When looking ahead at 2023, it’s clear there are economic headwinds out there impacting deal-making, including inflation and the threat of recession.
Big tech companies are entering a period of austerity, with giants like Google and Microsoft laying off tens of thousands of employees recently. They over-hired during the pandemic, and they are now having layoffs.
But I’d make the case that lower middle market M&A, especially with regards to tech, media, and telecommunications firms and business services companies, will see no slowdown in deals… In fact, there could very well be an increase in transactions in the coming year.
That’s because despite the headwinds out there, these lower middle market companies are benefiting from several tailwinds as well:
- The need for every business to embrace technology.
- The digitization of business.
- The outsourcing of business services.
- The need for cybersecurity.
- And more.
As outlined in the Data site and Merge market Deal Drivers: AMERS 2023 Outlook report, these tailwinds are unstoppable, the result of the inevitable and necessary embrace of technology by businesses of all sizes in every industry.
This means that existing businesses will always need new tech and key business services. However, they also benefit because there are new markets are opening up all the time that need the capabilities of small tech and business services companies.
As a result, the tech, media, and telecommunications sector is “on course to deliver more deals than any other industry. The sector has dominated deal making in the Americas in most quarters over the past several years,” according to the Deal Drivers report.
A great example of this phenomenon would be a SaaS company providing business and tech support services for a company’s operations. Services like this allow businesses to shave expenses and automate tasks in times when bringing on more people is not an option. An offer like that is especially appealing in tough economic times.
In short, there are a lot of needs out in the marketplace that smaller tech and other business services companies can fill—despite what’s going on in the wider economy. One reason these sectors are so strong, even now, is that these businesses often have recurring revenue—it’s baked into their business model.
They offer services and charge their clients/customers regularly for them. They don’t sell one-and-done products. Think of it like an insurance agency or broker (which, by the way, are also being acquired at record numbers right now). When you buy a business like this, you are also buying the “book” of policies that almost always renew every year because the policyholder does not want to bother with researching new options. It’s kind of like guaranteed income.
However, for M&A purposes, these lower middle market tech and business services firms will be a lot more affordable to acquire than during the frothy, go-go good times of the last two or three years.
That is good news if you are a Buyer. It’s a good time to buy because many top potential targets in this space will be more flexible downward on their asking price.
A “New” Place to Look for Tech Deals in 2023
When it comes to acquisitions in the tech space, Silicon Valley is the obvious place to search for targets. However, you should also be looking south…
As they put it in the Deal Drivers report:
“No region in the US has a more heavily stocked pipeline than the South and that includes potential TMT transactions.”
Why the South?
Many companies view the states of the South as more business-friendly, with low corporate and income tax rates…with cheaper real estate…at least compared to places like New York and California.
As they say in the report:
“Cities like Miami and the wider southern Florida area, as well as Atlanta, Georgia, and Austin, Texas, are fast establishing themselves as productive innovation hubs, competing with the stalwart Silicon Valley. Over the coming year and beyond, this should deliver more deal activity and especially M&A with a tech flavor.”
Something to Watch Out For
With all this as a backdrop, we do expect to see an overall drop in M&A numbers below historic levels, at least for a period, as Corporate Buyers hit macroeconomic headwinds. This is counteracted by Strategic Buyers who have access to capital and are looking for growth acquisitions in the tech and business services space, including PE firms with historically high levels of dry powder.
That said, even these companies will be very selective in that they invest in, given higher interest rates and other increased costs of getting deals done. These companies are also concerned about risk.
The perfect solution to mitigate that risk in the lower middle market sector is Transaction Liability Private Enterprise (TLPE) insurance. To bring you up to speed:
- TLPE insurance is intended for deals that are $30M EV or below, although there can be exceptions.
- This is a Sell-Side policy where the Seller, rather than the Buyer, is the policyholder.
- TLPE coverage is easy to get, with no third-party diligence necessary.
- With TLPE, the Seller is able to negotiate a reduced escrow/ holdback from Buyers. Assuming the purchase agreement includes a Buyer’s Basket of .5% of the purchase price, the TLPE Retention is $0. There is a $20K Seller Retention for defense costs and expenses which is not applicable to the Buyer. This helps the Seller keep most of the sale proceeds right after closing.
- TLPE policies are triggered when a Buyer brings a written demand for damages to the Seller, who in turn relays the notice to Underwriters .
In short, TLPE insurance can help M&A deal-makers mitigate risk at a fraction of the cost of Buyer-Side R&W policies. And it’s cheaper to secure coverage too, which is great for cost-sensitive acquirers.
It’s important to note that although TLPE is a Sell-Side policy, Buyers are very welcome to make the proper introductions to a broker to get the Seller on board.
If you have any questions or would like to explore the protection TLPE coverage could offer you or your clients, please contact me, Patrick Stroth, at pstroth@rubiconins.com.