The Public Market Correction Has Enriched The Fields For Healthy Private M&A Activity
War, inflation, rising interest rates, a plunging stock market, and Johnny Depp’s demise… what else could go wrong? Slowing corporate spending and recession! GDP went negative in Q1 and may very well continue negative while mortgage rates have more than doubled and are going higher. The S&P and NASDAQ are now lower than they were one year ago after two years of mammoth government stimulus: trillions in deficit spending, virtually zero fed funds rate, and massive government bond buying. This time around, the U.S. government was the culprit behind the mega asset bubbles building up across the land in real estate, stocks, biotech, private equity, energy, startups, crypto and even used cars. The government-induced COVID spending and stimulus hangover is upon us. With the Fed and the current administration handcuffed on further stimulus spending or interest rate relief due to inflation, the corporate world will be forced to reconsider hiring and spending plans in the near to mid-term. At some point, that will have a negative effect on our tech companies’ revenues and profits. The severity and timing of slower corporate spending is too tough to predict, so we will stick to tech M&A and valuations. ?
Public tech SaaS valuations have fallen to their early 2018 valuations, down from the COVID high of 19x revenues to 7.5x revenues. The private PE investors for the most part did not chase these frothy public valuations as the 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 three – overvalued.
SaaS business models with their 90% gross margins and uber growth rates are extraordinary, but they are not magic beans that grow to the sky. You can’t put a 30x revenue multiple on every deal that projects 100% growth into eternity and make money for your shareholders and LPs. In reality, that type of sustained growth is magical and only happens in rare cases. Buyers and investors had been applying 10x to 30x revenue multiples to SaaS business that will never actually be profitable or will fall short on their growth projections in the near to mid-term.
SaaS deal valuations are now down closer to their longer-term intrinsic value both on an EBITDA and revenue multiple basis. A 20x EBITDA valuation on 2022 may only return 5% for the time being, but on a solid 30% grower, you will be comfortably in the black not too far down the road. Sustainable SaaS profits require significant investment in retaining current customers. Successful young SaaS companies often achieve 90% gross margins, but the top 150 public SaaS companies have 76% gross margins. Clearly, SaaS businesses have to spend more on their customers as they mature in order to maintain 90%+ gross retention and 115%+ net retention. Suffice it to say that premium SaaS businesses with scale, growth, 80% gross margins, positive EBITDA (or path to), and strong retention metrics will continue to attract compelling valuations.
Surprisingly, tech M&A both on a value and volume basis hit a historic peak in Q1 of ’22 and is still at a solid pace through the fourth week in May. Year to date, the M&A run rate is tracking at roughly 5,500 deals and a total value of more than $800B. With public company tech values off dramatically and many PE funds over $20B, we have seen a surge in large tech take-privates. Take-privates in ’22 are on pace for 80 deals and over $300B in transaction value. That increased volume will continue with these 2018-level valuations on the top 150 public SaaS companies. Tech minority growth financings will face more scrutiny and valuations will fall much more in line with what the PEs have been paying for control transactions. The spray-and-pray easy money is over for the time being. That said, the super fast-growing tech companies with compelling unit economics will continue to generate premium valuations and lots of term sheets. The unicorn IPO filings will remain on hold for the foreseeable future and SPACs are toast.
The public market correction has enriched the fields for healthy private M&A activity. Although it will take time for sellers and buyers to adjust to these lower valuations, they are in fact largely in line with the longer-term historical averages prior to COVID. The COVID spike only lasted one year before yielding to the same gravity that contained multiples in a 6-10x range from late 2016 to 2019. So as we hammer out deals as I write this update, we are seeing a market with valuations at 6-12x current ARR for premium private SaaS companies. Obviously, there are some companies that will trade above that range, and many that will trade below it, but we are no longer in the COVID zone of mid-to-high teens. The AGC Public SaaS 150 Index is currently at 7.5x TTM revenues and 6x ’22 revenues. That is at the low end of what we are seeing in the private market because most of our companies for sale are growing faster than the publics, and there is a sentiment between buyers and sellers that the public markets have overcorrected.
With over 70 announced deals in the last 18 months and 40 current engagements, we have a pretty good feel of the ebbs and flows of the tech markets. In just the last five days, AGC has signed or closed five transactions: Instaclustr to NetApp, Tasktop to Planview, Qmulos to PSG, Bookboon to Access, and a non-disclosed $500M EV combination of two PE-owned businesses. PEs are mostly holding back on bringing their companies out into this turbulent market in a traditional auction process, but we are seeing certain portfolio companies where the outcome is not going to meaningfully affect the fund’s returns coming to market and getting more buyer looks in what will be a less crowded market. We remain busy doing deals generated from unsolicited compelling proposals from quality buyers, much like a developer knocking on your door out of the blue with an offer you just can’t refuse. We are also seeing a steady flow of entrepreneurs with premium businesses who are comfortable and confident that they will get a premium outcome teeing up deals for late Q3 and Q4.
I won’t go as far as to say we are in the middle of a tremendous buying opportunity, but we are in a healthier place for doing quality M&A based on strong fundamentals that include both growth and profitability. The 200 tech PE funds with their $1.3 trillion in assets under management and 4,000 portcos have the means, longer-term investment horizon, and conviction to continue doing quality M&A. So as the public market gyrates up and down 3-5% per day, the private tech M&A engine will power on at a slightly slower cadence.