Horizontal Disruption and Private Equity Dominance Will Drive 2019 TMT M&A

Spending on technology acquisitions moved at a record pace in 2018. Technology giants including Microsoft, SAP and Salesforce announced billion-dollar deals after not completing any in 2017. Private equity firms spent more money on technology sector acquisitions than ever before. These strategic and financial acquirers focused on the top of the M&A market, completing a record 108 deals of more than $1 billion in value. The stage was set for 2018 to be a historic year in technology acquisitions.

Winter threw a wrench into the celebration. An equity market selloff during Q4 2018 wiped out annual U.S. stock index gains. Global market exchanges were damaged. Corporate earnings normalized, with 2018’s 20 percent growth rate expected to be halved in 2019. Credit became harder to obtain as the Federal Reserve hiked rates for the fourth time.

Mounting corporate concerns led deals to slow down in Q4, leaving 2018 one large deal short of a historic year for technology acquisitions. Though some of the underlying instability that led to Q4’s disappointment persists, 2018’s transaction momentum will carry over due to the strengthened emergence of two key themes.

The technology sector’s movement from a vertical to horizontal market has caused companies from every sector to become involved with M&A. Private equity firms sitting on record levels of dry powder-money firms have not yet invested-have closed technology deals at an unprecedented rate. While macroeconomic concerns are prominent, the technology M&A cycle will persist in 2019 with the continued entry and development of private equity firms and diverse strategic acquirers. Macroeconomic conditions pose a threat to growth but will ultimately fail to drastically slow deal flow.

Technology sector acquisitions by non-technology companies are a strong driver of continued M&A performance in 2019. Software companies have remained disruptors of all sectors from transportation to fintech. Traditional businesses fighting off disruption find developing technology in-house costly and risky as dynamic startups often move faster. For these non-technical companies, purchasing other firms proves a much better process. These transactions are ubiquitous; from Walmart’s purchase of Jet.com to General Motor’s nine percent stake in Lyft. These examples from 2016 demonstrate that technology companies have been pressuring other sectors for years. The pace of disruption, however, is growing into 2019.

The boards and management teams of companies outside the technology sector have well understood the destruction of established corporations at the hands of technological disruption. These company leaders have reacted aggressively to the trend of mass displacement by the likes of Amazon in an effort to survive. Due to the painstaking nature of developing technology in-house, industry leaders maintain their stronghold through the acquisition of the technology companies that threaten their market share. This driver will persist as more firms create advanced underlying technology that provides clients with seamless adoption and a clear return on investment (ROI). Before the prevalence of cloud-based software, enterprise software was incredibly costly to adopt, providing industry stalwarts with a layer of protection against technology. Today, the velocity of software adoption is unprecedented, threatening to crush non-technical companies that fail to move quickly.

Beyond the need for survival, strategic acquirers are becoming more comfortable with the threat and pervasiveness of their technical competitors. As consumers across all sectors become accustomed to technology, traditional firms become more confident in adopting new innovations. Technology has created new business models that lead to quicker product adoption, shorter time to market and faster product iterations. With the prevalence of technology M&A, traditional companies have grown more comfortable with forward-looking valuations centered around growth. As technology continues to move from a vertical to a horizontal, firms will grow at faster rates and increasingly threaten disruption of traditional companies: strategic acquisition outside of the technology sector will persist as a driver of technology M&A activity into 2019.

Increased private equity involvement in technology accelerated the M&A cycle in 2018 and will continue to drive growth in 2019. According to the Financial Times, 75 percent of the most active buyers of $100M+ technology companies were private equity firms in 2018. Firms like Silver Lake, Francisco Partners and Vista Equity dominate the technology M&A space—not Google, Netflix or Microsoft. According to KnowledgeBase, private equity firms participated in over 2,700 technology transactions from 2016 to 2018, solidifying their role as market makers in the technology M&A space. In 2017, financial acquirers had a historic year, out-buying strategic acquirers. This trend continued into 2018, with KnowledgeBase reporting 1126 tech deals by private equity firms compared with 846 by U.S. strategic acquirers.

