Listen: MediaTalk | Episode 28: Tech M&A progressing under 'brand new environment'

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Joseph Williams

Hi. I'm Joseph Williams, veteran TMT reporter at S&P Global Market Intelligence focusing on capital markets, M&A, private equity and other cross-sector financial news. Welcome to Media Talk, our monthly podcast.

The tech M&A market has undergone a major overhaul in the past 9 months coming off broad and historic highs to very cautious and increasingly conservative lows. With me here is 451 M&A analyst, Melissa Incera. Melissa has been following the same M&A trends very closely with a particular focus on that software application sector.

Hi, Melissa, thank you for joining me today.

Melissa Incera

Thanks so much for having me.

Joseph Williams

Absolutely, Melissa. We have a lot to discuss about this rapidly changing environment. Before we get into specifics, I'd love to get your high-level general thoughts about what's driving these rapid and massive changes in the market.

Melissa Incera

Sure. Yes. I think if we're going to talk about the transition we've been through this year, it makes sense to kind of just highlight what happened last year, right, which is we saw tech M&A at record valuations. And what was driving that was there was a ton of cash floating on in the environment.

It was cheap. It was very abundant. And at the same time, tech was also experiencing this kind of surge of necessity, right, as the pandemic brought about a lot of changes in people's lives, where they worked from, how they spend their money, et cetera, et cetera.

And because of that, now we're undergoing a massive transition where we're moving from one of the most prolific and lavish capital environments that we've ever seen into one that's quite the opposite, where there's a lot of uncertainty, a lot of risk adversity.

And to your question, right now, capital is getting a lot more expensive as interest rates go up. Growth stock valuations in the public market, which is what tech valuations are, have dropped dramatically. And we also have a slowing economy, which is impacting companies everywhere their ability to post revenues and show strong growth rates.

Joseph Williams

Absolutely, certainly. And at the beginning of this year, coming off 2021, I think some of us that watched the sector were wondering how long tech M&A could continue. It started its sort of record run at the end of 2020. It was well over a year before things started cooling off.

And even after January, which really continued the trend, surprisingly enough into February, it was still running at 2021 levels. And even after that, you started to see very clear signs that it was retreating a bit, like there were still major deals being done, but like each month's activity on values and volumes hinged on these big deals.

But now, more and more as years went on, we've seen increasing concern, risk aversion, a chatter about the market being hollowed out against this backdrop of -- if you look at the whole year's metrics, it's actually pretty impressive historically.

Maybe you can tell me where we're at now and what's contributed to that building concern over this period when on paper, the M&A market has looked, in the recent history, pretty robust?

Melissa Incera

Yes. And I think you've hit the nail on the head, right, when you talk about how Q1, the beginning of 2022, was high flying. As you said, it looked like a continuation of 2021. And then it's been a gradual kind of slide down to where we are in Q3.

So Q2 looked a little bit more transitional. There were still some big deals, but a lot more turbulence. That's where we saw the markets really bottom out. And we saw the nature of deals start to change, too.

Q2, we saw a lot of mega takeover deals as a result of public valuations being down, some very opportunistic buyers taking advantage of maybe some sitting ducks or some companies that are coming from a position of weakness in the market.

And now as we close out Q3, we're really starting to feel the market slow. And so not just to the point where we're reverting back to where we were prepandemic, before the mania of last year, but it's looking and feeling like a brand-new environment.

Not a ton of big deals. Usually we track -- our team will look at billion-dollar deals to get a sense of kind of the robustness of the market. Last year, we were averaging about 40 billion-dollar deals per quarter and that's been on the downward slide since then.

In Q3, we saw only 14 billion-dollar deals. So we're losing the kind of the high end of the market. A lot of the deals that we're seeing are much smaller fish at lower valuations, and that's the projection for the way it's going to continue through the end of the year.

Joseph Williams

Got you. Yes. No, totally. So if you look at the year overall, you might still see some historically impressive numbers. But the fact of the matter is each quarter, each month, each week wears on, it's just eroding, eroding.

Let's talk about some of the more specific forces contributing to that trend, that erosion. Like you touched briefly on valuations dropping, on this caution that's already in the market. We also have a changing regulatory backdrop, it seems. What's driving this valuation concern at a time that tech was growing, not only in equity market interest, but with their revenue, with their sales and stuff like that.

