Your Full-Service Accounting + Business Growth Advisory Partner

How Insulated is Technology M&A from Rising Interest Rates and Inflation?

Technology, media, and telecoms (TMT) mid-market M&A shows resilience to ongoing macroeconomic uncertainties, led by software deals. However, questions remain over how companies and investors are likely to react in coming quarters.

Interest rate hikes, inflation, continued supply chain disruptions and Russia’s war in Ukraine all contribute to increased macroeconomic uncertainty.

For companies and investors, the situation raises questions about future economic prospects. Are we, for example, moving from a bull to a bear market? And what of the risk of stagflation?

Mid-market TMT M&A data indicates that technology, media, and telecoms companies remain attractive M&A targets – and are actively engaged in acquisitions.

While Q2 2022 saw a quarter-on-quarter drop in deal totals and value, the quarter was still among the best on record. The overall impression is of industries weathering the short-term fall-out of macroeconomic developments. Potential longer-term M&A resilience will be linked to market developments and the responses among companies, investors, governments, and central banks.

As companies and investors consider an uncertain future, their optimal paths to success depend on identifying strategies and initiatives that match markets and economies’ potential responses to ongoing stressors.

TMT continues strong deal performance

Mergermarket mid-market M&A data for Q2 2022 shows a slowdown in TMT deals. However, following a record Q1, the second quarter still posted impressive deal numbers and totals.

Only three recent quarters have surpassed the 715 TMT deals in Q2 2022. The US$58.2 billion total deal value was also among the best on record.

TMT sits firmly at the top of mid-market M&A in terms of deal volume, and that trend continued to hold true in Q2. Only the previous quarter topped its performance in terms of mid-market deal percentage.

Based on the findings, the fall in M&A activity between the first and second quarters should be put into a broader context. In other words, there seems to be a continued appetite for M&A in the TMT space, which has increased its overall share of mid-market M&A over the last five to six quarters.

Private Equity remains focused on TMT

Private equity (PE) firms were extremely active in Q2 2022, responsible for 51% of deal volume and 56% of deal value across TMT.

The average deal size for mid-market TMT M&A was US$81.4 million, one of the lowest in recent years. The same applies to the average US$73.7 million deal size for PEs investing in TMT.

However, the combined US$75 billion PEs have invested in mid-market TMT company buyouts during the first six months of 2022 puts it on target to match the US$158 invested in 2021. The first half of 2022 has already surpassed the US$60 billion PEs invested in TMT companies in 2020.

Simultaneously, PE funds have been busy expanding growth and venture assets. These types of PE investments have been growing at twice the speed of traditional buyouts over the past ten years.

One of the takeaways is that PEs, who hold vast stores of dry powder, continue to find TMT attractive sectors for investments.

Software deals dominate M&A

Split by industry, technology remains firmly in the driver’s seat for mid-market TMT M&A. The trend is toward strengthening dominance, with technology surpassing 83.4% of all TMT mid-market deals in the last quarter of 2021 and reaching a record 86.7% in Q2 of this year, marking a 20% YoY increase.

As has been the case for previous quarters, software is the strongest performer within technology, representing around 90% of technology deals. In Q2 2022, it set a high watermark, representing 94.4% of all technology deals.

The M&A data indicates that mid-market technology, led by software, has continued to perform well. The results are perhaps particularly impressive in the face of rising uncertainties, mainly attributed to macroeconomic trends, and raises the question of whether TMT M&A is somewhat insulated from the uncertainties.

The short answer to which would be a tentative yes.

Economic uncertainty raises valuation questions

Blip, stagflation, or recession? Questions abound about the globally rising interest rates and inflation levels. Russia’s war in Ukraine and rapidly rising energy and food prices raise their own issues. Market recalibrations and resets are nothing new, but they rarely have the size or display the volatility seen during the first half of 2022.

Their influence on stock prices, valuation processes, and M&A includes making debt financing acquisitions more costly, real returns on investments more uncertain, and asset divestment more difficult.

As my colleague Tom Manion has put it, M&A and valuations will be challenged after almost ten years of median target EV/EBITDA multiples being above their 30-year average.

As a result of rising macroeconomic uncertainty, companies and investors must, amongst other things, revisit financial projections, such as future earnings forecasts.

