By Sandeep Gogia, Managing Director – Investment Banking, Equirus
M&A in the tech sector hit a multiyear low in the calendar year 2023 in terms of the total deal value. Also, in terms of the deal count major strategic players such as Meta Platforms Inc., Salesforce Inc., Alphabet Inc., Apple Inc., and Amazon.com Inc. in calendar year 2023 collectively made just 4 acquisitions compared with 18 in calendar year 2022. Similarly, the likes of Infosys, Wipro, Cognizant, and HCL Tech together made only 4 acquisitions in calendar year 2023 compared with 14 acquisitions in calendar year 2022.
Many of the reasons for the lack of deal activity can be attributed to macro factors such as rising interest rates, geopolitical issues, and slowing demand amid talks of recession. Let’s try and gauge whether the worst is behind us or if is 2024 going to be much the same as the past year.
Today we live in a world wherein almost every major region has some form of geopolitical instability whether it be ongoing wars such as those between Russia & Ukraine or Israel & Palestine or be it escalating tensions between nations such as China & Taiwan, Iran & Saudi Arabia, Iran and Pakistan, US and China or US and UK against Iran-backed Houthis in Yemen. Moreover, for different reasons, the world’s two largest economies are facing significant domestic challenges, in the US political polarisation is challenging basic governance functions whereas in China, the challenges stem from macroeconomics and associated policymaking.
To compound it all 2024 is set to be a record year for elections with 50 countries to undergo elections including India, US, and the European Union. After eleven interest rate hikes since March 2022, there are talks of interest rate cuts in 2024 amid cooling inflation figures. This bodes well for the US economy with several economists now getting certain the US will avoid a recession with an accommodative Federal Reserve policy.
Ways in which macro environment impacts tech M&A
Investor interest in certain geographies: The most prominent and obvious impact of geopolitical issues in a region is the lack of deal activity of companies in those regions. Both strategic and financial investors are keeping away from companies in certain Eastern European countries due to the ongoing Russia-Ukraine war. Companies with over-reliance on such geos look to diversify their delivery base and look at more geopolitically stable regions and as a result demand for those regions increases. Managing the location of technology delivery teams is key in an uncertain geopolitical environment, avoiding over-reliance on a particular geography especially if there is an anticipated geopolitical issue.
Cost of capital: Due to the high interest rate environment financing has been more expensive than it has been for a decade. The higher cost of capital puts downward pressure on valuations and requires dealmakers to create more value to deliver the same return as before. A high percentage of sponsor/private equity-backed acquisitions are financed with expensive debt. With interest rates expected to be slashed going forward the cost of capital is expected to be lower which bodes well for private equity-backed M&A transactions. Also, with the increasing cost of capital, PE funds became more stringent with deploying capital. With the funding winter that began in early 2022 continuing to date, startups have found it difficult to raise capital.
Growth concerns and valuations: One major question that will need to be settled in 2024 is whether buyers/investors are willing to accept the prices potential sellers are seeking. That was a major obstacle to dealmaking in 2023. Transactions have been falling apart on bid and ask spreads.
Over the past year, the bleak economic outlook resulted in companies lowering budgets allocated to discretionary technology spend which had a significant negative impact on the topline of technology and IT services companies which in turn negatively impacts the profitability and in turn the valuation. The funding winter has lowered the technology spend budget of startups which has negatively impacted the topline of Technology companies with a large startup client base over the last couple of years. Going forward investors are expected to continue to be more selective when deploying capital, with more focus on unit economics/ profitability and realistic valuation expectations. Hence, growth and valuation expectations of start-ups as well as companies with a large startup client base are expected to continue to be subdued over the next year or so.
Data privacy concerns: Amid the rise of geopolitical uncertainties, data risks, and various region-wise data privacy regulations have taken center stage in the M&A process. Stakeholders are now considering data privacy, security, and ransomware issues during deal negotiations, especially in cross-border deals where they need to give M&A targets additional scrutiny.
The extent of state intervention in cross-border deals: With rising geopolitical issues the regulatory authorities of countries tend to increase the requirement for approvals associated with the flow of capital with certain countries or geographies. Regulatory scrutiny of M&A deals, particularly on anti-competition and national security grounds, is increasing. This tends to hinder deal-making and stretch the timelines for M&A transactions.
Certain factors are driving heightened optimism for 2024 relative to last year. These include the recent improvement in financial markets, decelerating inflation and expected reductions in interest rates; pent-up demand for deals driven by the pressing strategic need for many companies to adapt and transform to stay relevant and grow their topline. Moreover, there is substantial capital waiting to be deployed or dry powder with private equity firms.
According to S&P, global private equity dry powder has soared to an unprecedented USD 2.59 trillion in December 2023. Also, there is significant cash on the balance sheets of Tech and IT services companies that can be used to propel growth via acquisitions. As of September end 2023, Meta Platforms Inc., Salesforce Inc., Alphabet Inc., Apple Inc., and Amazon.com Inc. combined had a cash balance of close to USD 420 Bn. While, Infosys, Wipro, Cognizant and HCL Tech together had a cash balance of close to USD 12.0 Bn.
As the wider macroeconomic and more so geopolitical landscape remains uncertain, advisors should assess risks and plan for different scenarios. It is also important for the advisor to guide their clients on realistic valuation expectations, timelines, transaction structures, changing investor/buyer perspectives, and other factors based on the current macro environment. To ensure an efficient process and timely transaction completion, a specialized advisor is needed who can guide the client on the associated risks from the current macro environment and likely outcomes for the client.