And then on the financial buyer side, you had private equity just flushed with cash and highly competitive for these assets, paying huge valuations to add to their technology portfolios. So with all that, what's creating this immediate shift in risk aversion? What's like really threatening dealmaking right now that's causing this pullback?

Melissa Incera

So as always, there are a confluence of factors that are playing into this added degree of caution and risk aversion in the market. So one of the biggest ones is that there have been exit opportunities for companies, particularly early stage companies are starting to close. So with the fact that the public market is under -- is decidedly in bear territory and has been all year, we're not seeing any IPOs.

We're also seeing public tech buyers who are historically the most prolific and tend to spend the most, right, pay the richest multiples for their targets, are retracting from the market. At the same time, other buyers are finding capital a lot more expensive to come by, right? So private equity, for instance, there's a record amount of dry powder in the market, particularly because last year there was so much cash available.

A lot of it still is. But this year, private equity firms are having a much harder time achieving those -- their fundraising goals. So they're being a lot more cautious, a lot more diligent as it comes to deploying available capital. And above all, the valuations are coming down significantly.

Joseph Williams

So yes, like the dynamics you just mentioned are all pressuring valuations. Like you said, these potential sellers, these targets are seeing fewer exit opportunities. So they're like pressed if they do want to create some kind of liquidity. They're pressed to be more -- like seek out buyers and offer good terms as opposed to last year where like big private equity firms were acting as tech consolidators. And the strategic buyers were doing great post-pandemic, so there was just so much upward pressure on valuations.

Melissa Incera

Yes. Absolutely, absolutely.

Joseph Williams

So this private equity dynamic is interesting. It's been cool to watch over the past 2 -- 3 years, and yes, longer than that honestly. But really, got to a frenzy during the past 2 or 3 years, Thoma Bravo, some of the other large financial buyers in the market were scooping up as many tech targets as they could. And they were like consolidating these portfolios and combining assets, in a way strategic companies, that look similar to a strategic buyer.

And they were also paying these rich multiples. Fundraising was high. Investors just were putting a lot of money to work there. And then it's like private equity has been part of what's been propping up a lot of these metrics, probably to put a lot of that dry powder to work.

You mentioned they're just having a harder time with fundraising. So is this sort of just a forward-looking caution on the part of private equity? They do still have the dry powder, but they're just forecasting the growth in their capital start to dwindle, so they're just trying to like circle their wagons in a different way than the strategic guys.

Melissa Incera

Private equity has been really interesting to track because their buying patterns aren't changing as dramatically as we're seeing from strategic buyers, right? Strategic buyers, particularly public strategic buyers, are passing along the valuation discounts to their targets in many ways.

So the general consensus now is private market valuations are a lot more favorable than public, which has not typically been the case. And a lot of that is due, as you're saying, to private equity buyers who are reaching deep into their pockets to shell out for targets.

But again, consistent with what we're seeing across the rest of the market, deal count has slowed dramatically and deal size has also shrunk. The general trend we're seeing is that more and more private equity buys are looking like platform add-ons as opposed to more strategic and a little bit riskier core platform buys now just because there is that degree of caution.

Joseph Williams

Yes. No, that's interesting. And then how are we seeing very recent third quarter, let's say, private equity numbers? How are those looking? Because I know if you separated in some sectors private equity from strategic buyers, the valuations private equity was paying across an entire sector were averaging in the double digits sometimes. Now like how is this new sort of forward-looking caution affecting the numbers for private equity acquisitions?

Melissa Incera

Yes. As we were saying, I think it's reflected more in the deal count, right, and the total deal value. That P/E is posting for like tech targets in aggregate, the valuation multiples have come down, but really not as dramatically as we've seen from other buyer classes. Definitely not as rapidly.

Joseph Williams

How is this increased caution playing out? Are we seeing deals that are falling through because of these financial market dynamics, if you could give any examples there and like how that worked out. Again, Thoma Bravo was throwing money around a lot through the past few years and we're seeing them renegotiate deals and stuff like that. Any color on -- down to the specific deal level there?

Melissa Incera

Yes, absolutely. I will say deal terminations have been really interesting to track this year because the market's been so volatile, right? There's been a lot of fallout for different reasons, particularly because valuations have come down so dramatically, right?

There's often -- or we're seeing many deals where there's a huge discrepancy between what was on offer initially and what the market rate is now -- or market rate is now around the date of completion. So Thoma Bravo's acquisition of Anaplan is a great example.

