Tech sector M&A outlook

November 2020  |  COVER STORY  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

November 2020 Issue

Mergers and acquisitions (M&As) have remained a vital source of growth and value generation for the technology sector. Tech deal volume has surged in recent years, growing to more than $500bn in 2018, from less than $150bn in 2013, according to Bain & Company.

Last year, though activity in the sector was down compared to 2018, consolidation continued, reaching a total of $245bn by the end of Q3 2019, according to GlobalData. Notable deals included Google’s $2.6bn acquisition of business analytics software developer Looker, Broadcom’s acquisition of Symantec’s enterprise security business, Apollo Funds’ $5.4bn deal for Tech Data, and Salesforce.com Inc’s $15.7bn acquisition of Tableau Software.

Prior to the outbreak of COVID-19, tech M&A was robust. In February 2020, financial services provider Worldline confirmed it had agreed to acquire its rival Ingenico for $8.6bn, for example. But the pandemic, of course, had a devastating effect on activity in the first half of the year. Deal levels dropped due to a lack of confidence in the global economy as well as sudden changes to transaction execution methods.

Deal drivers

Yet some dealmaking has persisted as determined acquirers – particularly large tech companies and private equity (PE) firms – focus on picking up technology assets.

At the top end of the market, trade buyers with cash on hand have been active during the pandemic. Big Tech held more than $560bn in cash and marketable securities combined at the end of the first quarter of 2020, according to Refinitiv. Up to 26 May, Alphabet, Amazon, Apple, Facebook and Microsoft announced 19 deals – the fastest pace of acquisitions to this date since 2015.

In H1 2020, the business to business (B2B) software space also recorded a year-on-year increase of 15.9 percent in Europe in terms of deal count, and a 17.2 percent rise by value, according to Pitchbook’s European M&A Report. “Part of this is increase may be due to software being seen as part-insulated from COVID-19, but it also shows how high quality, and often venture backed tech companies, including life sciences and software companies, have filled the gap in the market by providing accessible, user-friendly and efficient platforms and services which attracted the attention of incumbent providers and financial buyers alike,” notes James Klein, a corporate partner and technology sector head at Shoosmiths.

These transactions have continued even as regulators and politicians voice concerns about the potentially monopolistic dominance of large tech companies. In the US, the Federal Trade Commission (FTC) has begun a review of small acquisitions made by the five tech giants dating back to 2010. Some Democrats have proposed a ban on ‘predatory’ crisis-era purchases by companies with revenues in excess of $100m. Whether such moves eventually curtail acquisitions remains to be seen.

With around $2.3 trillion of dry powder, PE firms have also been a catalyst for deals. “It is likely that we will see an uptick in PE activity in the wake of the crisis,” says Robert Fenner, a partner at Taylor Wessling. “There have been numerous reports of the dry powder that PE funds have at their disposal. With this liquidity behind them and some better priced assets waiting to be bought up, it would not be surprising if we saw activity start again in earnest.”

Overall, the tech sector has weathered the pandemic quite well, drawing the eye of potential acquirers. “Most tech companies are reporting positive trading and their businesses are holding up well,” says Mr Fenner. “Those on a recurring revenue model have been particularly good performers. It is those robust businesses that are attracting most investor interest.”

In June, Instacart, an online grocery delivery platform, saw its valuation almost double from $8bn to $14bn after securing a $225m funding round led by DST Global and General Catalyst. However, larger tech deals which have been common in recent years have largely dried up. In Europe, the only deal exceeding $10bn announced during Q2 2020 was the $12.8bn merger of the UK businesses of Telefónica TEF and Liberty Global.

Since the technology sector has suffered less than many others during the pandemic, tech professionals seem to be more confident about future prospects. According to EY’s Global Capital Confidence Barometer, they are markedly more optimistic about the speed of recovery from the crisis, with 63 percent expecting a ‘V’-shaped recovery, compared to only 38 percent of non-technology respondents. In addition, 70 percent of tech respondents expect to see M&A improve in the short term, compared with 56 percent of non-tech respondents.

As the global economy moves toward recovery, dealmakers are likely to target technology providers – especially those focused on remote working and online trade, which have flourished as a result of new working practices and consumer habits ushered in by the COVID-19 crisis. “COVID-19 has increased reliance on remote digital platforms, with Satya Nadella, Microsoft’s chief executive, observing that the pandemic has seen two years’ worth of digital adoption in two months,” says Mr Klein.

“The systemic trends that have arisen during lockdown – like flexible working or contactless delivery – will likely continue, and therefore likely generate continued M&A interest in this area,” he adds. “We also anticipate that there may be an uptick in distressed asset transactions as we move through lockdown and government subsidies start to dry up. Cashed-up corporates and PE houses may see bargains and the opportunity to realise cost efficiencies through roll-up strategies.”

Despite the challenging economic conditions, strong deal flow in distressed M&A is yet to be seen. According to Mr Fenner, this may in part be because the COVID-19 pandemic and lockdown has accelerated the shift away from certain industries. “Much of the distress is in those industries and there are ever fewer purchasers for what are now perceived as historic business models. We will have to see how the market performs in the coming months,” he says.

The shift to remote working practices precipitated by COVID-19, and calls to pursue a ‘green’ economic recovery, are among a number of factors expected to drive M&A activity in the technology sector in Q3 2020 and beyond. “Tech sector M&A has been surprisingly strong, despite the challenges of the global COVID-19 pandemic and the associated economic slowdown in other industries,” says Laurent Campo, a partner at Potomac Law Group. “M&A participants with strong balance sheets are using this period of economic uncertainty to acquire competitors at favourable valuations.

