Inovia Sessions: The State of the M&A Market

Given how much capital is available in the markets and the tumultuous macro environment we’re all living through, it’s no surprise that M&A has become a strategic pillar that many companies are leaning in on. Now more than ever, choosing the right partner to align yourself with is critical.

In this episode of Inovia Sessions, Scott Munro, Head of Corporate Development at Inovia, spoke with Neil Grunberg, Co-Founder of AlayaCare; Chad Bayne, Founder and Co‐Chair of Osler’s Emerging and High Growth Companies Practice Group; and Kiron Mondal, Managing Director at RBC Capital Markets. Together, they discussed the impact of valuation expectations alongside increasing global interest in Canadian companies, considerations for deal success, and changes to deal terms and structuring. Here are the key highlights of their discussion.

Current state of the market

Scott: 2021 was a banner year for M&A and companies going public. But by the time January 2022 rolled around, things had changed, and there was suddenly a lot more volatility in the public markets. Kiron, can you tell us a little bit about what you’re seeing in the market right now in terms of deals and opportunities?’re seeing in the market right now in terms of deals and opportunities?

Kiron: Growth through acquisition has become a core competency for many larger strategics. Even though we’ve seen a pullback on multiples in growth stocks, growth is still a valuable commodity in the market. Having a good, established M&A strategy has proven very important for many large corporations.

Over the past three or four years, we’ve seen a considerable increase in the correlation of valuations relative to growth and almost a disregard for profitability and free cash flow. I think the challenge is going to be if these conditions remain in the market, small- and mid-cap companies will either have to embrace the mantra of growth at all costs or be prepared to retool their businesses very quickly. Otherwise, they’ll run out of capital and be forced to sell. Of course, from the buyer’s perspective, that’s an opportunity.

Scott: Neil, you’ve done a lot of deals in your career. What observations do you have?

Neil: Our pool of potential acquisition targets is in the home care space, and there aren’t a lot of targets in Canada right now. Most are low-growth, low-profitability companies. As a result, we’ve walked away from a lot of opportunities where the companies were looking for the kinds of multiples they were reading about even when there wasn’t any rationalization for it. We saw more deals in the second half of last year — inbound opportunities that were lower-middle sized and where most were one or two standard deviations off from the bid to the ask.

Valuations

Scott: There’s certainly been a significant correction in the public market side of the tech sector. To a large degree, that hasn’t translated down to the private side yet, at least from an expectations point of view. Is that what you’re seeing?

Kiron: It takes time to readjust expectations. So what you’re likely to see is a period where it will be tough to get deals done because the bid-ask spread is too wide. Then people may come to the realization that the multiples aren’t coming back — or maybe they will, and we’ll be off to the races again.

I think the disconnect will continue, and expectations will have to adjust. I would also say the run-up in multiples on the public side, which we saw start about 18 months ago and that peaked at some point last year, wasn’t necessarily reflected in M&A multiples. The adjustment to the downside doesn’t need to be as radical as what we see in the public markets. There’s so much noise in the public markets and fast money driving valuations. I don’t think we necessarily need to have that big of a reset for things to work.

Scaling Canadian Companies

Scott: It used to be that many Canadian companies got sold early. Now that’s changed because a much larger percentage of companies are doing active buy-side work. What’s changed in the market? Is there more available capital? Have management teams become more experienced? Clearly, there’s a lot more building going on in Canada than there used to be, and we’re building wealth in the Canadian ecosystem rather than selling companies prematurely to US private equity firms. What are your thoughts on this, Kiron?

Kiron: What we’re seeing now, and what we’ve seen over the last few years, has been the effect of three factors. The first is the increasing availability of smart money in the market, such as institutional money, with a core mandate in growth equity. The second is just the proximity of success. Having examples of management teams, investors, and companies in your community that have gone on to become unicorns and completed a successful IPO or big exit to a strategic is important.

The third factor, which we often underestimate, is investors’ change in mentality. Fifteen or 20 years ago, when they put money in businesses, especially locally, they wouldn’t give any secondary; they wanted to have all this skin in the game. Today, funds are more open to giving a little bit of secondary so that founders can secure themselves and not be all in all the time. That extends the runway and lets founders take more risks than they otherwise might not.

Scott: Chad, what are your thoughts on that?

