Watching valuations over the last 18 months in the public and private markets reminded me of the old fable about the tortoise and the hare in the big race. Public market values took off like the hare, rising to 18x revenues in Feb ’21 with little concern for quality gross margins, sales efficiency, future profitability, competitive threats, etc. Meanwhile, private market valuations were moving up but much more slowly with a keen focus on performance metrics and clear limits on what they would pay to own an asset. So as we enter the fall of ’22, the private markets power on doing tech M&A mostly at valuations between 6x to 11x current ARR. Reinforcing this valuation range, AGC has closed 32 deals so far in 2022, including 22 SaaS deals with a median revenue multiple of 11x. Public SaaS companies are currently trading at 6.4x trailing revenue, which is exactly the same as the six-year pre-COVID median and well below the ’17-’19 median of 8.5x. If this group of companies’ projections hold up, then the SaaS sector is clearly oversold.
The public market is driven more by momentum players and macro sound bites than fundamental research. Institutional investors – despite being the most influential public market drivers – are for the most part uninvolved in managing the operations, strategy, or acquisitions of the public companies they invest in. Alternatively, private equity investors have controlling ownership of the companies and therefore hire/fire the executive team, approve budgets, compensation, acquisitions, and are involved on a monthly basis in the operations of the business. The PEs are not all brilliant business builders, but they do bring a ton of experience and are highly incentivized to make the company thrive for a big exit down the road. Because platform deal and business building skills are critical for PE success, you have seen far more discipline on both fronts by the PE world during the recent boom times, particularly when compared to the public markets, IPOs, and SPACs.
The tech PE world and their LP backers need to remain vigilant so that, as fund sizes, teams, check sizes, and number of portfolio companies continue to grow, they do not stray from their intense investment disciplines and fall into some of the same traps that public companies have succumbed to. As tech AUMs are now so large and macro headwinds have become so strong, PE funds will need every bit of that discipline in order to maintain superior IRRs.
The new $500B+ spending bill (called “The Inflation Reduction Act”) and recent $500B student loan handout will obviously add to our current inflationary inferno of spending and price increases. So while the common man is paying twice as much for his new home, rent, and energy bill, his income has only marginally increased. Maybe massive continued stimulus is more the problem than the solution. Expect high inflation to continue, real GDP growth to remain flat to negative, and corporate revenues and earnings to be scaled back for ’22 and ’23. Some companies are beating their forecasts, but most of those projections have been revised downwards and are at lower growth rates than the trailing twelve months. A big question for all of us across all business sectors is how much of our great success over the last two years was COVID/government stimulus-based and, if so, what is the new normal? Putting off taking the medicine and doctor visits will prolong illness or even cause death in severe cases. As our country’s leaders endorse further reckless spending over fiscal discipline, they dig us deeper into a hole and closer to the precarious third rail of high inflation, negative growth, and mounting deficits common for a banana republic.
The public market correction and macro headwinds have our clients reforecasting the next 12 months with a more conservative eye so they can over-deliver during the M&A process. AGC is deep in the trenches with 40 active engagements and 10 under LOI. Interestingly, we have not seen the large public strategics buying many VC, PE or founder-owned SaaS businesses as of late. In fact, the tech bigs (Apple, Microsoft, Google, Amazon, and Meta) have combined for only 12 acquisitions YTD in ’22. That compares to 30 during the first eight months of ’19 pre-COVID. With the downturn in valuations, we anticipate this could be an area of growth, but for now, some strategic acquirers remain on pause as they get their own house in order. The banks and debt funds are on the run, abandoning previously committed deals and drastically lowering the debt offered on new deals. The tightening of the debt markets is driving down IRRs and valuations. LPs are likewise pulling back, putting the hurt on funds attempting to raise capital in 2022 or planning to go to market in 2023.
On the bright side (which I always have a need to find) we have a tech ecosystem full of great companies with super smart entrepreneurs and more private capital than ever before. Over the summer, we signed up 25 new engagements because these CEOs feel great about their prospects even with the inflation and recession headwinds. Yes, the larger deals are on hold hoping for clear skies which may be a ways off, but overall, transaction volumes for YTD ’22 are tracking at a historic high of 5,200 vs. 4,300 deals for 2021 and 3,800 between 2016-2019. In our discussions this summer with the large strategics, PE-backed strategics, and active PEs, we hear a very common theme of, “we are more excited about acquisition prospects than we have been in some time to get quality deals done at reasonable prices, and we have the capital and mandate to do so.” That said, August transaction volumes came in light, so we will see if that is just deal makers taking more beach time or something more ominous. So while uncertainty swirls around the world, the tech M&A engine in middle markets is powering on doing deals and building businesses.
The private PE investors for the most part did not chase the frothy 18x public valuations as the less disciplined cohort of minority growth venture investors did. So while there are many overvalued and cash-strapped VC-backed companies out there, there are far fewer among the controlling PE portfolios. The overspending unicorns with low cash reserves are struggling right now to find funding that they can swallow. The PE-backed SaaS portfolio companies are generally profitable, growing nicely, and some are probably a revenue turn or two – or even three – overvalued. As you can see from the top tech PE acquirers, add-on acquisitions are the top priority for these PE funds. The top 325 tech PE funds have now amassed 3,200 tech portcos via platform acquisitions and non-control stakes. In talking with the largest and most active PE funds, it is clear that a very large percentage of their returns have come from add-on acquisitions. The value creation from these add-on acquisitions will make the PE portcos arguably the best buyers in these down markets.
Since the tech IPO boom started in early 2020, there have been 235 tech IPOs: 74 SaaS-based and 161 non-SaaS. Overall stock performance on these 235 is down 54%, with the non-SaaS companies down 58% and SaaS down 35% – largely in line with the broader SaaS 160 index, which is down 48%. Even worse is the fact that the non-SaaS tech IPOs are trading at 2.2x revenue while the SaaS IPOs are trading at 4.9x ’22 revenue. Wall Street obviously did not show much discipline as the sponsor of this crop of IPOs and as such it may be another year or two before institutional investors come back to the IPO trough in volume.
During that same period, there were ~200 completed tech SPAC acquisitions representing $540B in deal value and ~600 tech SPAC IPOs raising $170B in proceeds. Those de-SPACs are now trading at roughly $230B in aggregate value and 3.6x ’22 revenues. The 60 announced and pending tech SPAC acquisitions have less than a 50% chance of closing, and most of the 300 pre-acquisition IPOs still standing will time out and return the IPO funds. For most any SPAC deal that closes these days, it’s more badge of horror than honor. The stock typically drops from $10 to $5; they barely have enough cash to pay their banker fees; and, they have virtually no float and little (if any) Wall Street support. So they should definitely be asking themselves, “should I close my SPAC?”
Click to download AGC’s report: AGC’s Fall Tech Capital Markets Update
