The Impact of a Slower IPO Market on M&A

While 2023 was an active year for U.S. mergers and acquisitions, according to Wally Cheng, Head of West Coast M&A in our Technology Investment Banking Group, 2024 is positioned to be a busy year.

Wally Cheng is not a member of Morgan Stanley’s Research department. Unless otherwise indicated, his views are his own and may differ from the views of the Morgan Stanley Research department and from the views of others within Morgan Stanley.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income and Thematic Research. 

Wally Cheng: And I'm Wally Cheng, Head of West Coast Tech M&A for Investment Banking. 

Michael Zezas: And on this special episode of Thoughts on the Market, we'll focus on the outlook ahead for mergers and acquisitions in US tech. 

Michael Zezas: Wally, I really wanted to talk with you because 2023 was arguably the toughest year for U.S. mergers and acquisition markets since the global financial crisis. And we saw a three prong set of challenges in the form of rising interest rates, geopolitical conflicts and recession concerns. And that seems to have weighed on deal activity across the globe. Looking back, the first quarter of 2023 marked the lowest point of the M&A market, and since then we've seen deal activity tick higher. But from your perspective in tech banking, where are we right now and what should investors be watching for this year? 

Wally Cheng: The punch line answer that, Mike, is they should be looking for a bounce back in M&A in 2024 for all the reasons that you mentioned. Activity was very muted in 23. You highlighted rising interest rates. You highlighted geopolitical risks, wars, etc.. In that kind of environment deals just don't get done. There's not a meeting of the minds between buyer and seller. We're in a different environment now, I think what's happened over the last quarter or so is an appreciation or an acceptance of the new normal. The world has a lot of uncertainty around it, and that's no longer a new thing. It's a thing that buyers and sellers now know that they have to face for the foreseeable future. So my expectation for 2024 is much more activity, and we're seeing green shoots of that. And we saw a lot of that happening towards the end of last year. A number of large strategic deals that complemented the flow of private equity driven deals that we've seen for the last couple of years. The playing field now going into the full year of 2024 is really about all groups of buyers and sellers being active. What do I mean by that? I mean, on the buyer side, it's both corporate buyers and private equity buyers. Both active. First half of 2023 was only sponsors. Second half of 2023 was largely only strategics. Now they are both playing in the game. That's on the buyer's side. On the seller side, for the reasons that are articulated, sellers are no longer playing for a material change in the operating environment and a return or snap back, back to 2021 valuation levels. That was a blip on the screen, going to be a very long time to get back to there, if ever, and they're being much more sober and reasonable and realistic about valuations that they can get. So we're seeing much more of a meeting of the minds between buyer and seller. All buyer groups are active. 

Michael Zezas: So drilling down into your area of expertise a little bit more. It's been a slower tech IPO market recently. What's the impact of a slower IPO market on M&A? 

Wally Cheng: That is going to drive more M&A. And what I mean by that is when private companies can't get public, and return money to their private shareholders, they have to seek other ways of doing that. And that's M&A. Last year, and the year before were historically low in terms of IPO volume. Every year, on average over the last decade or so, there's been roughly 40 tech IPOs, last year and the year before less than ten. We're not expecting much more than that this year either. So with that kind of IPO volume, the huge number of private companies, by last count, about 1300 private companies of $1 billion in greater valuation were sitting in the private domain in technology. And of those 1300 companies, just a few of them are going to make it public in the next few years, which means they're going to have to seek other ways of monetizing for their shareholders. And that's going to be through M&A. 

Michael Zezas: So there's obviously a lot of discussion right now about when the Fed will begin cutting interest rates this year. But in any case, the consensus is that even when they are cutting, you're likely to see levels of interest rates also will be somewhat higher than what we saw in the decade between the financial crisis and the pandemic. So what's the potential impact on the next wave of M&A activity from having somewhat higher interest rates? 

Wally Cheng: It will be a factor that is going to hold back a more robust M&A market. But I think the real impact of it is going to be twofold. One is there are going to be many more stock deals. So deals where stock is used as an acquisition currency to buy the target. And then two is I think there's going to be a lot more activity from buyers who have a lot of cash firepower sitting on their balance already. They're going to press their advantage in an environment like this, where for many buyers who don't have that same luxury of cash on their balance sheet and require outside financing at the higher rates that you mentioned to go finance deals, which will make those deals a little bit more difficult to justify economically. So if you've got very inexpensive cash sitting on your balance sheet, now's the time to go use it. 

Michael Zezas: Drilling down a bit here, what sub sectors within technology do you think will see the most M&A activity? 

Wally Cheng: Number one software. And number two Semis with an asterisks on Semis, which I'll get to in a second. In both of those industries consolidation is imperative. In software. Customers are looking for best of platform solutions not best of breed anymore. So in a landscape where there are a thousand plus software companies valued at greater than $1 billion that are either public or private today there's going to be a lot of M&A happening, to get to a product offering that looks more like a best of platform solution for their customers. Similarly, in Semis, the dynamic is the same, a little bit more driven by scale, and that is really what's driving M&A in Semis. There's about 100 semiconductor companies that are public today with more than $1 billion in value. Our expectation is that the need for scale is going to drive that number down to about a third of that through M&A over the next 5 to 10 years. The asterisks that I mentioned on the semiconductor activity is that in order to get the semiconductor deal done today, given the global nature of their revenue, is that they require regulatory approval from governments all over the globe. And in today's environment, where East and West are in a tug of war for tech supremacy, those approvals are really difficult to get. Are they impossible? No. Does it take longer to get them? Yes. So buyers and sellers in semis are really, really taking a hard look at whether or not they can get regulatory approval before announcing their deals, because the last thing they want to do is announce a deal, wait for two years to get it approved, it not be approved, and they've got damaged companies coming out of the end of that.

Michael Zezas: Got it. So geopolitical concerns, still a limiting factor for cross-border M&A, but overall we're seeing tailwinds for M&A activity picking up. 

Wally Cheng: You got it. 

Michael Zezas: Well Wally thanks for taking the time to talk. 

Wally Cheng: Super speaking to you Mike. Thanks. 

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