They didn't back out of the deal, but they did renegotiate slightly and it ended up with about a 3% haircut to the original price, which they articulated had to do with some kind of actions that happened on the part of Anaplan after the agreement was signed. But I guess the takeaway there is buyers are getting a little bit more diligent. They're getting more cautious.

Another thing, as we're talking about forces working against tech M&A right now, I think we have to talk about regulatory forces that have really come right into the mainstream media this year. We're seeing some headwinds for some big deals that came through earlier this year. So great example would be Broadcom-VMware.

Even it could be argued that there are a lot of buyers that are staying on the sidelines. For example, Facebook, we've done a lot of coverage of Facebook's M&A strategy or lack thereof recently because these regulatory forces are a big question mark, right, and they're making buyers apprehensive.

Joseph Williams

Yes. That's interesting. So it's not just necessarily assume the regulatory scrutiny and risk is not necessarily something that they just accept as they try to move forward in this environment, it's actually adding to a forward-looking wait-and-see caution. No, it is interesting.

So you mentioned Broadcom-VMware, the semiconductor sector has come under a lot of sector-unique international scrutiny on the part of regulators. The current FTC is almost blatantly signaling that they're going to be judging deals by new criteria, and they've actually blocked some deals that over 2021 or 2020 period might have sailed through. Any specific examples there or any like dynamics that illustrate that?

Melissa Incera

Yes, absolutely. So there have been a few examples. The one that comes quickest to mind, specifically since we just -- I just mentioned Facebook or Meta. They made a really interesting move last year where they attempted to acquire a company called Within, which is a virtual reality fitness app, and keeping with their transition into kind of a metaverse company.

And the FTC interestingly -- very interestingly blocked the move in July, which at first sense is pretty odd, right, because Meta doesn't have a foothold here. It's not seemingly that anticompetitive. But the message there was, hey, you can't just buy your way to the top anymore, which has been Meta's model if you can conceivably develop this in-house.

So from my limited knowledge of FTC's approach, this is not a type of ruling that we've seen before and could be indicative of a very different type of attitude as it relates to regulating big tech, which it has been pretty vocal about clamping down on, but it's an interesting kind of unexpected example.

Joseph Williams

Absolutely, yes. No, this idea that there's going to be more pressure against deals that can be developed in-house could potentially, if it actually like plays out rigorously and broadly, work against the primary growth strategy on the part of tech companies, right?

They expand and grow by acquisition because they deem that's more efficient in many instances than, yes, building a team to do a specific thing. I could certainly see all that clip the wings of a big strategic motivation to get deals done. Yes, that is interesting.

Yes, so we've talked about this regulatory pressure, which is a unique and uniquely impacting potentially a significant strategic motivation for tech M&A as competition is declining, as the strategic buyers are circling the wagon. Some have retreated a lot just in their sales from the pandemic period.

And then in general, there's just more caution, there's just more like forward-looking risk aversion. And then on the private equity side, you might still read headlines about how much dry powder there is out there, but as fundraising gets more difficult, they have more incentive to hold on to that dry powder.

So among all these dynamics and among the current quarter where this retreating M&A has really -- has continued to decelerate to, like you mentioned before, below prepandemic levels even, like how do you see this playing out? If private equity and strategic buyers -- a lot of the motivation to retreat from the M&A market, not all but significant amount, is to just kind of hold on and see what happens, what's going to happen?

Like do you see a scenario in which things loosen up again and all this dry powder goes back in there? Or do you think we're going to be in the sort of like valley retreat period for a long time based on the longevity of these trends?

Melissa Incera

Yes. I think for at least a little while longer, we'll see the trend that has emerged through Q3, which is a lot of really small deals, the hollow middle market, maybe an occasional big mega deal because valuations are low. I think we'll see that continue within the near future, at least through year-end.

I think we're coming to a point where a lot of companies are going to be hitting on really important crossroads, right? So a lot of young, smaller start-ups raised capital at the height of last year's kind of boon year and they're going to start -- usually, those funding rounds are designed to last about 18 months.

So we're going to start seeing a lot of these companies run out of funding and then have to make a decision, hey, do we try and raise another round where there's really not much -- there's really not a lot of capital on the table anymore? Or do we sell? Do we try our luck hitching our wagon on to someone else?

So I believe that's a lot of what we'll see moving end of this year, early next year as a primary driver of deals. And then bigger picture, cash is expensive and the people aren't parting with it very willingly right now. So the market is really looking to the Fed, looking to see how monetary policy will shake out, how high do they have to go to get us out of the inflationary mess we're in and will that tip us into a recession.

