Middle-market private equity firms have mixed expectations for U.S. deal activity in 2023, but conditions in Texas suggest the state’s mergers and acquisitions market will have a busy year despite broader economic turbulence on the horizon.
Katten’s 2023 Middle-Market Private Equity Report reveals a split outlook among U.S. PE dealmakers, who faced a slew of new hurdles last year, from the limited availability of capital and rising inflation to interest rate hikes and fears of a recession. Regulators in Washington, D.C., have also taken an aggressive posture on buyouts, proposing tighter rules and increasing their scrutiny of acquisitions across the board. But even as U.S. M&A volumes declined last year — including a marked slowdown in PE activity — corporate dealmakers in Texas outpaced the national environment and worked on a record 1,082 transactions in 2022, The Texas Lawbook reports.
And Katten survey respondents were optimistic about deal activity in key sectors such as tech, finance and healthcare, despite their macroeconomic concerns. That bodes well for Texas, which has cultivated a significant number of tech startups — not just in Austin, but in cities like Dallas — and remains diversified in areas like healthcare and insurance.
Texas is also prepared to leverage its dominance in traditional energy sectors to accelerate the broader shift to alternative energy sources, which could produce a windfall for dealmakers in the state.
Those are just some of the findings from our report. In what follows, we’ll cover major trends and areas of opportunity in the Texas middle-market PE landscape — and why the state is uniquely positioned for a robust 2023.
Texas PE Firms Are Looking Toward Tech to Weather the Storm
Katten’s research found that 43 percent of dealmakers across the U.S. invested in tech last year, making it the third highest area of investment among respondents. What’s more, close to half believe the industry offers the best opportunities for dealmaking moving forward.
So it’s no surprise that several Austin-based middle-market PE firms, like Vista Equity and Peak Rock, are doubling down on tech investments. This comes despite a series of high-profile challenges facing the sector, including industry-wide layoffs and tumbling stock prices. Although recent bank runs have left tech-focused lenders like Silicon Valley Bank and Signature Bank scrambling, in Texas a number of significant deals are still getting across the finish line at discount valuations.
These transactions underscore dealmakers’ belief that tech will have staying power for the foreseeable future. They recognize that digitization is likely to accelerate as industries like ecommerce report sustained revenue growth and as technology reshapes sectors from banking to healthcare, giving rise to new specialty areas such as telehealth. And the sector still has support from U.S. policymakers, who are funneling cash into tech to ensure the domestic tech sector stays globally competitive. For example, Congress recently set aside $280 billion for semiconductor research and manufacturing, as well as advanced technologies like artificial intelligence and biotech, through the CHIPS and Science Act.
Almost six in 10 dealmakers in our report anticipate transformational opportunities will be the primary catalyst for deals in the tech industry in 2023. That outlook is reflected in recent deals by firms like Dallas-based Highlander Capital. While traditionally a direct PE and mezzanine investment firm, Highlander saw white space in the consumer tech market, which is poised to reach $989 billion in global market size by 2027, according to Fortune Business Insights. Highlander, represented by Katten, later acquired McIntosh Group, a leading seller and distributor of premium consumer audio technology. The firm is now well positioned to pursue further opportunities in the home electronics space — an impressive long-term play, especially as tech becomes increasingly integrated into consumers’ daily lives.
Renewable Energy and Carbon Reduction Will Fuel Texas M&A Activity in 2023
As the world shifts from fossil fuel dependency to green alternatives like solar, wind and biomass, we expect the energy transition will be the greatest driver of middle-market M&A activity in the state. While only 19 percent of U.S. survey respondents saw energy as an area of opportunity in the coming year, almost half of respondents believe transformational opportunities will drive those deals.
Texas stands to see a higher degree of deal activity due to its prominence in the energy sector and the unique role the state is playing in the energy transition. The abundance of fossil fuel in the region has produced a niche focus on carbon capture, storage and utilization technologies. What’s more, the Inflation Reduction Act, which allocated $370 billion in incentives for green energy, has already spurred an interest in renewable investment in Texas.
Chevron recently announced plans to build one of the largest carbon storage projects in the U.S. off the coast of Port Arthur. Tailwater, an energy PE firm in Dallas, recently went all in on the shift to low-carbon energy production, taking a “full immersion” approach that divides energy supply, delivery and logistics infrastructure, and recycling and byproduct management into distinct focuses.
Elsewhere, the transition in energy production has opened the door for investments in battery technologies and energy storage infrastructure. Some deals involve other sustainability plays — for example, Southlake-based Insight Equity, a traditional manufacturing-focused PE firm, recently acquired Clearly Clean, a maker of 100-percent recyclable food and beverage packaging.
As the Securities and Exchange Commission firms up disclosure requirements around environmental, social and governance metrics, big market players will be the first to adapt. Eventually, middle market (and even lower middle market) PE dealmakers will have to factor in ESG criteria if they want to sell to these larger funds, so they better prepare now.
Alternative Deal Structures Are on the Rise — Again
All-equity, backstopped deals have been on the rise here in Texas, and across the country. Companies like Austin-based Atlas Technical Consultants, an engineering consulting firm, are getting snapped up in 10-figure, all-cash PE transactions. In our report, 41 percent of dealmakers surveyed believe all-equity deals will be an important contributor to winning deals this year, and a majority expect an uptick in all-equity transactions.
This strategic pivot makes sense. The Federal Reserve is eyeballing further interest rate hikes, and PE players are having to come up with creative ways to court sellers in today’s debt-constrained environment. By promising quick and uneventful closings, all-equity deals are providing sellers certainty in today’s uncertain M&A landscape.
The search for alternatives has played out elsewhere in the market. Some dealmakers are turning to seller-note-financed deals, which have always been common in middle-market M&A but are experiencing a wider resurgence. Others have turned to joint-ventures to avoid taking on the entire valuation risk and financing burden.
Like many investment fads, the popularity of all-equity backstopped deals may wane as dealmakers pile on and new developments come into play. Take the recent dive in special purpose acquisition company transactions: As companies missed business projections and markets became more volatile, SP Global reports the number of SPAC IPOs went from 610 in 2021 to 86 in 2022. To complicate matters further, new regulations proposed by the SEC may force SPAC offerings to function closer to traditional IPOs. It’s a cautionary tale for investors looking to get a leg up through any means possible.
Successful Dealmaking in Texas Hangs on Investment in Key Sectors
While our report may indicate a level of trepidation about the future of middle-market M&A on a national scale, Texas’ diversified and entrepreneurial approach to dealmaking could bring in a banner year for dealmakers. But they’ll have to be smart about where they make their investments — and how.
David Washburn is national co-chair of Katten’s Mergers and Acquisitions and Private Equity practice. Regularly recognized as one of the Best Lawyers in America since 2015, David utilizes his in-depth understanding of market trends, relevant case law and complex transaction structures — as well as his skills as a persuasive negotiator — to meet his clients’ business objectives.
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