The mergers and acquisitions (M&A) market was subdued in 2023 — up to August, deal volume was down 14% compared with the same period in 2022.
That, however, is expected to change in 2024.
Lyall Davenport, principal at Claret Capital Partners, says businesses last year reduced costs with the goal of becoming more financially efficient, but not every company was successful in doing this.
“The stronger businesses in the market are now looking at picking up some of the companies that have underperformed but still have really interesting technology or a strong customer base,” he says.
The financing of such deals is important to consider. With interest rates remaining high and growth funding low, what roles will debt play in the M&A market this year?
Using venture debt
While all financing is key to a flourishing M&A market, venture debt is expected to play a significant role in 2024.
Warrants are important because it aligns us with the shareholders — whether that’s the founders, the early investors or the other VCs
Venture debt is a type of loan for early-stage startups that provides liquidity between or as a complement to funding rounds. For example, in the case of Claret Capital Partners, the fund gets its money back in three to five years but also uses warrants, a security that gives the holder the right to purchase company stock within a specific timeframe.
“Warrants are important because it aligns us with the shareholders — whether that’s the founders, the early investors or the other VCs,” says Davenport. “There’s an incentive to aid in creating a positive outcome for the business, albeit the return is much smaller than the equity investors’ when it goes right.”
Holidu is a platform for holiday rentals and has used venture debt since 2021. Its cofounder and CEO, Johannes Siebers, says venture debt is well suited to finance growth initiatives, which create a predictable cashflow stream (such as M&A).
“If we open a new touristic area and build a local office, we can very well predict the break-even point and cashflow of the new area,” says Siebers. “This is, therefore, well suited for funding through venture debt.”
Getting the right fit
In 2021 and 2022, the Madrid-based unicorn Job&Talent acquired more than 20 companies using a combination of debt and equity.
Juan Urdiales, its cofounder and co-CEO, believes venture debt is the right solution for earlier-stage companies that are in between Series A and Series C — companies, he says, that already have early-stage investors, a validated valuation and are generating revenue.
Whether that’s an exit, breaking even at a cash level or a future fundraise, debt facilities can provide that additional runway for a business to achieve a better result in the future
“You should not get venture debt if you’re incapable of generating — or see that you’re going to be generating ± positive cash flow in 18-24 months, because it can be very risky,” he warns.
But, on the other hand, he says: “For any company that has a limited access to capital, venture debt could be a great opportunity for raising money without massive dilution and a downround and, instead, have the opportunity to acquire other companies that suffer in those valuations.”
Daniel Mallon, vice president at Claret Capital Partners, agrees that venture debt is best suited to those startups that are in a strong position both financially and commercially.
“[Venture debt works for companies] looking at M&A as an option for bolting on additional solutions or expanding into new markets where there’s a certain level of predictability around payback periods,” he says. “This provides a strong credit story where an acquisition is largely being financed through debt rather than equity.”
Davenport says that he tells entrepreneurs to have a reason to take on debt — and that having debt to just sit on the balance sheet doesn’t always make sense. Debt can be useful when there are key drivers, identifiable roadblocks or cash requirements that you need in the future.
“This type of funding provides runway extension for businesses to achieve a future milestone,” he says. “Whether that’s an exit, breaking even at a cash level or a future fundraise, debt facilities can provide that additional runway for a business to achieve a better result in the future.”
He adds that bringing in some debt could provide a business with another 18-24 months runway — in that time, he says, a company could double the size of the business and come out the other side in a stronger market from a valuation standpoint.
The cost of debt in 2024
Venture debt can also be used to finance M&A opportunities where existing investors may not have the total funds to support — and it is hoped that the volatile state of interest rates that impact the feasibility of taking on such debt is coming to an end.
There is a growing desire from LPs to see cash returned on their original fund investments, and this should lead to more willing buyers and sellers in the next 12 months
In the venture space, the cost of capital has increased slightly, but not at the same rate as a typical bank rate, says Davenport. He adds that it’s much cheaper to use debt or a combination of debt and equity to grow businesses in today’s market and preserve some of the dry powder that investors might have for future funding.
“The general view is that we’ve hit the peak from an interest rate cycle perspective, allowing risk to be priced with more certainty,” says Mallon. “There is a growing desire from LPs to see cash returned on their original fund investments, and this should lead to more willing buyers and sellers in the next 12 months.”
Mallon says there are record levels of cash being held by funds coming into 2024, so he expects more M&A deals to be primarily cash-driven.
“The expected decrease in the cost of borrowing over the next 12 months will likely provide more certainty on pricing these transactions where debt is being used,” he says. “We would expect that this increasing certainty around financing costs will lead decision-makers at acquirers to accelerate M&A plans around pulling forward future needs.”