We may be looking at a major upheaval in the Israeli M&A market, as recent times have been quite a change compared to the last couple of years.
During 2020-21 the Israeli market, having recovered from the initial Covid-19 influence, has seen exceptionally high volumes of M&A deals. So much so that according to certain analysts, the year of 2021 reflected a 70% increase in overall M&A deal value, with both local and foreign entities acquiring Israeli companies and fuelling the market with cash.
This period of time has been the finest hour of sellers. Low interest rates alongside plenty of available funds and growing global interest in technology companies in the face of the Covid-19 crisis, led to increasingly high demand on the part of buyers, looking to take advantage of the inviting investing atmosphere in Israel and invest in Israeli companies. Naturally, a respective rise in the valuation of acquired companies followed, all leading to a very pro-seller market. Consequently, we have witnessed a significant portion of our clients, mainly foreign buyers looking for a toehold in the Israeli market, willing to pay considerable sums of money, as well as to compromise on some legal aspects of the deal, all in order to secure their desired transaction.
It seems, however, as though we are witnessing reality twisting in a different direction, as recent developments indicate. As seen across the globe, high inflation rates lead state treasures and national banks to respond by increasing interest rates. Israel is no exception to this tendency (albeit to a lesser extent), with local interest rates as of August 2022 increasing from 0.1% to 1.25% over the past three months. It appears that the end of the cheap money period may be approaching, with following sell-offs by investors and sharp downfalls in public companies’ values, which may mark the trend reversal. Although a full assessment of the consequences of the new market trend on M&A deals seems somewhat premature at this stage, it can be carefully said that we are starting to see a shift in the pro-seller paradigm that has dominated the market in recent years.
Nonetheless, we see that many of the relevant companies and investment funds still appear to have plenty of available cash for investment and an appetite for investing it.
In addition, the Israeli industry, which is based on strong innovation and tech sectors, is expected to continue to be an attractive target for foreign investors, as technology innovation continues to drive the world economy. This leads us to believe that while we may see a temporary pause in investments while players re-evaluate the changing market and their increased costs of capital, a stagnation is not expected. Rather, we expect to see a continuance of the previous investment trends albeit with potentially different market characteristics. These characteristics are likely to reflect a more buyer-oriented market in which buyers might find themselves, in contrast to the investment atmosphere of previous years, in a better position to shape the terms of the deal in their favour. Buyers are also likely to benefit from a decrease in company valuations, which we expect to trickle down from public companies to private ones. Indeed, among our clients, we still see companies receiving diverse investment proposals even though the proposed valuations may be lower than their initial expectations. Likewise, we continue to help local and foreign investors to take advantage of attractive deal prices through investments in Israeli companies.
We can already see the shifting market standards reflected in some of the recently published transactions. For example, the American private equity fund, Insight Partners, currently takes part in a US$35m equity financing of Bizzabo, an Israeli hi-tech company focused on innovative events and conferences organising solutions. This financing, which reportedly reflects a company value lower by 30% compared to the prior round in 2020, also includes a 3X liquidation preferences protection. This protection, which basically guarantees an investor a three-times return on its investment in case of a future exit, would have been difficult to imagine in similar investments that took place in the pro-seller investment atmosphere of the last couple of years.
Another trend that we are starting to see among our clients is an increase in the use of earn-out and similar mechanisms to determine a bigger portion of the deal consideration. This mechanism allows parties who disagree on the valuation of a company to make a portion of the consideration subject to the occurrence of future events, thus reducing the risk associated with the deal for the buyer, while allowing the seller to enjoy the future success of the business despite current market uncertainties.
