The outlook for tech M&A in 2023 is difficult to predict, with consensus forecasts pointing towards a stronger second half than first half of the year. In spite of a challenging economic and political landscape in Q4, and widely reported measures to trim headcounts across the goliaths of the global tech world, the number of tech deals closed in Q4 actually hit its highest level since 2019.
The momentum going into 2023 is positive. With tighter and more expensive debt in the new normal, we expect the mid-market to be the key battleground for M&A in 2023. While the frothier valuations may have eased back, the appetite for annual recurring revenue (ARR) based investment remains strong. It may be a more subdued M&A market in H1, but TMT businesses are likely to remain at the forefront of investor appetite.
You can find out more in our latest quarterly review.
Investors are re-pricing risk in a high inflation, rising interest rate environment – and the largest global tech businesses are trimming headcounts. However, look below the surface and UK M&A deal activity across TMT tells a different story. We tracked 1,125 deals across software, IT services, fintech, and advertising and marketing services - up 1.8% on 2021 and comfortably higher than 2019 levels, and any of the previous three years.
The combined enterprise value of deals (where the value was shared publicly) in 2022 was £53.1 billion, down 8.1% in the final quarter compared to Q3. Larger mega-deals became more challenging as debt-financing costs rose in the final quarter, but still edged past the £53 billion recorded in 2019. So, while some of the froth may have subsided, the M&A market for UK TMT assets has remained robust, particularly in the mid-market, while valuations have, perhaps a little surprisingly, also stayed strong.
This is impressive, given the multiple headwinds which confronted investors in Q4: the continuing war in Ukraine; record inflation; costly debt; changing fiscal policy; and two changes of UK prime minister.
While some sectors were more subdued – notably broader advertising and marketing services and fintech, where end-consumer market exposure made dealmaking more challenging – the plethora of buy-and-build platforms continued to underpin deal activity, most notably in IT services where there was renewed impetus during the year. The extent to which well-funded platforms with strong balance sheets – whether PE-backed or listed – remain confident in adding to their portfolios, and continue to see value in capability and market extension through M&A, will be a key factor in how 2023 activity levels play out.
Our Q3 report identified the first signs of a tapering off in deal activity as a result of the high levels of uncertainty and economic headwinds, after a very strong first half of 2022. It was perhaps surprising therefore to see growth returning to the UK TMT M&A market in Q4, with 273 deals reported, 10% up on Q3 2022 and 3% up on the final quarter of 2021. These are encouraging signs of market momentum going into 2023.
Tech stocks appear to have settled at a ‘new normal’, following a fall from the dizzying highs driven by the COVID-19 bounce and the prolonged period of very cheap debt and positive market sentiment for growth stocks.
Public market performance stabilised in Q4, and while investors in TMT stocks won't have been immune to the widespread negative returns that characterised public markets over the year, this doesn't seem to have impacted M&A deal volumes. The challenge is whether the reset has been enough, and whether it creates value expectation gaps between buyers and sellers that may prove a drag on M&A activity in 2023. Creative and pragmatic deal-making may well be required to bridge the gap and get deals done.
Private market M&A valuations haven't been subject to the same volatility as has been evident in public markets. Activity levels are dominated by mid-market deal activity, and have perhaps not been subject to quite the same valuation multiple inflation and volatility as has been experienced in publicly traded stocks.
We saw a slight easing back in ARR valuation multiples for private software assets in Q4, while the equivalent metric for IT services businesses actually trended upwards. The continued demand for digital transformation capability was clearly evident. The broader corporate landscape continues to need to invest in technology to deliver both growth and efficiency, while ensuring they are able to operate securely as cyber risk continues to be a core consideration on board agendas. This is creating opportunities for M&A and keeping valuations strong for quality and niche assets in this market.
Years of cheap and readily available debt came to something of a shuddering halt in late 2022, as inflation and government instability drove up interest rates. Perhaps as a result, there was a notable step down in the proportion of primary PE deals, which accounted for just 8% of deals compared to 13% in Q3.
