M&A Deals Decline In First Quarter Due To Higher Interest Rates, Credit Conditions

‘What we’re seeing in 2023 is a return to pre-COVID. It’s not a crisis or anything, it’s just really returning to pre-COVID levels. Eventually, interest rates go up and the credit conditions tighten. The party can’t go on forever,’ John Holland, managing director of Corporate Finance Associates, tells CRN.

The first quarter of 2023 saw a drop in M&A deals due to rising interest rates and tightening credit conditions, but some businesses were exempt from that, including MSPs and telecom and cybersecurity companies.

“The theory is that when money flows and interest rates are low, as in 2019, 2020 and 2021, you have merger-and-acquisition activity across industries and everything is hot,” John Holland, managing director of Corporate Finance Associates, told CRN. “Companies have a lot of cash to acquire businesses, and private equity firms have a lot of cash. That’s what we saw in 2021. It was a record year across industries for M&A, and 2022 was similar.”

Laguna Hills, Calif.-based Corporate Finance Associates is an investment banking firm with decades of experience in executing mergers and acquisitions in the IT and telecom services industries.

[Related: Report: M&A May Slow Down In 2023, But Not For All MSPs]

“What we’re seeing in 2023 is a return to pre-COVID. It’s not a crisis or anything, it’s just really returning to pre-COVID levels,” Holland said. “Eventually, interest rates go up and the credit conditions tighten. The party can’t go on forever.”

Now that conditions are tightening and interest rates are rising, acquirers are being more selective, according to Holland. They’re searching for particular types of IT services companies that they think are more attractive by offering more growth potential.

“Managed service providers have recurring revenues, they’re considered safe even in a recession because the MSPs really wrap their arms around their clients,” he said. “It’s very hard for a client to divorce itself from a MSP.”

It’s similar at telecom companies, as they offer recurring revenue, and cybersecurity companies, as they offer “really great” growth potential in a recession.

Businesses that are riskier in this economic climate are VARs as they work on a project-by-project basis and typically have lower margins, he said. However, a “very safe” category is resellers that sell to the government because the government continues to buy, whether there is a recession or not.

One such company is Cary, N.C.-based BlueAlly Technology Solutions, which acquired Greenbelt, Md.-based n2grate Government Technology Solutions in February.

In March, Tulsa, Okla.-based VAR Cherokee Federal acquiredCriterion Systems, a Vienna, Va.-based cybersecurity solution provider that also services the U.S. government.

“You will see more of that activity, I think, if the economy slows down,” Holland said.

M&A deal sizes also declined in the first quarter due to the absence of “mega deals.”

“Banks are just more conservative lenders,” he said. “So non-bank lenders are very conservative now too. They’re only going to provide a loan for an acquisition if it’s a quality company that’s being acquired. That just has the effect of eliminating M&A transactions of businesses that are not rock-solid. I think that we’re going to see this state of M&A for a little while. It could be another quarter, it could be the rest of the year. That’s hard to say.”

However, private equity firms are in a better position to buy than IT companies that are strategic buyers. The private equity companies have a lot of cash on their balance sheet, Holland said. Because they conducted their capital raises last year, they’re sitting on “billions of dollars” to potentially use for M&A regardless of the state of the economy. They just have to be more selective due to tightening credit conditions, he said..

But despite record-low interest rates fueling a lot of M&A in the last couple of years, it was bound to come down eventually., according to Holland.

“We just had two all-time record years for M&A,” he said. “Because the federal government kept interest rates artificially low, it stimulated the capital markets. It’s like for two years we put extra fertilizer on the crops. Now there’s less fertilizer on the crops, but it’s not doom and despair.”