Recently, we have even seen another type of M&A deal taking place, one almost unheard of in the local market: a hostile takeover attempt where Aviat Networks attempted to take over Ceragon Networks, following a 68% drop in its traded share price compared to its two-year record high. There are a few reasons why hostile takeovers in Israel are so rare, but of particular note is the structure of the Israeli capital market, which traditionally includes mostly public companies with a strong controlling shareholder, as well as a unique limitation under Israeli law which requires buyers that wish to acquire initial control in a public company to make their bid public through a ‘Special Tender Offer’. According to this procedure, the buyer’s offer must not only be addressed to the shareholders of the company in their entirety, but it also must be approved in a general meeting. This means that even if a buyer manages to find enough shareholders who are willing to sell their holdings, a majority of disagreeing shareholders could still frustrate the deal. However, the increase in IPO of tech companies without a strong controlling shareholder which we have seen in the last few years, particularly during the SPAC Spring of 2020-21, together with a sharp drop in share prices may make this type of deal more attractive in the near future, as evidenced by the on-going Ceragon Networks transaction.
Another deal of similar nature is the tender offer made by Panopto for its competitor, Israeli-founded video creation company Kaltura. It is the third tender offer Kaltura has received from Panopto in the last couple of months, which comes as no surprise as Kaltura’s shares have dropped by roughly 80% since its US$1.3bn IPO only last year.
Stock-for-stock mergers and acquisitions are also starting to gain more traction in Israel. In addition to the increase in the costs of funds, which makes cash investment more expensive, this trend may be attributed also to psychological reasons that arise from giving up equity under a low company value by investors who have not too long ago seen their stock going for much higher figures. In this sense, it is somewhat difficult to convince an investor whose stock was sold last December for US$100, to now sell it for a third the sum. But when an acquiring entity who also took a hit to its share price offers to acquire a company with a consideration consisting of shares of its own, the picture turns into a more comfortable transaction from the shareholders’ view who may consider the current situation in the capital markets to be temporary and expects the purchaser’s stock to increase in value, much like their own case.
A look on the recently-announced merger between Israel’s ironSource and Unity Software, the popular video game software developer, shows exactly this. The transaction took place early last month, after valuations of both companies dropped by roughly 80% in the preceding seven months. Reflecting a company valuation of US$4.4bn while being entirely stock-for-stock, this transaction may have been easier to swallow for both parties: ironSource’s shareholders were not required to liquidate their holdings for low figures, while Unity was not required to bear the rising costs of funds. Similarly, such transaction, in which employee stock options are usually rolled-over into the buyer’s stock instead of being cashed-out, obviates some of the concerns of this important group of constituencies.
Another practice, which may also become more common for companies seeking finance as the market transforms into a new phase, is debt financing. In light of current market conditions, companies that find themselves in financial hardships and in need of swift funds are not too eager to give up equity portions given their relatively low valuation at present. This mostly psychological effect is heightened by the fact that most investors receive anti-dilution protections as part of their investment, which guarantees at least partial protection from a dilution of an investment round which reflects a lower valuation than the one at which they have invested. This means that the dilution of ordinary shareholders in such ‘down round’ is usually higher than that of the investors, and, accordingly, the incentive of such ordinary shareholders (which typically include the management of the company) to agree to such investment is lower. In these situations, financing through debt becomes a more attractive solution, and together with the increase in the number of institutions that specialise in financing early-stage companies, we expect to see more debt financing as company valuations continue to decrease. Indeed, we are already witnessing several clients being involved in loan agreements, including investors that invest in transactions involving debt financing coupled with equity kickers, who find this type of investment appealing on their part because of the general increase in interest rates and their improved bargaining position.
All in all, the new market situation is still in its early stages and, as the saying goes, it is tough to make predictions, especially about the future, but it is not too far-fetched to draw an interim conclusion, according to which there are new rules to the game, and that they are here to stay, at least for the near future. But for all the shifts and changes, it does appear that the Israeli investment market is still very much alive and kicking, although not in exactly the same way as it was before. These shifts and changes, may mark a general shift towards a more pro-buyer atmosphere, as can already be seen in recently published M&A deals and in our clients’ on-going transactions. Now, it is for time to tell how things will unfold.