Tech Investment Banking: What to Watch in 2023Published:
For the past decade there has been a singular sector - year-in and year-out - that has driven overall M&A deal activity and deal size higher: tech. In fact, even during 2020, as the pandemic ground almost all M&A activity to a halt overnight, tech M&A activity increased relative to the prior year.
In 2022 tech still represented the largest sector when it came to both deal activity and deal size. But there was no doubt that we were entering into a new normal and the last few quarters saw activity slump to levels not seen since the onset of the pandemic (albeit still quite a bit higher overall).
There's no getting around the fact that tech benefited from an unprecedented tailwind in the dozen years following the financial crisis: extremely low rates, calm capital markets, and sponsors that were not only raising bigger and bigger funds but who were also no longer apprehensive about doing tech buyouts.
However, last year, as the Fed began its fastest rate hike cycle of the past forty years, those sectors that benefited the most from low rates (i.e., high growth companies that had cash flows far in the future) were hit hardest. And it goes without saying that tech has a disproportionate number of those companies.
With that said, it's not like 2022 was a complete write-off when it comes to tech M&A activity or deal volume, and it's not the case that being in a high rates environment, or even potentially on the cusp of a recession, will neuter deal activity and reduce deal volumes going forward...
Tech M&A Activity in 2022: A Reversible Slump?
In many respects, the slump in tech M&A deal volume doesn't look like that much of a slump at all given that it returned to a more pre-pandemic era level (per S&P Global below...).
However, the above graphic is a bit misleading as it doesn't reveal how front-loaded the first half of the year was while rates were still low. Indeed, there was a bit of a mad dash during the first half of the year to get deals done -- sponsors were particularly active as they tried to lock in their buyout debt at relatively low yields after seeing the writing on the wall regarding future rate hikes.
This turned out to be a wise move because for a non-trivial amount of the second half of 2022 funding markets were all but closed for sponsors (especially for tech-related buyouts), with many hung deals eventuating that blew holes in bank balance sheets.
But it's not a given that the gloom of last year is going to hang over into this year. We'll get into some specific catalysts for why this could be the case (no, it's not that lower rates are likely -- the swaps market isn't pricing in any Fed cuts this year and if they were to happen it'd be due to an ugly recession onsetting).
However, to give you a bit of a preview: even though actions speak louder than words, words still matter. Or, perhaps better said, sentiment still matters. And in a recent survey by S&P Global strategics and sponsors both forecast that they'd be, on average, more likely to do deals this year than last.
So the relatively low levels of actiity that we saw through the last few quarters may not persist for the next few quarters. Here are some reasons why...
Rationale 1: Feeding the Growth Machine
There's been much made over the past quarter about the number of layoffs in tech, along with the equity price declines that have been observed over the past year across all of tech (especially in the software space).
But there is an oddity about the mass layoffs that we've observed over the past quarter or so: they're being done, for the most part, by quite profitable companies or at least companies that aren't necessarily struggling.
This is because in this higher rates environment, the market is demanding that tech companies show a path to enhanced profitability unless they have a path to meaningful growth (if they have growth, then excess fat is permitted).
For example, the market is basically telling a company like Meta, "Figure out a way to get back to high growth, or begin chopping your costs so you have the economics of an energy company (i.e., high cash flow and thus an ability to do more buybacks to support the stock)".
Most strategic acquirers were quite quiet throughout 2022 with the exception of some like Adobe buying Figma (a classic expensive acquisition to protect one's moat and increase growth).
The reason for them being quiet hasn't been that there aren't deals out there (multiples have compressed significantly, especially for growth tech companies that aren't profitable).
Rather, the reason for (public) strategic acquirers being so quiet has been that they've historically relied on their high-flying stock price to help fund purchases. But suddenly when your stock has fallen 20-50% in a year, making an acquisition where a significant amount comes through equity looks a lot more expensive.
Many acquirers have looked around and said, "If we fund X% of our acquisition with our own equity, and our equity has fallen by 40% this year, then if our equity normalizes back to 2020-2021 levels it'll probably look like we really overpaid for this acquisition".
