What are the key M&A trends observed in 2019?Some of these trends have changed the contours of deal making

Introduction

• The global economy has witnessed a significant growth post recession. The continued growth in the corporate sector followed by low interest rates and reduction in corporate tax rates(from 35% to 20%) along with surge in stock market indices have contributed to record levels of cash reserves in corporate balance sheet and access to cheap credit for Financial acquirers like Private equity firms.
• The companies are using this excess cash for share buybacks and in Mergers and Acquisitions.As the companies find organic growth difficult to come, they are resorting to acquisitions and other inorganic expansion to increase their market share and hence their shareholder returns.
• Technology contributes to a majority of deal making in M&A today.As technology and digital continues to disrupt every industry in how it operates, majority of the acquisitions are focused on buying emerging technology assets that can insulate companies from digital threats.

Major areas within technology and digital that sees huge demand in 2019 is:

• Cybersecurity - There is a huge demand for these assets and valuations are over the roof with some of them valued at exit multiples of more than 30x.As 90% of the data is created in the last 2 years, there is an increasing need to protect this data from hacking and other security threats.In addition, as more and more companies are moving their data towards cloud from on-premise, the demand for cybersecurity services has become high.The incumbent market leaders like Symantec and Pao Alto networks do not have enough security and preventive measures to counter hacking and other frauds.Hence there has been a rise of startups that provides digital platforms in Cybersecurity which use Machine learning technology and Artificial intelligence to identify threats and data that are vulnerable to threats. High IPO valuation of Crowdstrike recently is a proof that investors are interested to put their money in Cybersecurity.
• Cloud computing - Cloud computing continues to be in demand and companies focusing here are valued at very high price by investors.IBM acquisition of Redhat is a clear proof how lucrative this area is and why 70% of the companies want to push their data from their data centers to multi cloud.IBM acquisition of Redhat at ~$33B was the highest ever by IBM where Redhat was bought at its highest trading price.
• Machine Learning - This is one area which is witnessing a highest growth in acquisitions at recent years.As more and more data are collected and stored in cloud, algorithms are required to be built that can analyze this data and generate powerful insights which can improve customer experience.Machine Learning and Artificial intelligence would be in demand for years to come.
• Enterprise and Marketing Apps - These continue to be in demand for their ability to automate data and improve productivity.

More and More Acquisitions today are done for Transformational growth

As we analyse the recent M&A deals in Technology space, one realize that these acquisitions are done to increase revenues and market share as against consolidation and reduce costs.

Some of the transaction that standout are:

• IBM-Redhat acquisition - IBM, whose business continues to shrink and most of it's recent investments have not generated returns acquired Redhat to venture into Hybrid cloud to strengthen its cloud offering.Redhat strong support towards Opensource and it's open culture is a strong contrast to IBM conservative and bureaucratic thinking.Further IBM which is valued at 1x sales has bought Redhat with around ~7x sales multiple.The success of this acquisition depends on how IBM can preserve Redhat innovation and culture when trying to integrate Redhat over the coming years.
• Microsoft's acquisition of Github - Microsoft which is known for proprietary technology right from its Operating system to Software and was strongly opposed to Opensource goes and acquires Github which gives its source code to public for free.This is because Microsoft have realized that innovation around Devops is more in Opensource and Github developer community is mainly responsible for the success of its devops platform.
• Atos acquisition of Syntel / DXC acquisition of Luxoft - These acquisitions by IT service firms either to build digital capabilities or expand geographically focus on complementary capabilities in order to build an end to end service offering.Atos can expand its business to North America with Syntel acquisition and DXC which is purely an Infra player can enter into Digital engineering and services with Luxoft.Both these acquisitions have an extremely sound strategic rationale and if integrated well can transform their businesses.
• Google acquisition of Looker/ Salesforce acquisition of Tableau - These acquisitions find mention as enterprise software providers continue to diversify and strengthen their products/service offering to increase their market share.Google which wants to increase its market share in Cloud Infrastructure segment added Looker Analytics as an add on service for customers to analyze their data in cloud.Salesforce which is a leader in CRM segment acquired Tableau to compete against Microsoft Dynamics and PowerBI offerings to increase its marketshare.These acquisition have ensured that stand alone analytics players cannot compete and sustain in prices against bigger players. This would would lead to further consolidations in analytics market.