The uncertainty affects companies and investors’ valuation processes, potentially complicating deal negotiations. As highlighted in BDO USA’s recent Private Capital Pulse Survey, PE fund managers identify gaps between buyer and seller valuation expectations as their top challenge to closing deals.

Different scenarios in play

The longer-term consequences – and likely actions of companies and investors, depend on whether inflation, supply chain issues and interest hikes are temporary, medium-term or long-term issues. Put briefly, the outline of each scenario and likely company and investor reactions are:

  • Temporary scenario: Inflation and interest hikes rates are temporary phenomenon. Energy price and supply chain issues abate soon. Companies and investors will likely keep focusing on M&A, human capital, and developing supply chains.
  • Medium-term scenario: Inflation rates of 3-4% continue for years, alongside interest rate hikes, and elevate supply chain, energy, and production costs. Companies and investors (especially PEs) will focus on performance improvements.
  • Longer-term scenario: Inflation remains elevated (8% to 9%) for an extended period. Interest rates rise globally as supply chains remain stretched and production costs continue to rise. Companies and investors may look to diversify and focus on cost savings to weather the fall-out.

The range of possible outcomes and consequences is immense: from inflation and other issues being transient to long-term inflation and possibly recession.

Which scenario will become reality in the coming months and years remains unknown. However, the lesson for both investors and companies is that working with varying future scenarios and planning strategic and financial responses to changing circumstances is pivotal to increasing resilience.

TMT outlook bright despite impacts

TMT companies and investors are feeling the impact of the ongoing disruption, especially on operations costs, sales and projections of future earnings.

Publicly traded technology companies have taken massive hits, some seeing stock value drop as much as 70%. Simultaneously, CB Insights data shows how VC funding for start-ups dropped by 23% between the first and second quarters of 2022.

TMT is feeling the impact of ongoing economic disruption. Publicly traded companies have taken massive hits, with the Nasdaq Composite Index recording its worst first half year and top tech companies losing US$3 trillion in market cap.

Against such a backdrop it may sound odd to describe TMT, led by software, as somewhat insulated and perhaps even protected from the short-term fall-out. However, many companies continue to see relatively strong investment and deal activity.

One reason is the recurring revenue generated by many TMT companies, especially in the Software-as-a-Service (SaaS) space. A Capchase analysis of 400 SaaS companies showed how many are maintaining healthy gross margins and beating the so-called “Rule of 40,” where the combined growth rate and profit margin should exceed 40%

There are several underlying reasons, but the best way of summarizing it is perhaps the famous quote from the CEO and founder of Vista Equity Partners, Robert Smith:

“Software contracts are better than first-lien debt.”

In other words, many companies are now so reliant on TMT services (exemplified by software in this case) that they will defer interest payment on their first lien until after they pay their software maintenance or subscription fee.

This may become even more the case as TMT solutions are pivotal for other industries to create efficiencies, performance improvements and cost savings needed to weather the current financial upheaval.

Mid-market companies in a sweet spot?

A central question is what factors are contributing to ongoing developments. As explored here, there are several factors in play.

One particularly important dynamic to consider is that periods of uncertainty generally encourage investors to focus on safer investments.

Aswath Damodaran, Professor of Finance at Stern School of Business at NYU, has explored this topic in depth. Among his conclusions is that we are experiencing a drawback on risk capital.

Risk capital is the portion of capital that is invested in the riskiest segments of each market, and safety capital is that portion that finds its way to the safest segments in each market.

Against this backdrop, mature companies with proven profits, deep customer ties and solid revenue streams are likely to be extra attractive. One example of this can be found in the Capchase report on SaaS companies. Here, industry leaders are not just beating the rule of 40, but the rule of 80, meaning that their growth margin and profit margin exceed 80%. In other words, the companies are strongly focused on strong financial performance.

With this in mind, the mid-market, may be viewed as more robust and resilient to the current pressures. Combined with immense potential for future growth, it makes TMT companies in this segment especially attractive targets.

Written by Patrick Bisceglia. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.

Acquisitions, M&A, Mergers, TMT, VC, venture capital

Leave a Reply

Your email address will not be published. Required fields are marked *


Copyright 2022, Wiss & Company, LLP Accountants & Consultants. All rights reserved.