Rationale 2: Sponsors Sitting on Sidelines
Something we've talked about a number of times - back before the bear market even really took hold - is that there's a lot of sponsors that have raised significant funds, many specifically focused on tech, that really need to deploy it sooner or later (i.e., Thoma Bravo's Fund XV).
The issue that sponsors have run into is relatively simple: the funding markets were closed for much of the latter half of 2022 as everyone readjusted to how much rates had increased, and buyout debt is much more (i.e., 1.5-2.0x) expensive than it was just a year ago.
This has changed the landscape regarding the kinds of deals that can be supported by meaningful amounts of debt, and has required sponsors recalibrating how much cash they're willing to put into tech deals.
Something we also talked about quite a bit in the guides is that sponsors were historically quite skeptical about doing tech buyouts because of the economics: classically, a buyout fund wants a company with lots of free cash flow now that can service a large debt load and then, through modest growth and debt pay down, can achieve a good multiple on money upon exit (all without needing crazy growth during the holding period).
Tech companies flip the script a bit: the companies can't (generally) handle that much debt, because they don't have that much cash flow now to service it, but they can grow significantly and thus achieve a good multiple on money through sheer earnings growth. This is ultimately why sponsors warmed up to the idea of doing tech buyouts to begin with (i.e., changing their perspective on how they produce a good multiple on money: through cutting a larger equity check and banking on higher growth through the holding period).
Anyway, there has been a real slowdown in tech buyouts over the past year although, as you can see, the volume and deal value is still elevated relative to the historical norm...
And the reason why there's this elevation relative to the historical norm is just because so few buyouts (relatively speaking) were done prior to the late 2010s in the tech space, as this chart makes more clear...
The reality is that doing buyouts in any sector - including tech - has become much more expensive to do relative to a few years ago because of the higher rates environment we find ourselves in.
Even if sponsors are willing to cut a bigger equity check (to make debt servicing costs less onerous) that impacts returns (as the whole point of buyouts and why they create solid returns is that you're benefiting from the leverage put onto the business!).
But sponsors are sitting on the highest levels of cash they ever have, and fundraising wasn't too dented last year. So sponsors are willing and able to do deals so long as capital markets are open (i.e., they can raise debt) and the price is right, which is what we'll discuss next...
Rationale 3: Multiples are Coming Down
In many respects the stunted deal activity of late last year can be chalked up to a kind of stalemate that arose due to the inability of those that could be acquired to capitulate to lower valuations.
This isn't really that surprising. Whenever there's a deep selloff in a sector, every company thinks they've been unfairly harmed by the broader macro backdrop (i.e., maybe it makes sense for others to have their valuations cut, but not us).
However, we're beginning to see a new equilibrium form as most recognize that the lofty double digit price-to-sales multiples of 2021 were an aberration, not the norm.
Further, because the Fed has made it clear that they aren't looking to raise rates and then rapidly cut them as soon as negative economic tremors occur, sponsors are recognizing that if they wait around for an easier funding environment, they'll be waiting a long time. In other words, debt isn't going to be as cheap as it was during 2020-21 for the foreseeable future.
In the early months of this year we're already seeing sponsors lining up to do some larger deals (i.e., Blackstone circling Cvent and Silver Lake looking to buyout Qualtrics who they already have a 15% stake in).
In the end, there's no getting around the need for both strategics and sponsors to deploy capital while rejiggering the mix of cash, debt, and equity being utilized to make the numbers work (for strategics there'll definitely be less of their own equity used, especially for the cash rich big tech companies).
The next year will be an interesting one for both strategics and sponsors. It'll likely be the case that a lot of deals are done that folks aren't particularly excited about, but that they'll look back on and think were excellent deals.
It's an old rule of thumb that the deals that often make you feel the most uncomfortable, and that are done against the worst economic backdrops, are those that end up turning out the best (likely because the economic backdrop makes you unduly pessimistic).
Make no mistake: there are still deals getting done and there will be plenty of deals this upcoming year. It's just that the excessive froth has definitely been taken out of the market.
If you're about to do interviews for a tech group, be sure to check out the tech investment banking interview questions. Alternatively, if you're looking to join a TMT group, there are the TMT interview questions and TMT primer. Since this is around the time when group placement happens, I also wrote a post on how to navigate the group placement process as well.