RBC Capital Markets managing director says M&A will be a big theme in the back-end of 2023.
After an explosive period of record growth and investment activity, there were early signs last year that the technology sector was veering in a different direction. A confluence of geopolitical tensions and economic pressures drove market volatility throughout the year, with 2022 closing on an ambivalent note as publicly traded company stock prices tumbled from 2021 highs and private market valuations contracted.
Tech companies in Canada are very well positioned to ride out what could be an extended period of uncertainty, capitalizing on the changes through a lens of opportunity and emerging stronger when the turbulence subsides.
We have just exited a decade-long bull run, and one of the clearest indicators is the shift away from a “growth at all costs” mentality to one that places greater emphasis on profitability and balanced growth. While the current pivot has been relatively swift, a return to growth will likely be more gradual, due in part to the rapid rise in interest rates to levels not seen since 2008, which are only now potentially levelling off. After a 25 basis point hike in January, the Bank of Canada has breathing room to pause, with the fed funds target range expected to peak at around 5 percent early this year, as RBC predicts.
As the macro environment stabilizes, investor focus will shift to a “micro” one, where individual company performance and fundamentals will again drive valuation. A key bellwether for the turning tide will be an equity market climate favourable to IPOs. When that time comes – and it will – companies should be ready and positioned to turn the growth taps back on. These headwinds are not a signal to hunker down and do nothing, as alternative deal-making options and opportunities are still on the horizon.
The shift in private market funding
Amid the challenging backdrop, investment firms that deployed record amounts of capital across a heightened volume of deals have pulled back sharply since mid-2022. The likes of Tiger Global Management and SoftBank Group, which led some of Canada’s largest growth equity rounds in 2021, have been noticeably absent over the last six months.
Prior to the downturn, companies across the spectrum of growth and profitability could easily raise capital in various forms with few strings attached. Today, a new type of private capital raising is taking shape – debt and structured equity raises. Private equity and credit funds are doing more structured investments in technology, a strategy that provides capital to companies that are unable to raise equity, or do not want to print a down round, while offering investors greater downside protection in an uncertain economy. Companies seeking capital today have become increasingly receptive to these types of investments, accepting PIK dividends, warrants and liquidation preferences above 1x.
While providing downside protection for investors, structured debt also allows companies to postpone crystalizing a formal valuation to a later date, when circumstances are more favourable. If a company closes a down round, a myriad of dilution-driven issues can arise for management, employees and earlier investors. For these reasons, companies would rather defer pegging a valuation to a later period when markets are more hospitable.
Despite these changes in the landscape, growth investors are still testing out what the new norm is across various investment stages and whether deals with heavy structure are here to stay for the long haul.
Of course, there are always outliers. High-quality companies with exceptional growth runways and strong unit economics will still attract investors and Canada has its fair share of them. A recent example is Edmonton-based SaaS company Jobber, which just raised a $100 million USD growth round led by General Atlantic.
Canadian tech well positioned to weather storm
In the recent past, companies were encouraged to take money and scale as quickly as possible, irrespective of profitability. And while today, companies are retrenching and adopting a more balanced mandate of profitability and growth, this adjustment presents an opportunity for Canadian tech to shine.
Many Canadian firms have taken a prudent approach to building their businesses with an intrinsic focus on durability and capital-efficient growth. Despite the recent fundraising boom that had brought some of the “grow at all costs” mentality north of the border, the Canadian tech ecosystem remains highly resilient, nimble and balanced overall.
Across the private and public landscape, Canadian software companies have continued to shine in today’s environment. Privately-held PointClickCare was recently valued at more than $5 billion USD after its largest investors increased their stake as tech valuations were reaching 2022 lows. A sustained level of interest in publicly traded names has also been notable. For example, Kinaxis has demonstrated its ability to sustain organic growth and profitability and Constellation Software, a leading global consolidator, continues to deploy a high volume of capital over a consistent cadence of acquisitions to drive profitable growth.
M&A likely a big theme in the second half of 2023
Software consolidators drive all or part of their growth from acquisitions, and with valuations depressed, they are well-positioned to pursue larger deals. In 2022, for example, OpenText announced its acquisition of UK software firm Micro Focus International for $6 billion USD, Constellation Software purchased Allscripts Healthcare Solutions’ Hospitals and Large Physician Practices business segment in an agreement valued at $700 million USD, and Descartes completed several strategic tuck-in acquisitions.
Consolidators are not the only active Canadian players. Shopify made its biggest M&A deal yet when it pushed further into logistics by acquiring Deliverr for $2.1 billion USD, while TELUS acquired Lifeworks for $2.3 billion to establish scale in HealthTech and TELUS International bought Willowtree for $1.2 billion USD, to grow its presence in higher value tech services.
While the larger cap and mature public tech companies have been active in M&A, the recent class of IPOs is facing significant headwinds. They are bearing all the costs of being public but enjoying few to none of the benefits. Loss of acquisition currency mitigates their M&A capacity, closed equity markets shut off critical access to growth capital, and low-volume trading dynamics make it difficult for long-only institutions to invest due to lack of liquidity for entering and exiting a stock. Given this dynamic, management and boards may increasingly explore the go-private option with partners or consider a strategic sale to navigate these uncertain times. Through 2022, these stakeholders were hopeful that the market rout would be temporary or that recovery would be quicker. However, as tumult sets in, many may be unwilling to wait out another year as a subscale public company lacking the tools to execute on their business plan.
Several factors are hampering the M&A market, including the valuation gap between buyers and sellers, though this is closing. Macroeconomic uncertainty is also making it difficult for buyers to underwrite growth-oriented business plans. Meanwhile, frozen leveraged finance markets are creating a challenge for buyout funds to get deals across the line within return thresholds. Corporate acquirers are also increasingly trigger shy when their own share prices are down, are completing reductions in force, and shoring up their core businesses. Once these challenges dissipate, M&A deals are expected to pick up in the second half of the year.
Bright spots are already emerging: there is a crop of well-capitalized and opportunistic growth and private equity funds pursuing buyouts without relying on debt, but instead a focus on driving unlevered returns through growth, rather than financial engineering. Several recently announced transactions, including Vista Equity’s take-private of Duck Creek Technologies for $2.6 billion USD, Nuvei’s acquisition of Paya for $1.3 billion USD and Thoma Bravo’s deal for Magnet Forensics for $1.8 billion, are perfect examples of early signs that the market is turning.
Better times ahead
Canadian entrepreneurs are resilient and resourceful in lean times, and there are still deals to be made – through structured investments, more attractively priced acquisitions, and even through the birth of new companies. Having experienced both a boom and slowing cycle, these businesses will come out of this period with a mature, durable and resilient mindset.
To be sure, there is still ample private and growth equity dry powder on the sidelines; these investors are looking to transact, but they need a confluence of factors to realign before earlier deal activity returns. Tech companies in Canada are very well positioned to ride out what could be an extended period of uncertainty, capitalizing on the changes through a lens of opportunity and emerging stronger when the turbulence subsides.
Check out last year’s event and make sure not to miss it in 2023!
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