsui said.
Shifting strategies for strategics
To right-size after the pandemic, many companies have been focused on cutting staff and scaling back on spending. Meta CEO Mark Zuckerberg famously called 2023 "the year of efficiency." Yet, strategic buyers in the tech sector are facing hurdles beyond rising interest rates.
For one, corporate acquirers are facing an unprecedented level of scrutiny as regulators across the globe step up their review of any transaction that makes Big Tech bigger. Antitrust regulators in the US and UK have sought to block Microsoft's $74.01 billion deal for Activision Blizzard Inc., while regulators in both the EU and UK are performing in-depth reviews of Broadcom Inc.'s pending $61 billion buy of VMware Inc.
"The strategic buyers, they're looking at deals now trying to figure out, 'Will we get it done, will we get past the regulators?'" said Lori Bistis, a deals partner at PwC who focuses on technology, media and telecom. The time spent to get regulatory approval for a TMT deal has roughly doubled over the past three years, Bistis noted.
"So you kind of put all that together and ... the loans are going to cost me more, and the valuation is still high. Maybe it's not the right time to do a deal," Bistis said.
Less is more
While strategic buyers have stepped away from larger deals, smaller, less risky transactions continue. These deals are often financed with cash on hand rather than debt.
And it is not just the deals that are getting smaller. In some instances, it is the tech companies themselves.
The serial acquirers who were largely behind the 2021-2022 deal spree are now doing portfolio reviews in what Bistis believes to be a healthy psychological shift for a sector that historically has pursued growth at all costs.
"A lot of the [M&A] activity we're seeing in the market right now is sell-side preparation to divest or spin," Bistis said.
Some companies are even unwinding the deals they did in better times. Communication software company Twilio Inc., for instance, averaged two to three deals a year between 2018 and 2021, according to the 451 Research M&A KnowledgeBase. Today, Twilio is divesting, starting with its internet of things business earlier this year and more recently its India-based communications platform as a service, ValueFirst Digital Media, which Twilio purchased in early 2021.
Financial sponsors fall flat
While a multitude of factors have caused strategic buyers to reassess their dealmaking, the direct impact of higher interest rates on private equity firms is clearer.
"Few industries benefited more from [zero interest-rate policy] than PE. They took advantage of the historically cheap and readily available credit to more than quadruple the number of deals they did," said Brenon Daly, 451 Research's head of financial research.
According to the 451 Research M&A KnowledgeBase, the prevailing price-to-sales multiple for tech deals has more than doubled over the past decade, from roughly 2x revenue after the Great Recession of 2007-2009 to 5x revenue since the pandemic. While PE firms historically avoided transactions with higher multiples, cheap debt made expensive deals more palatable.
"Easy credit was the fuel that drove the M&A engine at PE shops," Daly said. "When it stopped flowing, the engine sputtered."
The tightening credit has come not only because of the 10 consecutive interest rate hikes by the US Federal Reserve, but also due to shocks to the country's financial system. The collapse of tech-centric Silicon Valley Bank has made lenders of all types less likely to lend.
"Nobody's lending any money," Richard Tobin, CEO of industrial equipment maker Dover Corp., told analysts in March. "There's a significant amount of pressure in the banking industry to ... not deploy capital. So that's got a downward effect on M&A in total."
As a result, financial acquirers have had to dramatically scale back their dealmaking. Spending by sponsors in both April and May plunged to about $1 billion per month, down from an average of about $10 billion in the first three months of the year, according to the M&A KnowledgeBase.
The end of tech-ceptionalism
These changes in the tech M&A environment do not mean that no deals are happening. Rather, it means the fervor for growth at any cost has cooled.
"We had a situation two or three years ago where everybody was doing deals," Bistis said. "They felt like they had to. That mentality has definitely shifted."
Now, buyers are performing more diligence work. They are rigorously assessing risk. And they are far more discerning when it comes to valuations. The latter especially has proven a point of contention in deal negotiations.
"Public valuations came down as interest rates went up," said Dover's Tobin.
"The salad days of paying 18x EBITDA for medium-growth industrial companies are probably over."