We expect this to be temporary. There will be a number of PE deals in Q4 that hit the pause button as investors got to grips with trading performance risk and re-assessed returns and debt liquidity and appetite. We would expect these to progressively flow back into the markets in 2023 as forward macroeconomic visibility improves and debt leverage availability and pricing become clearer.
It will take time for PE to adjust to a world where leverage multiples and the cost of debt are higher. This may actually create an opportunity for strategic trade buyers with solid balance sheets and the ability to execute and integrate swiftly. A particular window of opportunity for listed software businesses perhaps, where PE has really dominated the M&A landscape over recent years.
In December, business management software specialist The Access Group announced its acquisition of Construction Industry Solutions (COINS), significantly enhancing its presence in the construction vertical. As one of its largest-ever acquisitions, the deal demonstrated both the ability and desire of Access to pursue larger transactions, notwithstanding the current challenges in debt markets for PE-backed consolidators.
In October, Graphite Capital acquired IT-managed services company Digital Space from Horizon Capital in a secondary PE transaction. The reset of the PE clock serves to renew the investment cycle and brings new impetus to pursue bolt-on M&A for Digital Space.
In December, FPE Capital continued its strong recent run with another investment from their recently raised third fund, backing 15gifts, a customer experience management SaaS platform. As a b2b guided selling software platform delivering improved conversion rates online for major consumer brands, the transaction illustrated the opportunities that still exist within end consumer spend markets if the proposition is strong enough.
ECI Partners backed CSL acquired Caburn Telecom, a global provider of secure IoT connectivity and SIM management. The acquisition adds expertise and scale to CSL’s offer. Caburn has over one million live IoT connections across a variety of sectors and geographies. Its proprietary platform allows customers to easily manage and monitor their entire SIM base. Our team provided sell-side advisory services.
Managed service provider, Air-IT acquired IT solutions specialists Silverbug and Scoria, bringing further scale in London and the Midlands and enhancing capabilities and skills across a materially larger client base. AIR IT helps UK SMEs grow their business through a range of managed IT services, including IT support, comms, cloud, cyber security, and business intelligence. Our team provided buy-side advisory support.
FPE invested in 15gifts, guided selling software for online retailers which serves almost all UK telco-mobile network operators, and large mobile operators in the US and Europe. Its software combines consumer behavioural psychology with machine learning to humanise online sales journeys and model real-time, data-rich customer profiles. Our team provided sell-side advisory services.
Maven VCT completed a £3 million VCT investment in Bud Systems, which provides a SaaS platform to apprenticeship and other training organisations to deliver high-quality training while improving the visibility of progress and performance. It also takes care of compliance in an area subject to increasing regulatory obligations. Our team provided sell-side advisory services.
For more insight and guidance, get in touch with Andy Morgan.
The Chancellor, Jeremy Hunt, is squeezed between a rock and a hard place – under pressure to provide ongoing support for businesses affected by rising interest rates and inflation, and clarify how he's going to pay for it.
Research and development tax credits (RDEC) – a key fiscal measure which has broadly stayed consistent for 20 years, are now being revamped.
In the Autumn Budget 2021, the government announced that both SME tax relief and RDEC would be reformed to support modern research methods by expanding qualifying expenditures to include data and cloud costs. The intention of these reforms is to more effectively capture the benefits of R&D funded by the reliefs: refocusing support towards innovation in the UK, targeting abuse, and improving compliance.
Claimants can look forward to several changes to research and development reliefs from April 2023. Claimants can look forward to several changes to research and development reliefs from April 2023.
RDEC will increase from 13% to 20% - a 53% gross increase. The cash credit will play more of a central role for all key business stakeholders and help fuel further innovation.
