As published in Finance et Investissement on 29 November 2023 (in French).
Since early autumn, La Belle Province has seen a significant uptick in mergers & acquisition deal activity among small cap companies. To date, several Quebec-based companies have been acquired at healthy premiums by private equity firms and strategic investors. What do they know that other investors should also be aware of? For some time, in our commentaries and webinars, our portfolio managers have been beating the drum about the attractiveness of the current wide divergence between the intrinsic value and market prices in some of these companies. Savvy investors and those with asymmetric knowledge of the appealing risk/reward attributes and expectations of high future returns in these high-quality, bargain-priced Quebec-based are happy to pay up to close the deal.
The list of recent transactions spans the gamut of sectors and industries from semiconductors (Opsens), to water treatment (H2O Innovation), marine terminals (Logistec). Why the sudden interest from investors?
There are several key reasons for the rise in dealmaking and why we expect there is more to come. First, the valuation gap between small and large gap companies is at historic levels. In November 2023, the S&P 500 was up 17% for the year compared to the Russell 2000, up only 2%. Investors have started to finally take notice. Second, there is pent-up demand and a more favourable match-up between motivated buyers and sellers. Private equity funds have a lot of dry powder, $2.5 trillion and sellers are coming to terms that the calendar says 2023, not 2020, and company valuations should be adjusted accordingly. Frustrated shareholders and increased activism directed at boards to unlock value makes companies more receptive to offers at a premium to the current market price. And insiders with the advantage of asymmetric information are seeking to capitalize on this environment. For example, the completed acquisition of Magnet Forensics and current offers for H2O Innovation and Q4 Inc are effectively private equity led management buyouts with insiders rolling their interest into the privatized company. Aimia Inc. is also subject to a hostile takeover from its largest shareholder, Mithaq Capital and is the subject to a contentious battle amongst insiders.
This is a favorable environment for several of strategies including our small-cap focused equity funds which hold many small-cap businesses trading at deep discounts to our estimate of intrinsic or private market value. This is also a favorable tailwind for our arbitrage funds as M&A activity from our core small-cap universe are typically our largest positions and biggest contributors to performance.
There are several unique market dynamics which make small cap M&A particularly compelling right now:
- There is a large pool of buyers for smaller companies, including strategic buyers, management buyouts, private equity funds, pension/sovereign funds and industry consolidators;
- The end-market for small cap businesses is typically domestic or trans-boarder. This is an attractive characteristic in an uncertain geopolitical environment where governments are promoting reshoring supply chains;
- Financing conditions remain a challenge in this rising rate environment, particularly for large-cap mergers and LBOs (leveraged buyouts) which require a large syndicate of financiers. Smaller acquisitions are much easier to finance with cash on hand and more flexible funding options;
- There is a large vintage of IPOs from 2020-2021 which are trading well below their IPO price. Even with positive growth and attractive fundamentals, many of these businesses will find it challenging to gain new public market investors due anchoring bias. Many investors once bitten, are twice shy. These companies can be attractive insider buyout targets;
- The regulatory environment remains hostile in both Canada and the US with smaller mergers less likely to receive the regulatory pushback of larger mergers.
- In a slowing economic environment, strategic buyers seeking to acquire competitors for scale and synergies are better able to compete and negotiate favourable prices.