So for me to see that things really change -- for me to anticipate that things will really change, I think we'll probably have to see a pivot in terms of monetary policy to see investor sentiment really pivot as well. But, yes, I'll caveat that with a lot of investors, growth stage and early stage, see an amazing market opportunity right now.

And we talked about Thoma Bravo earlier, right, that's an amazing example of a private equity company. They were founded in 2008, right? They grew to their prominence they have today out of a period like we're experiencing right now. A lot of people will take advantage of this really unique investment opportunity, right?

Joseph Williams

Absolutely. Yes. No, that's a really good point. Obviously, there's a lot of uncertainty and a lot of people talking and writing about that. But you also see interest in investors in taking advantage of this low valuation period if you can make sense with interest rates and everything. But yes, that is a really good point because the 2008 recession did create a new kind of investment firm, almost, just to take advantage of those market lows, yes.

And then talking about the run-up in valuations, in fundraising for private companies, small company valuations and the VC market and stuff like that, as an example of an outlier, we did see Adobe pay a pretty startling price for Figma. And to be fair, Figma's got a really interesting growth story. And then Adobe is seeing the market, to some degree, shift away from its distribution style.

So there's a lot of specifics in there. But at the end of the day at a time when it's increasingly becoming a buyer's market and everyone is more cautious and you have Adobe out there doing a deal at like 2021 levels in late 2022. So is that -- do you think that's just going to be an outlier? Or do you think there might be still some compulsion for companies to pay high multiples outside of just the individual strategic motivation?

Going forward, do you expect to see any more of these kind of like big prices paid to create growth stability in a slower growth company? Or do you expect the Figma-Adobe deal to be one of the last fireworks of the big historic high period?

Melissa Incera

I would say that I expect it to be an outlier and one of the last fireworks, but I would have said that back in June about a number of deals and then Adobe-Figma happened. So I guess this year, more than anything, has been characterized by on the extreme duality of the market, right?

The really high-end record -- most expensive deals on record and then the fact that there's not a lot in the middle. But I guess, yes, I think you only really have to look at the market's reaction to the Adobe-Figma deal, which is that Adobe was severely penalized for it because it was not in keeping with the current market dynamics.

Joseph Williams

Absolutely. Yes, yes.

Melissa Incera

So I guess -- just I'll also throw out there. In contrast, another big deal that happened in Q3 was OpenText's acquisition of Micro Focus. Yes, it's really interesting example that really shows how much the market has declined, in that OpenText is buying the way it always has, right? It buys legacy vendors past their heyday, but that have cash generative power and it doesn't pay much of a premium for them.

And that's what's available right now, right? There's a lot of discount deals, a lot of opportunity for maybe not hostile takeovers, but unsolicited takeovers. And that's more in keeping with what we're seeing as opposed to Adobe-Figma, which was very unexpected.

Joseph Williams

Yes, yes. It was a deal that would have happened in more of a seller's market there, yes. And even in the case of you have the public -- they still paid twice the public market valuation, but they only get them like 2x, like double public market valuations. Typically a pretty big swing up or -- but at the same time, if it only gets you 2x, that's still deeply discounted by -- yes. Interesting.

Yes, it will be cool to see how the -- or it could be painful, et cetera, et cetera. For those of us that follow it in nerdy curiosity, I mean really interesting to see how these dynamics play out because it sounds like there's a lot of forces pushing and pulling. And yes, thanks for going through this with us. It's an interesting time that impacts all these forces and motivations.

Melissa Incera

Yes. It's a super interesting time. A lot is happening, a lot to unpack. And I'm sure we're going to see a lot more surprises before year-end if recent history has anything to show us.

Joseph Williams

Absolutely. Like you said, with the Adobe deal, it's like you thought the last one of those would have been coming in, the Adobe thing happened. I'm like here we go again. But it seems like this turbulent backdrop is creating a lot of ambivalence.

Yes, I definitely wouldn't be surprised if I was very surprised next month. Thanks so much for joining me, Melissa, and going through this. Really appreciate the detail and color here. Yes, and you can see Melissa's work on our platform. It's a really great research.

Melissa Incera

Thanks so much, Joseph. It was great talking to you.

Joseph Williams

And thank you for joining us for our regular Media Talk podcast. Again, I'm Joseph Williams, and shortly we'll have another installment covering another interesting topic in the sectors and trends of the broad TMT industry.