SMEs enhanced deduction rate to drop by a third, from 130% down to 86%. Tax-paying SMEs may not see much of a material difference due to the corporation tax-rate increase, but loss-makers will be the most impacted as the headline payable cash-credit rate drops from 14.5% to 10%. So, for every £1 spent on R&D an SME will only get up to 21p (instead of 33p).
Careful planning will be required to manage this reduction. Claimants will also have to answer the question of whether surrendering losses would now be commercially favourable, or if it's better to carry them forward to offset against future taxable profits that will be subject to a higher rate.
The new rules will cover all cloud costs associated with R&D, which includes data storage. This is welcomed news as the initial briefing from HMRC had limited scope. For tech businesses who incur any amounts on upgrading their cloud infrastructure used in R&D environments will now be able to benefit more from these changes.
Relief is now available for businesses involved in artificial intelligence, quantum computing, and robotics. This means that roles previously overlooked and considered ineligible for R&D tax reliefs (eg, data scientists and data modelling) may now potentially be brought in scope. Our historic claims data shows that businesses operating in the tech and financial services industries will be the main beneficiaries of this new change.
As expected from HMRC, new additions are balanced by new restrictions. This is mainly around claiming for R&D conducted overseas. Larger corporates and scale-ups with established presence overseas will no longer be able to claim for costs unless under exceptional circumstances.
The intention is to draw R&D back into the UK - rewarding companies who invest in domestic skills. Now is the time to review your overseas development costs and consider the potential impact on your claims.
If the changes mean that you can now claim for R&D relief for the first time you need to ensure that your documentation is sufficiently robust to avoid delays in receiving your credit. Many companies across the market are now having to wait 40 days instead of the usual 28 because of queries around their evidence. For accounting periods starting on or after 1 April 2023 for an R&D tax relief claim to be valid a claimant must submit an Additional Information form to HMRC.
For more insight and guidance, get in touch with Lindsey Copland.
US firms are leading the way in establishing annual recurring revenue (ARR)-based lending in the UK – replicating products established in the states. Institutionally-backed TMT businesses can benefit from debt packages for M&A, growth CAPEX, and providing additional cash runway. It's a less mature market than its US equivalent, but more and more UK-based firms: ranging from private credit funds, alternative lenders and even the high street, have specialist teams and funds dedicated to building it up in the tech sector. Smaller US-based firms are also injecting additional liquidity into the UK market.
Unlike conventional bank lending, ARR facilities are typically provided to investment-phase businesses forecasting profitability in the next 12-24 months, even if they're currently making a loss.
Lenders structure their facilities against the level of ARR with the majority of the market providing 1-1.5x of ARR in debt facilities. But, it is a new structure and some use an adjusted EBITDA by adding growth-related costs back and looking at a reduced growth case. The potential for borrowers to switch off investment and move into profitability earlier if necessary gives confidence to lenders.
While 1-1.5x is the norm there have been deals at 2x+ ARR with subordinated debt sitting behind the senior facilities.
The quality of ARR is essential. Lenders focussed on recurring contractual revenue supported by financial due diligence and repeat/re-occurring revenues are viewed less favourably.
Equity cornerstone from institutional investors: either venture capital and/or private equity, is necessary to show that the business can be supported alongside the debt provider. Understanding the debt: equity ratio in terms of the business value and how much cash equity has been introduced by the sponsor gives lenders comfort when establishing the debt level. Historic and forecast revenue / ARR growth of 20%+, or CAGR or 30%+. Equity warrants often feature but aren't required and some lenders can structure exit fees instead. The business plan needs to show profitability within 12-24 months where the covenants will switch from growth capital (revenue and liquidity test) to leverage finance (leverage and cashflow generation).
Despite the challenges in the macro-economy and pressure on valuations, lenders remain positive in the TMT space. Credit processes are more detailed, with scrutiny of business plans and potential risks. But, significant liquidity is still available across banks, challengers, and funds to support transactions, which means the debt markets are very much still open.
For more insight and guidance, get in touch with Adam Hughes.