Regulatory risk is real for M&A—where is risk/return more attractive?

May 17, 2023
Written by Amar Pandya
Regulatory risk is real for M&A—where is risk/return more attractive?

As published in Conseiller on 16 May 2023 and FI: Finance et Investissement on 3 May 2023

The punchbowl has been taken away. The era of “free money” being thrown with abandon by investors at entrepreneurs and fast-growing companies is now giving way to sober second thoughts. Not only is this a necessary correction to prevent speculative bubbles from getting bigger and eventually, as they always do, blowing up,
but it’s also a potential tailwind for the next merger & acquisition cycle in Canada, particularly in the small-to-mid-cap space.  

The rapid rise in interest rates over the past year and now the recent turmoil in the U.S. regional banking sector and Credit Suisse in Europe has further cast a chill on market conditions, adding to investors’ stress and uncertainty. Smaller, growth-oriented businesses are finding a less hospitable credit environment amidst the ongoing challenges of managing their higher interest debt. Consensus view from Fed officials is for greater risk to the downside—the last time there was near unanimous agreement on an economic forecast was back in 2007.  

An encouraging development is the return of banks offering buyout debt financing. Other promising news is private equity firms have ample dry powder for acquisitions, and recent deals have occurred without the use of leverage. Now with banks more willing to step back in and provide financing, private equity-led deals could be on the rise.  

The sparks to set off a potential increase in M&A are everywhere: 1) private equity and strategic buyers incentivised to do deals; 2) approximately US$1 trillion in coffers ready to be deployed; 3) public market valuations being more attractive than in the private markets; and 4) acquisitions being a faster means of growth to offset slower organic growth rates. 

M&A is especially likely to occur in the small-cap space where valuations have been depressed for far longer. As share prices continue to languish, shareholders of target companies are coming to accept current valuations instead of holding out for the higher multiples from the days of yore (2021).  

The regulatory environment has been hostile towards large and mega merger deals with Big Tech and Big Pharma finding themselves in regulators’ crosshairs. This was exemplified recently with UK regulators seeking to block the US$69 billion acquisition of Activision Inc. by Microsoft. So, while mega- and large-cap M&A activity has slowed down partly due to an increasingly hostile regulatory environment, small- and mid-cap M&A activity and expectations remain elevated. Across a broader range of sectors and industries, we are seeing more acquirers take advantage of low, and in some cases dislocated, public market valuations for both strategic and financially motivated acquisitions. The tech sector, which has been severely beaten down in the past year or so, in our opinion is likely to see an increase in M&A activity in 2023 and 2024.  

There are many high-quality tech companies in Canada that are trading at a discount of greater than 50% to their private market value, despite double-digit growth rates and an attractive long-term runway to compound growth. However, with the macro headwinds of rising interest rates and concerns about slowing economic growth, these companies are experiencing reset valuations and multiple compression making them appealing acquisition targets.  

Stock prices appear to be broken, but these businesses are not broken. We are already seeing M&A picking up pace as pockets of Canadian small caps are very attractively priced relative to the business quality. Strategic buyers are looking for attractive unit economics, long-term growth runways and durable competitive advantages.  

Magnet Forensics is an example of a high-quality technology business with a public market valuation at a discount to its private market value that was recently acquired by a financial and strategically motivated buyer.  

Unprofitable technology companies may continue to underperform with investors’ flight to safety. Some of these unprofitable companies will find it difficult to fund their growth plans with capital markets effectively closed to them. Not all good companies will be able or willing to withstand the tough environment or capture long-term growth opportunities. Today, their management teams and boards may be more receptive to a buyout offer than they would have been 18 months ago. The anchoring bias, or ideé fixe, of mentally holding on to a higher past valuation, is giving way to the realization that the company may have a better chance of survival in stronger hands.

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