Tech dealmakers: Picking up steam despite activist, financing, and regulatory headwinds

Deals are happening, but financing challenges are a factor

Between January and June 2023, the tech sector has recorded roughly 1,300 transactions, on par with the first half of 2022; however, the average deal size has dropped from approximately $175 million to $45 million¹. Deals are still happening, but the focus is on smaller transactions that are easier to finance. Gallardo said he believes that M&A activity and valuations will rebound as financing becomes more predictable. He also indicated that his practice at Paul Hastings has seen a significant uptick in M&A activity in recent months.

Among strategics, Gallardo noted a high volume of carve-outs, divestitures, spin-offs and split-off activity in recent years as board members and executives take an active approach to rationalizing their asset portfolios. He attributes this trend to the perception that investors are closely scrutinizing assets and deals, and boards are treading carefully to avoid triggering protests and litigation from activist shareholders.
 

The influence of shareholder activism is growing

The modern era of shareholder activism has seen the rise of a more vocal and aggressive activist, said Gallardo. These activist shareholders have been fairly successful at pushing companies to be more receptive to their ideas, as evidenced by the trend where companies replace their CEOs within a year or two of activist shareholders securing seats on the board. Activist shareholders have launched campaigns around everything from stock buybacks and dividends to a company’s basic operations. However, Gallardo noted that recently, they have shifted back to a laser focus on transactions, exerting pressure on boards about whether to pursue M&A deals.

Recent regulatory changes have also affected the nature of shareholder activism – in particular the universal proxy rules for director elections that took effect in 2022.² The new rules allow shareholders to select individual candidates as opposed to choosing between the full slate of directors proposed by the company or the full slate of nominees put forward by activist shareholders. Gallardo said these changes are likely to shift the balance of power in favor of activists in ways that may have unintended consequences in the coming years.

In addition, publicly traded companies are increasingly facing aggressive tactics from short sellers. A third-party “research firm” or anonymous website will post a report criticizing management and the board, and even if the allegations are untrue, the consequences can be severe — Gallardo described one client that lost 40% of its market cap within two hours of being targeted by an activist short seller. “If you’re too successful, you’ll end up with a short seller. If you’re not performing, you’ll end up with a traditional activist,” he said. And while the technology industry has always been prone to agitation by activist shareholders, disruption generated by the introduction and evolution of AI will likely set off new waves and flavors of activism in the space.
 

Legal and governance implications of AI are emerging

“AI is a very significant issue for companies, not only from a business perspective but also from a regulatory, legal, and corporate governance angle,” said Gallardo. Tech companies need to prepare themselves for litigation from shareholders and other parties related to copyright issues around generative AI or the use of machine learning in human resources decisions, for example. However, very few board members currently understand the nuances of AI, or the differences between AI and generative AI, or AI and machine learning. On the bright side, AI also has the potential to make certain deal-related legal tasks, like writing proxy statements and performing due diligence, more efficient — a use case that may become more compelling as regulatory demands mount.
 

Scrutiny from Federal Trade Commission (FTC), U.S. Department of Justice (DOJ) and U.S. Securities and Exchange Commission (SEC) is intensifying

Within the past few months, the FTC and DOJ have proposed two regulatory changes with significant implications for M&A in the tech space. The first will increase the amount of information parties need to file on the premerger notification form under rules implemented in the Hart-Scott-Rodino (HSR) Act.³ Gallardo explained that these updated requirements could multiply the time it takes parties to complete the filing by four or five times. The new regulations will also require private equity firms to provide new information about their LPs and portfolio companies as part of the filing. HSR requirements apply to transactions above a $111 million threshold and are likely to take effect before the end of 2023.

The second regulatory change with major implications for tech M&A is the new set of merger guidelines proposed by the DOJ’s antitrust division.⁴ These guidelines, which would apply to the government’s review of proposed M&A deals across industries, include new considerations around labor and competition, compared to earlier rules that focused on synergies that would allow businesses to pass savings on to customers. These guidelines are also likely to go into effect by the end of the year, following a 60-day public comment period.

In addition to this DOJ antitrust activity, SEC initiatives such as universal proxy, new cybersecurity regulations, and new requirements around environmental disclosure may also go into effect in 2023.

“We’re definitely moving to a very high level of regulatory scrutiny out of D.C. And I think what happens with that agenda going forward will be driven in part by who is going to be the next president,” said Gallardo.

To learn more about our industry expertise, visit www.key.com/m&a. To discuss this topic and more as it relates to your business, connect with one of our KeyBanc Capital Markets technology experts.