SMALL CAP TECHNOLOGY - MORE M&A TO COME?
THE TD COWEN INSIGHT
With M&A momentum expected to carry into 2024, we believe there are several companies within our coverage universe that are attractive acquisition targets. In this report, we provide an overview of the current landscape that we believe is conducive for accelerated M&A activity and discuss the relative attractiveness of the small cap companies in our coverage universe.
M&A activity within the Canadian small cap technology universe rebounded sharply in 2023, with cumulative transaction value of completed deals growing ~129% to ~C$6.4bln last year, over 2x higher than the 20-year average of C$2.8bln. This bucked the trend of the broader market, with global M&A deal values down ~16% in 2023.
Current backdrop makes for a favourable M&A environment. We believe 2024 should see strong levels of M&A activity driven by several key factors.
1 The broad expectation of interest rate declines in H2/24 should help lower the cost of debt that could be used to fund acquisitions. TD Economics currently forecasts the U.S. Fed Funds rate to decline to 4.75% by Q4/24 and 2.75% by Q4/25, down from 5.50% currently.
2 Financial buyers have accumulated a record US$3.9Tn of dry powder globally, with 26% of the buyout fund capital of US$1.2Tn over four years old, suggesting GPs could begin to feel pressured to accelerate deal making.
3 Strategic buyers with strong balance sheets and excess capital can seek to augment growth and strengthen their competitive positioning, particularly in the wake of potential GenAI disruption.
4 Public market valuations for small cap technology companies have lagged overall market performance and currently trade at a historically wide valuation gap.
We see software companies as attractive takeout candidates. Driven by inherently strong fundamental characteristics, such as recurring revenues, low capex, and high gross margins, SaaS companies continue to attract significant private equity interest, particularly with companies that have had less success transitioning from a "growth at all costs" to a "durable growth and profit model."
What companies in our coverage fit the bill? Considering several key factors, including strategy, financial performance/outlook, relative valuation, leverage levels, and key shareholders, we identify several high probability M&A targets, including BlackBerry, Blackline Safety, Converge, Coveo, dentalcorp, Docebo, Lightspeed, and Sangoma.
We believe that the current market backdrop is conducive for a rebound in M&A activity for the following reasons:
• Expected decline in interest rates;
• Significant capital waiting to be deployed by financial buyers;
• Strategic buyers looking to augment growth and strengthen their competitive
positions;
• Small cap underperformance and valuation gap presents attractive M&A opportunities.
In our report, we provide more colour on each of these factors, outline the potential impact of increased M&A activity to the consolidators in our coverage universe, and discuss the relative M&A attractiveness of the small cap companies (<C$3 billion market cap) in our coverage universe.
A More Favourable Interest Rate Environment Could Spur a Rebound in M&A Activity
The global M&A market recorded its second weakest year in a decade, with the total value of closed deals declining ~16% in 2023, following an ~23% decline in 2022, according to Pitchbook. The sharp pace of interest rate increases to help tame high inflation has resulted in significantly higher borrowing costs and broad macro uncertainty, reducing confidence to take bigger investment bets in a weaker economy.
Technology sector M&A activity followed a similar trend, with M&A deal value declining ~45% in 2023 after an ~15% drop in 2022. After three years of elevated M&A activity from 2020-22, both on an absolute dollar basis as well as the sector’s proportion of global M&A value being well above the pre-pandemic average during this period, activity normalized in 2023 as the impact of the sharp increase in interest rates took hold.