As we finish off a very strange year, where M&A/financing activity went from a complete halt to roaring back, reflecting pre-Pandemic levels, it begs the question, what’s in store for 2021? What are the current trends and drivers that are likely to continue into next year, providing more visibility than uncertainty? Is it possible that the froth that we’ve seen during Covid in 2020 can continue into next year, if not increase? My expectation is that all signs are pointing to the froth continuing into 2021 and,  believe it or not,  may even increase. Here is what I am seeing:

  • Record Levels of Dry Powder in the Market: $1.5 trillion of dry powder with significant pent-up demand to make up for inactivity during q1/q2 of Covid. Q3/Q4 has come back strong, yet expect a steady uptick in 2021
  • Covid Accelerated Existing Trends; M&A Also – Flight to Quality: This flight to quality, e.g. paying up for higher quality assets, has not only persisted during Covid, if not accelerating. While paying up for these high quality, best in class assets may reduce upside, it also dramatically mitigates downside. An example who be a company that’s experiencing strong financial performance and fundamentals (>$20mm ARR, 30% growth, breakeven, capital efficient, low churn, negative net retention) in a growth market (think tele-health, logistics, ed-tech), with a proven team, diversified customers, and where comparable companies have exited at astronomical values. Each positive attribute strengthens the likelihood of continued strong performance and outcome, thus mitigating downside. This trend has and should sustain, if not drive-up, values of high growth, of scale assets into 2021
  • Buy High and Sell Higher: As values of these high growth, of scale assets keep increasing, it begs the question, how are the buyers generating a meaningful return on the back end? Well, put simply they expect to sell them at similar if not higher multiples, after a normal PE hold, and assuming continued growth. Those buyers are in a similar if not a frothier environment with an expectation of exiting to the larger PE funds or taking such companies public, where such multiples are even more exorbitant. The tidal wave of SPACs has only added more well-priced exit options for companies who can now go public earlier. On a more macro level, a low-rate environment coupled with an increase in money supply, and broader adoption of retail trading, make equity markets poised to continue its bull run into 2021. The graphic looks something like this:

  • Demand Across Size Spectrum: As you can see above, there’s strong demand for growth tech companies across the spectrum of size, as middle market ($25-50mm) will buy lower middle market ($5-25mm) and upper middle market ($50-250mm) will acquire middle market. There are private equity firms that back these size/stage of companies along the way based on fund sizes, which actively seek add-on/tuck-in acquisitions. 68% of acquisition in 2019 were add-on acquisitions. While the graphic above is specific to SaaS companies, the same dynamic and activity is occurring in tech services, we’re seeing rich EBITDA multiples from 7-15x, where historically, these were in the 5-10x range
  • Multiples Increase with Size: The larger the company, inherently the more scarcity. The more scarcity, inherently the higher barriers to entry, and likely can suggest a market leading position. With such position, and significant buyer demand from large PE firms, SPACs, public companies, it is no wonder you see the higher multiples go to the industry leading providers that are of scale ($25-50mm+ in revenue). The multiples only increase as companies get larger, with the pinnacle being if you can take a company public, where multiples are even higher, in the 15-20x+ revenue range (assuming a high-growth SaaS business)
  • Value Arbitrage on Smaller Add-ons: Why only grow organically, when you can make strategic tuck-ins/add-ons to bolster growth, when there’s no shortage of well-priced capital, and you can significantly arbitrage on value? Well, as noted above that 68% of all deals we’re add-ons in 2019, clearly many are heavily drinking this Kool-Aide. For each acquirer within the circle in the graphic, it’s fair to assume that they have a multiple that’s 20-30% higher than the target, creating a material day 1 arbitrage on value
  • SPACs Add Fuel to Fire: SPACs have added another viable exit option at an earlier company stage, where they still can receive the public company multiple premiums. Interestingly enough, many PE firms, are creating SPACs in addition to the PE funds, increasing the capital/acquisition supply, and thus incremental demand
  • Private Equity – More New Funds, Existing Funds Get Bigger, More Demand: Primarily fueling this engine are the private equity funds, that have generated strong returns YoY, which have been consistently growing over time, adding more capital into the markets, creating more demand, again, supporting the frothy, and potentially growing valuations

Fund Lifecycle

  • Fund 1: Two years in, showing a 3x return on liquid/illiquid investments, and had 5x return on software deal. 75% of fund deployed even though only 40% of investments are liquid. The group raises a new larger fund based on performance
  • Fund 2: Now focused on slightly larger deals due to larger fund, and with more of a focus on software, given strong prior experience. Ability to pay up for software company considering 5x return in prior fund. Moving away from slower growth, less sexy industries due to mediocre experience. PE fund general partners motivated by larger fund as they get same economics (2% mgmt. fee on fund size, and 20% of carry aka upside). In this example, economics are doubled assuming same 3x performance
  • Fund 3: Cycle continues as with such strong returns, funds are oversubscribed, and folks can raise larger funds, again, highly incentivized by fund size due to linearly correlated economics. However, as funds get bigger, groups need to do larger deals, which means having to pay up for scale assets, as the competition is only increasing, and the supply is low

 

  • Tech/Software M&A Increases: Especially the amount of capital focusing on high growth tech vs. value, to capture this more certain upside while limiting downside. Such flight to quality has been an accelerated trend across the board, fanning the flames of the tech M&A landscape

 

You can see the various forces at work in the graphic below. All the forces at work, create a significant imbalance of supply and demand, heavily weight to the buy-side, likely to sustain if not boost the valuation of growth technology companies into 2021