Chad: The first thing we have to look at is changes to the tax laws about a decade ago that opened up investment from abroad. Before that, while it was possible for investors to come into Canada, it required a lot of heavy duty structuring. Those changes opened up Canada for venture investment, which has attracted a lot of new capital into the system.

I also think about the influence of US investors coming to the table and bringing US style deals with much more founder-friendly terms. Foreign investment has helped clean up a lot of things in our domestic market, making Canada a much easier place to build companies.

Advice on using M&A as a growth strategy

Scott: Neil, given your direct experience, do you have any advice for people who are contemplating using M&A as a pillar or their core strategy?

Neil: M&A in the tech space impacts every single function of your organization. Your entire company will be affected culturally, systematically, and operationally, from HR to product engineering to client success. It’s critical to be prepared for that impact at the leadership level and make sure the organization is ready.

It’s also critical to ensure that leadership at the top of the house and the second layer down aligns with your mission, culture, plan, and deal thesis. That’s essential to ensuring there’s alignment on the deal pieces across your organization and across the incoming organization.

Scott: The allure of the deal is exciting, but the real work happens post-closing. What are some of your tips for getting integration right?

Neil: Even before integration, during diligence, it’s crucial to ask uncomfortable questions repeatedly. That’s something I learned when we were closing our Series D and kept getting asked those questions, and again when we acquired a company a few years ago. We just kept asking the company about NPS and were told they weren’t tracking it. I got answers that bothered me, but I was so enamoured with the deal that I let it go. Ultimately, we dodged a bullet because when we finally did evaluate their NPS, it was actually off the charts. Still, not pushing on that point was a huge mistake I’ll never make again. You always have to keep asking the tough questions and try to dispel any discomfort across the organization. In my view, that’s what leads to a really good post-acquisition integration plan.

Market Considerations

Scott: Chad, what else are you seeing in terms of M&A activity over the past year?

Chad: M&A activity has been brisk over the last 12 months, but it hasn’t been as robust as you might expect in terms of the number of deals. I think it’s a sign of the Canadian ecosystem development and of where we’re going rather than where we’ve been.

The vast majority of companies are raising money and are growing, but they’re not necessarily looking on the sell side. On the buy side, we’re seeing some of our more mature clients turn to acquisitions as a strategy for growth. There’s uncertainty in the market and a vast disparity between bid and ask and expectations versus reality. That’s especially true with the compression in the public markets. In uncertain times like this, it’s not always an ideal situation from an M&A perspective, particularly for small or mid-sized companies that want to use their equity as currency.

Scott: In my experience, in these types of markets, there’s more activity, but it occurs at lower valuations, with the companies at the lower end getting compressed. Is that something you’ve seen before or anticipate happening again?

Chad: The companies going out to market right now have often stalled or aren’t high flyers. Maybe they haven’t been able to raise enough capital to get to the next level, or their growth has flatlined a bit. In a different market, they probably could have been purchased. Still with the compression right now, good companies with limited profitability or growth have very few options to sell at any valuation. There aren’t enough buyers around, and those out there are focused on profitability and growth.

Evolving Deal Terms

Scott: Now, let’s talk about deal structure. Chad, any specific terms that may be changing?

Chad: The biggest development of the last five years is the proliferation of rep and warranty insurance initially intended to replace traditional escrow. Over the last few years it’s effectively evolved to help ensure that sellers no longer have any liability to buyers in M&A activities. As a result, we’re seeing deals in private markets where sellers literally have no risk on the sale anymore, which is very different than where we were just a decade ago.

Scott: Kiron, to wrap things up, as we noted earlier, there’s likely going to be some friction between bid and ask. From a banker’s perspective, how do you deal with that?

Kiron: A lot of thought goes into why you’re buying a company. Naturally, you’re going to ask, what will this acquisition do for us? You also have to consider an eventual exit. Whether it’s an IPO or a sale of the business, the deal has got to do something for the buyer.

When you get into the public markets, publicly traded companies have many more variables and tools at their disposal to generate value for their shareholders. It’s not just all about M&A. I think it’s important to understand the counterparty and their options and what they need to do so that you can level-set expectations. You have to set the table for what the buyer needs and what they’re trying to achieve.

Scott: Thank you all for today’s insights into what’s going on in the M&A market. What a very illuminating discussion and one that we can all take something away from.

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