“Financial M&A participants are proving to have incredible amounts of untapped capital to deploy, and, in my view, looking to acquire businesses in sectors that are proving resilient in the new operational paradigms imposed by the pandemic, especially the challenges presented by remote work,” he continues. “For both types of M&A participants, the current low interest rate environment is making the use of leverage highly attractive.”

At the same time, the current, volatile environment has forced larger companies to re-examine their divisions to identify underperforming units, seek ways to slim down and to unlock value where possible. This introspection is set to bring more assets to market. “So far this year, companies globally have sold 8895 non-core assets worth a total of $391bn at the last count, according to Refinitiv,” notes Mr Fenner. “While the numbers are still low, we can anticipate divestments becoming more and more commonplace as executive teams look to divert resources to core activities.”

Mr Campo also notes the current trend of corporate entities carefully reviewing their operations and seeking to divest themselves of non-core assets or those operations that appear vulnerable considering the global recession. “For targets that have thus far proven to be protected from the economic downturn, and that show signs of continued resilience, I find valuations to be remarkably strong,” he says. “PE buyers appear willing to extend higher than anticipated multiples for key technology players, especially those related to facilitating, enhancing or securing remote work.”

Certainly, the sudden boom in remote working, contactless delivery and other technologies during regional lockdowns may change the game for many companies and create opportunities for acquirers in the future. “The adoption of remote working and contactless delivery will not fall away any time soon, driving demand across the tech ecosystem, including for payment and e-commerce platforms, cyber security, smart supply chain solutions and endpoint delivery,” says Mr Klein. “Technologies that remove the human element, such as blockchain, automation and robotics, are likely to benefit too. We also anticipate an increasing shift towards sustainability and greentech, with companies in renewable energy, electric vehicles, and sustainable food- or plant-based meat alternatives likely to see increased demand and growth.

“Healthcare and life sciences are perhaps the most obvious beneficiaries from the pandemic,” he continues. “Technology in these areas is proceeding at a breathtaking rate, and companies with offerings in virtual- or tele-medicine, biometrics and wearables, dietary supplements and other similar products, are likely to see increased M&A demand as the world emerges from the pandemic with a newfound health consciousness.”

A new playing field

It is clear that the deal market post-COVID-19 will be very different than prior to the outbreak. Already, dealmaking processes have changed out of necessity and those pursuing M&A have been forced to adapt. “Levels of access for diligence will be reduced, especially for site visits and in-person management interviews,” says Mr Klein. “Opinions from auditors and warranties from sellers are likely to be heavily caveated. Forecasts will be more difficult to define and nail down. Buyers and sellers alike will be trying to anticipate the unexpected.

“From a legal standpoint, we expect to see more material adverse change (MAC) clauses, break fees and other similar provisions,” he adds. “We think this is unavoidable and ought not to paralyse M&A activity. A reluctance to recognise the new reality of dealmaking, or insistence on precedent or the established orthodoxy, will need to be reconsidered.”

We can also expect acquirers to utilise more restrictive or specific operating covenants effective between the signing and closing of deals. However, as Baker McKenzie notes, the impact of the COVID-19 crisis will likely be excluded from any offered coverage under warranty and indemnity (W&I) insurance.

On the other hand, MAC clauses, which were already more prevalent prior to the outbreak, may be more common in tech M&A deals as they grant the buyer a right of withdrawal in the event of a substantial deterioration of the target company’s assets or financial situation between signing and closing. That said, MAC clauses can be hotly contested and difficult to enforce. Where possible, sellers will certainly look to remove circumstances such as a pandemic from possible MAC clause triggers.

Given the economic impact of COVID-19, business resilience will be a much greater focus in M&A. According to EY’s ‘2020 Technology M&A Report’, 39 percent of technology executives believe that a target’s business resilience will be one of the key factors determining future M&A strategies. As Mr Fenner points out, resilience is fundamental to dealmaking, and those with resilient business models, including businesses in software, gaming, e-commerce, healthcare and life sciences, can be attractive targets for PE investment.

“Business resilience should always be a focus, especially during positive economic environments,” suggests Mr Campo. “The reality is that the time to prepare for economic shocks is during periods of prosperity. We expect the current downturn to, once again, present an opportunity for resilient entities to emerge stronger than their competitors.”

This rising awareness of resilience will also factor into due diligence processes. According to Baker McKenzie, “due diligence will reflect greater pressure-testing of corporate infrastructure to withstand crises like the current pandemic and risk mitigation measures, with potentially new or more extensive representations being requested of targets”.

Bouncing back

Signs are emerging that the M&A market is beginning to rebound. Nine deals worth $5bn or more were announced in August 2020 – the biggest count for that month since 1999. According to MarketWatch, deals in the tech sector totalled $69.3bn in August, representing 27 percent of global M&A activity for the month. Moreover, six of the top 10 global announced deals involved tech sector targets. NVIDIA’s $40bn offer to acquire UK chip designer Arm Ltd., announced in September, is another indication that the tech M&A market is reawakening.

In the coming months, certain segments of the tech sector are likely to draw the eye of investors. Cloud computing, software as a service (Saas) and cyber security, for example, have flourished since the introduction of social distancing measures and the growth of remote working, according to PwC. The BVP Nasdaq Emerging Cloud Index is 30 percent above its previous record high, illustrating the strong performance of cloud and SaaS companies.

Although dealmaking will present challenges for tech acquirers of all sizes, the sector is flush with opportunities and set to prevail as a hotbed of activity.

© Financier Worldwide

BY

Richard Summerfield