Trends in Financing Tech M&A

During the recent 2019 Tech M&A Forum, I participated as a panellist in a round table dedicated to Trends in Financing Tech M&A.

During this conference, I touched on three core underlying trends shaping the industry:

(i)    The Tech universe is rapidly transforming and impacting many economic sectors, while benefiting from increased sources of capital with growing interests from financial sponsors

(ii)   Tech-issuers are very distinct in their financing journey, going through different types of financing solutions much faster than the average company to cater to their high-growth profile

(iii)  Equity sources for tech businesses have expanded and enabled companies to stay private longer

Here’s a detailed summary of key points prepared together with my team members Susanne Lahtinen and Pierre Lambert

Fast-evolving universe benefiting from increasing sources of capital

The tech sector comprises several distinct sub-segments from software and payments to big data, IoT and smart metering. The line between horizontal and vertical categorisations is becoming increasingly blurred as various industries are impacted by innovation. Tech has been a driving force in the M&A landscape in the past years with landmark transactions such as IBM’s acquisition of Red Hat and Dell’s acquisition of VMware. Continued rise of e-commerce, cloud computing and fintech are supporting M&A activity in the sector in 2019.

Private equity activity has grown consistently due to the amount of dry powder available and sub-sector focused investment strategies. Software has been a focus area, underpinned by the recurring, subscription-based revenue model as a defensive asset with strong free cash flow potential, even in an economic downturn. PE firms are increasingly making use of “buy & build” strategies and investing into companies earlier. We have witnessed corporate acquisitions change from scale and geography driven to capabilities, technology and innovation focused, as exemplified by the acquisition of eFront by Blackrock.

Tech issuers use debt products catering to high growth

Due to their fast growth, tech companies go through different financing solutions much faster than the average company. Post initial VC / PE equity, they often move to unitranche debt and then onto the institutional debt markets. This evolution can happen over only a couple of years.

We estimate that ~15% of the European syndicated leveraged loans last year were tech-related. The significant growth has been underpinned by sector appetite from PE. TLBs are more popular for PE names overall than bonds, but this is even more pronounced in tech where fast growth and high cashflow generation underscore the value of pre-payment flexibility. Use of high yield bonds by tech businesses remains limited to relatively large issuers. US HY tends to see more varied issuers given larger volumes. Many tech issuers headquartered in other jurisdictions also issue in the US either due to high $-denominated revenues or a view that tech companies are better understood by US investors.

The TLB market has largely converged with HY, with cov-lite becoming the standard for smaller and smaller European issuers. The growing prevalence of buy and build strategies has underlined the importance of add-on flexibility. Debt funding of M&A is also facilitated by more generous EBITDA adjustments manifested as a wider scope of synergies and a longer look-forward period.

One of the drivers of looser TLB terms is competition from direct lending. Unitranche liquidity has seen a marked increase in the last two years and the market has become highly competitive. Terms are not as borrower-friendly as those of syndicated TLBs but have moved closer. Direct lenders are investing in regional European capabilities and playing in a wider size range of deals, with the broadening scope facilitating capital deployment from equity investors into smaller transactions and less standard jurisdictions.

Venture / growth debt has seen a significant increase in usage over the past three years. This is a further reflection of capital supply-demand imbalance where funds face significant competition to deploy capital. TMT is a popular sector, having received almost 80% of venture debt investments in Europe in 2018 according to LCD. Recurring revenue lending is another relatively new debt source for software companies especially. The product originated from the US and is more popular there due to it being a large, uniform market unlike Europe where jurisdictional differences make the structures more cumbersome to implement.

Equity sources have expanded and enabled companies to stay private longer

Sponsors are investing at earlier stages with many private equity firms having established separate growth funds. Large tech businesses are also setting up special funds for supporting new fast growth technologies. Google Venture invests in tech businesses in their early life with notable investments including the collaboration platform Slack and the cross-border payments business CurrencyCloud.

In the public markets, we have seen the largest number of richly valued tech listings since the dot-com boom. Shares of Lyft, Pinterest and Uber are now trading. The likes of Slack and Palantir are expected to follow soon and the pipeline remains strong despite increasing competition from private sources of capital. The European IPO markets saw a slow start to 2019 with global macro and geopolitical concerns but despite this, a healthy number of companies are preparing for IPOs later this year.

The large cohort of recent tech IPOs has displayed some significant differences versus the 1990s tech listings. Many rode the rise of mobile connectivity and cloud computing in the last decade to multibillion valuations and spent longer as private companies than the 1990s IPOs had. When Yahoo went public, none of its tech IPO cohort had been in existence for more than three years. Uber, Lyft and Pinterest, in contrast, have all been operating for over a decade. Increased regulation of public companies can be considered as one of the reasons for this change along with increased access to VC and other sources to finance start-ups away from the scrutiny of the public eye. Stock market liquidity, aggressive valuations and relative scarcity of IPOs have permitted debut issuers to raise significantly higher amounts in recent years. This trend could soften in the medium term given disappointing results of IPOs including Uber and a busier pipeline potentially constraining liquidity.

 Read the article on LinkedIn.