M&A in the post “tech-ceptionalism era”

After the exceptional run of exponential growth in tech investment and M&A activity which peaked in 2021 and H1 2022 — a “tech-ceptionalism era” enabled by low interest rates and pandemic-fueled demand — investors and corporates are approaching investment and M&A in 2023 with caution. This new era is also likely to be shaped by the recent turmoil in the banking sector, in particular the collapse of Silicon Valley Bank.

The second half of 2022 and start of 2023 has been a more challenging M&A and fundraising environment for tech companies and investors. Parties are having to adapt their approach to pursue opportunities in this new market dynamic. The market instability triggered by the collapse of Silicon Valley Bank will, at least in the short and medium term, likely intensify some of the recent trends we have been seeing in the tech sector:

1. Revaluation of tech companies – Deals are taking longer (with more time spent at the term sheet stage) as buyers and investors take time to assess the market, do more diligence on targets, assess their value and reach agreement on price. The “fear of missing out” mindset no longer drives the deal timetable and the nature of the terms, instead there is more caution in the market and we expect this to continue through 2023.
   
   
2. Sharing risk – Investors (in particular, funds) are increasingly looking at co-investments. Strategic buyers are looking to mitigate and share risk through minority investments or investments stapled with a call option right, commercial agreement or partnership arrangement adopting a “try before you buy” approach.
   
   
3. Bridging the value gap – Buyers and investors are seeking alternative pricing mechanisms to protect against overvaluations and to also reward outperformance including earn-outs (both traditional cash and more innovative non-cash earn-outs linked to financial targets or KPIs), staged investments with increases in investment linked to actual rather than projected financial results and in Asia, variable price adjustments linked to financial targets.
   
   
4. Fundraising challenges for companies and investors
   • Buyers are securing increasingly investor friendly terms as tech companies and investors seek to avoid down rounds. For example, convertible loan and warrant instruments are becoming more prevalent, and we are seeing deeper discounts on conversion, higher liquidation preference multiples, greater investor control/veto rights and capped valuations for future fundraises for existing investors.
     
     
   • Tech companies are also looking to alternative funding sources including credit funds and secondary debt markets often on less favourable terms for investors.
     
     
5. Distressed M&A and further consolidation on the horizon
   • Many tech companies are undergoing internal restructurings to reduce costs (e.g. employee layoffs and consolidating/focusing on core businesses). Despite this, many tech companies will need funding in the near future and with capital being more expensive and less available, there is likely to be an increase in distressed M&A.
     
     
   • Tensions between existing and new investors are increasing. Existing investors may face massive dilution in distressed situations if another investor or a new investor is only willing to fund on the condition that existing investors are significantly diluted and/or lose preference rights. As new investors look to “cram down” new terms on existing investors, different factions of investors are created with existing investors looking to leverage their veto and other rights to protect their own interests. As investors seek to manage their own downside risk, more tech companies could be pushed into difficult situations.
     
     
   • The challenging funding environment and weaker macroeconomic climate is also driving consolidation in the tech sector as tech companies (and their investors) seek faster paths to profitability, opportunities to bolster balance sheets and achieve growth, economies of scale and/or routes to exit. Companies with stronger balance sheets are in a good position to flex these to take advantage of companies trading at lower valuations or in distress.
     
     
6. Uncertain regulatory environment
   • Regulatory scrutiny of tech mergers specifically is at an all-time high, from both competition and foreign investment authorities. EU / UK merger control has seen increased jurisdictional uncertainty over which transactions authorities will review (lowering thresholds/maximising extra territorial reach). There is also greater uncertainty over whether transactions pose concern due to greater focus by authorities on innovation and long-term competition. Foreign investment rules also increase regulatory challenges for investors and buyers, particularly those emanating from high risk jurisdictions.
     
     
   • Regulatory risk has increased even for minority/small acquisitions given heightened regulatory scrutiny of these transactions, although they are likely to be less problematic than control/large acquisitions.
     
     
   • As a result, we are seeing an increased focus on regulatory risks in transactions with investors and buyers undertaking more extensive competition and foreign investment diligence to spot issues pre-transaction and ensure potential regulatory requirements are factored into the transaction timetable and that risk is appropriately allocated in deal docs. It has become increasingly important for companies to build and sustain relationships with competition authorities.
     
     
   • There is an increased focus by parties on (1) risk management (e.g. proactive vs reactive approaches where voluntary filings are triggered, strategic sequencing of authorities’ reviews) and (2) risk allocation with parties agreeing remedies and solutions (e.g. divestment strategies and access remedies) to possible regulatory risks (even where regulatory intervention is unlikely) as part of regulatory CP and transaction documentation negotiations.
     
     
   • The regulatory climate is unlikely to soften for any rescue deals of so-called “failing firms” which may be on the horizon given the current economic challenges, with competition authorities remaining cautious around consolidation in distressed industries.