Mergers and acquisition activity is declining—and a weakening economic outlook isn’t helping. The technology sector could be the ripest area for deals, though.
The dollar value of global deal announcements dropped 20% year over year in April, according to
‘ investment bank analysts. It was even worse for U.S. deals, which dropped 47% in April. It is worth noting, however, that deal activity had recently been trending lower compared with prepandemic levels; deals in 2021 in North America totaled $1.15 trillion in 2021—about a fifth lower than the 2019 total.
Of course, the current economic and market environment isn’t exactly an ideal backdrop for M&A. The Federal Reserve is lifting short-term interest rates in order to combat high inflation, a move meant to reduce economic demand. That threatens to slow down earnings growth. Plus, higher interest rates have already begun to lift borrowing costs. Now, it’s more expensive to borrow money to buy a company—and the return from such an acquisition could look less appealing.
“We see the current [deal] slowdown as a consequence of elevated uncertainty about the economic path,” wrote Richard Ramsden, investment bank analyst at Goldman Sachs.
The best bet for deal activity, though, seems to be the tech sector. One reason is earnings in technology companies generally depend less on strong economic growth. Many of these companies are tapping into new industries with the potential to become much larger, so these businesses can often continue growing briskly even if the economy slows down.
The other reason is tech valuations have plummeted, though not because of slower profit growth. Long-dated bond yields have soared this year, which makes future profits less valuable—and many fast-growing tech companies are valued on the basis that the bulk of profits will come many years down the line. The Technology Select Sector SPDR Exchange-Traded fund’s (XLK) aggregate now has a forward price to earnings ratio of 21 times, down from its pandemic-era high of 28. That makes these companies attractive buys. Already, 23% of deals year to date have been in the tech sector, up from 17% in all of 2021, according to Goldman Sachs.
“If we continue to see pressure in equity valuations in the tech sector as we’ve seen as of late, I would expect to see more LBO [leveraged buyout] activity in tech,” said Rit Amin, head of corporate and institutional markets at Regions Securities.
To that point, it certainly seems that LBOs—usually done by private-equity buyers —could drive deals in the sector. Already, LBO deals have accounted for just under 10% of all U.S. deals this year, according to Regions. In 2021 overall, LBOs made up 6.1% of deals. That’s partly because private-equity buyers usually seek cheaper valuations than strategic buyers—or regular companies—do. PE firms don’t always have the luxury of creating synergies, the result of putting two businesses together to create a greater combined profit stream.
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