One key explanation for the dominance of private equity across all M&A sectors is the record-levels of dry powder that they are sitting on. Pitchbook estimates dry powder totals over $1 trillion among private equity firms, with smaller growth equity funds sitting on over $500 billion.

Alongside a massive amount of available capital, the rapid movement of financial acquirers into technology is driven by an ideological shift. Private equity firms have thrown out their traditional playbook for technology, increasingly purchasing companies that are not generating any cash flows and even burning cash. Private equity firms began entering technology near 2005 when they viewed technological investments as they did all others—regardless of the industry, they targeted large companies that generated high cashflows but were experiencing limited growth. Cashflows of an acquisition target are critical in private equity because they support the leverage used to fund the acquisition. This model has since been dramatically updated. The valuation environment has become incredibly rich, with many in the industry proclaiming “20x EBITDA is the new 10x EBITDA”. The new attitude of financial acquirers dramatically expanded the companies these firms could target, leading to larger and more frequent buyouts.

The ideological shift of private equity firms extends to strategy. Some of the largest private equity funds are playing a larger strategic role within their acquisition targets, expanding upon their traditional strategies of buying and building companies. Generalist funds, too, are staking their claim to technology companies. As technology firms become more horizontal, generalist financial acquirers understand more product ecosystems. This allows them to become more competitive, develop a hypothesis and hire operating partners to add experience.

The themes of rich valuations by growth-centric companies were present in late 2018 when Vista Equity took both MINDBODY and Apptio private—the firm paid over 8x trailing sales for both software companies, both of which were incredibly growth-centric and burning through capital.

While the entrance of traditional non-technology companies and private equity firms into the technology M&A space spurs optimism for the industry’s continued expansion in 2019, a volatile macroeconomic environment has the potential to both improve and harm the cycle. An EY survey of TMT M&A participants found that shifting geopolitical and regulatory landscapes were the leading cause of deal failure in 2018. The survey found that the volatile macroeconomy is forcing executives to be disciplined—96 percent of executives reported walking away from a deal in 2018 as opposed to 76 percent in 2017. Macroeconomic concerns including volatile global equity markets, reversals of capital flows to emerging market economies, historically rich M&A valuations and increasing protectionism against cross-border M&A deals all threaten the persistence of the technology M&A cycle in 2019. In Deloitte’s 2019 M&A Report, technology executives cited an increased desire to acquire for the purpose of talent acquisition, likely a result of a tight labor market and historically low unemployment.

Macroeconomic concerns may also benefit technology transactions in 2019. Tax legislation and a looser domestic regulatory environment helped M&A in 2018—corporate tax rates were slashed from roughly 35 percent to 20 percent, and penalties in bringing overseas profits home were largely eliminated. This looser regulatory environment spurred deals in 2018 and will continue to boost corporate confidence in 2019. While the Federal Reserve hiked rates four times in 2018, the cost of borrowing is still historically low. Cheap financing and a relatively strong equity market will contribute to increased deal flow in 2019.

Alongside macroeconomic uncertainties, the theme of private equity dominance that will continue to drive technology acquisition in 2019 could have major implications for investors, entrepreneurs and analysts. The IPO market is likely to be affected as technology companies choose private ownership over public scrutiny. Unicorns, including Uber and Lyft, waited for incredibly high valuations before even posturing to go public. Further, Qualtrics and Appdynamics opted to sell in 2018 over pursuing rumored public offerings.

While private equity firms are increasingly accepting of acquisition targets burning cash, they still push for companies to reach profitability sooner. As these financial acquirers further entrench themselves in the technology space, entrepreneurs may focus on positioning themselves for private equity investment. Pragmatic innovation, combining a balance of growth and profitability, may become a dominant strategy among technology companies seeking an exit. The themes of private equity and non-technology firm dominance in the technology M&A space are here to stay. Only time will tell whether the technology industry will slow from a shift to pragmatic innovation or grow through private equity’s ability to pursue long-term, operationally intensive strategies and avoid the public market’s fixation on short-term results.