As more companies acquire to transform their business, their ability to integrate the target to realize synergies becomes even more important.Most of these acquirers pay huge money at high multiples for these acquisitions. Hence integration success would mean not only realizing synergies target but also ensure preservation of the target companies identity and culture.

Targets like Tableau, Github and even Redhat have a huge loyal userbase and developer community which have contributed to these company's overall success and their brand reputation.

Why valuations are so high for Technology companies?

• Due to disruption of digital, there is a demand for companies that offer platforms and service offerings in emerging technologies.
• The macroeconomic indicators like low interest rate and booming stock indices in all major exchanges globally have contributed to the high valuations but the standout reason is the emergence of Private Equity firms competing with strategic acquirers that have raised the valuations high.
• PE firms that buy companies using leverage generally invest in matured business that has predictable cash flows and where there is a scope to reduce costs to increase their EBITDA. Hence most of their investments and their exit multiples rely on EBITDA valuation.This changed when PE firms instead of focusing on EBITDA gave more importance to growth and revenue projections of the technology companies.This resulted in intense competition for technology assets between strategic and financial acquirers.
• The rationale followed by PE firms is that they would hold such digital companies for 3-5 years and then exit at far higher multiple by either selling to strategic acquirers or through an IPO which would give them an IRR of more than 30%.In some cases the PE firms also are involved in add on acquisitions where they look for targets that can be rolled up to their portfolio companies which can result in increase in portfolio companies revenues and market share.
• PE firms are also the big buyers of VC sponsored startup companies.Previously most of the VC sponsored companies exit by either selling their startups to the other VC companies or they lead to an IPO.Of late PE funds have become huge buyers of startups and these startups are rolled up to one of their portfolio companies. This gives scope for PE firms to add value to their portfolio companies which would help in increasing their returns on investments.
• Even though the valuations are high due to the high competition from PE firms, it is generally observed that PE firms are not able to either get an higher exit multiple or due to their high use of leverage, their IRR at exit is lower than expected.

Emergence of Activist Investors

• The emergence of activist investors has also made a significant impact on the recent M&A trends.Companies are not only looking to acquire companies to buy growth but at the same time are constantly assessing their portfolio to divest any non core assets which can be spun off to unlock shareholder value. Activist investors push their management and board to divest assets that are no longer adding value.This can improve EBITDA of the company which can directly increase the shareholder value.

Unicorn and Digital companies get huge IPO valuation

• Unicorn and other emerging digital companies that have raised money through Venture Capitalists are making an entry to the stock market through IPO.Most of these companies have been able to get huge valuations and have been able to increase their price in the secondary market.Other companies like Uber and Lyft were not as successful as they expected.This again indicates that investors are looking to speculate on revenues growth of these digital companies though most of these companies are still not profitable and continue to burn cash.

Conclusion

• M&A activity would continue to increase for remaining part of 2019 as there is no indication of economic slowdown.With fed not looking to increase interest rates, the stock market would still continue to rally which will make the valuations of technology companies high.
• Most of the corporate acquirers are looking to buy growth as organic growth continues to decline.Hence acquisitions are happening for accessing technology, expand business geographically and diversify the product and service offering in order to increase market share.With strategic rationale behind most acquisitions continuing to be transformational, integrating the target company with the acquirer to achieve synergy is the major challenge and going to determine the success of the transaction.
• PE and VC funds still continue to acquire technology companies at scorching rate due to the availability of dry powder along with low interest rates.As PE firms buy companies at high valuation, a clear strategy needs to be there to improve the operations of the portfolio company in order to exit at higher multiple.For this, operating partners are going to be critical and it is important that these partners have industry wide experience in digital and technology which can help in turn around the portfolio company.