Investment Banking Trends: M&A, AI, US Fed rates, and private credit with Gaurav Bhasin

Posted by | Fuld & Company

Fuld & Company Director, Vinit Gala, interviews Gaurav Bhasin, Managing Director at Allied Advisers, on the latest trends and developments in investment banking. They discuss recent deal activity, the impact of potential US Fed rate changes, and the evolving roles of private credit and AI in investment banking.

How would you assess the deal activity for H1 2024? Is the market finally picking up?

In the first half of 2024, we have seen some promising signs in tech M&A activity. The overall deal value is up almost 20% from the same period last year, according to Pitchbook. However, the market hasn’t fully picked up yet.

Certain areas of technology like AI and Cyber are active. Also, companies growing in a sustainable capital efficient manner are generating interest from private equity firms. While many buyers had pulled back in 2022 and 2023 to focus on improving operations, we are now seeing more interest from corporates now seeking targets to enhance inorganic revenue, improve product portfolios or acquire critical AI talent. The rebound in public markets has also made buyers more bullish about acquisitions, and sellers are adjusting their expectations to current market valuations, rather than the “frothy” valuations of previous years, which is helping in deal-making.

We expect a stronger second half of the year and have already seen an uptick in closed transactions and increased velocity in deal-making for our clients.

What are your expectations for the Fed funds rate this year? Do you think a single rate cut could have a meaningful impact on lower middle market deal activity in 2024?

Based on current economic and political factors, I am cautiously optimistic about the Fed funds rate. Central banks, like the Federal Reserve, typically avoid making rate moves during election years to prevent political perceptions. However, given the recent inflation drop in July which fell to its lowest level in three years on an annual basis, along with the weaker job report, the Fed will likely make a couple of interest rate cuts in 2024.

A Fed rate cut would significantly impact lower middle market deal activity in 2024 by lowering borrowing costs and stimulating investment into emerging companies. Some market pundits optimistically anticipate two 25 basis point cuts this year, which could coincide with increased market activity as sellers react to improved conditions.

While the Fed has postponed rate cuts, global easing trends and expected Fed actions will significantly enhance market activity. This will empower buyers to be more aggressive in deal making, potentially revitalizing lower middle market deal activity in 2024 and beyond.

Where do you see the most significant improvement in investment activity? We’ve observed an increase in capital raises, especially in venture debt and recapitalizations. What’s your perspective?

Seed stage investments have continued to be active, in line with historic norms over the last couple of years. However, post-seed activity has been generally muted. Companies that were doubling and tripling in prior years would have easily gotten Series A and B term sheets, but now investors are more cautious about investing in the companies. Diligence is taking longer, and investors are pickier about which companies they back. If there is any concern, they generally hold off on investing.

Late-stage investing (Series D and beyond) has slowed down as well, given the public markets’ valuation drop from a median of 16x ARR to 6x ARR. Late-stage investors see public market valuations as a proxy for where the next round will be priced. Recent IPOs such as ARM, Klavyio, Instacart, and Rubrik have helped thaw the frozen late-stage financing market but not to the extent needed. However, top-tier companies in the AI space, such as Open AI and Databricks, with astronomical growth, have been able to attract capital at peak valuations.

Overall, the market for later-stage financing has improved from 2022/23 but not to 2020 levels, which is healthy for the eco-system.

In venture debt, after a drop to $12B in 2023, a partial rebound is expected in 2024, with US tech venture debt projected to rise to $14-16B, up 25% from 2023 levels according to Deloitte. Venture debt has become an attractive vehicle for companies to raise capital without the dilution that comes with an equity raise. Many companies aren’t growing at a rate that would merit the next round of venture funding; hence venture debt continues to fill a much-needed financing void. Entrepreneurs see this as an astute way to raise financing to help grow their business.

What’s holding back financial buyers right now? Private equity-backed middle market deals seem to be languishing. Why have buyers become so selective?

Financial buyers, especially in private equity, are facing challenges driven by higher interest rates, recession fears, and varied company performances which have stagnated middle market deal activity. Deal volumes in Q1 2024 are comparable to Q1 2023 and down from Q4 2023, reflecting a decline from the peak of $2.2T in 2021 to $850B in 2023 according to PWC.

Buyers are now more selective, seeking stronger financial metrics and profitability drivers from middle market firms. This contrasts with sellers’ expectations of sustaining high valuation multiples from 2021 and 2022 into 2024, leading to a mismatch in valuation perspectives, making deal making difficult.

Despite expectations of rate cuts potentially boosting private equity investments, these cuts have been delayed, impacting strategies reliant on leveraged transactions. With rate reductions anticipated later in 2024 or early 2025, financial buyers, particularly private equity firms which are most impacted by interest rates, are currently cautious, and deal making has slowed as a result.

Has private credit become a credible alternative for middle market firms? With its rapid growth from around US$500 billion to over US$1 trillion, do you think firms will increasingly rely on credit funds for their financing needs?

Private credit has strongly emerged as a credible alternative for middle market firms, growing tremendously over the last 5 years. This sector offers predictable returns by lending to private companies, filling the gap left as traditional banks reduced their financing over the past two decades.

Private credit’s appeal lies in its stable income potential regardless of market conditions. Recent years have shown higher returns and lower risk compared to other asset classes due to limited equity funding. With nearly 200,000 companies in the U.S. middle market and private equity firms controlling $1.7 trillion, according to Angelo Gordon, lenders focusing on sponsored companies in this segment find ample opportunities.

I believe this segment in the middle market will continue to grow, driven by moderate leverage requirements, favorable bond terms, higher asset yields, and detailed company scrutiny by smaller lender groups. The core middle market is less competitive than the upper segment, offers wider spreads and better pricing control, enhancing lender performance opportunities.

What are the current sentiments in your area of expertise? Do you think the technology sector will lead deal activity in 2024-25?

Current sentiments in the technology sector for 2024-25 reflect a marked positive improvement from 2023. While the technology sector thrived initially during the pandemic, it has faced headwinds such as inflation, high interest rates, and global uncertainties, impacting consumer spending, product demand, and leading to market capitalization declines. The focus has shifted back to businesses that are managed with capital efficiency.

Despite these challenges, there are signs of a potential rebound. Economists have lowered recession risks, and analysts predict modest growth for 2024. Tech leaders are focusing on leveraging cloud computing, AI, and cybersecurity to drive expansion. Investments in these technologies, particularly generative AI for productivity enhancement, are expected to stimulate market growth.

Regarding M&A activity, financial acquirers saw a decline in their share of transactions in 2023, but corporate acquirers have stepped up in the first half of 2024. Valuation expectations remain somewhat tenuous between buyers and sellers, with neither side willing to compromise on their preferred multiples. The current focus in M&A deals is centered around platforms utilizing generative AI, ML, and adaptive learning algorithms, particularly within the software segment. Cybersecurity platforms, known for their strong buyer interest, are leading in traction among software products.

In conclusion, while challenges persist, the technology sector shows resilience and potential for growth in the coming years, driven by advancements in AI and cybersecurity.

Have you noticed an increase in the use of AI among investment banking professionals in their deal process? Could you share some examples?

It’s not just now that IB has been using AI and ML algorithms, these concepts were picked up decades ago through NLPs, employed to automate processes like trading processes, and risk management. Automation technologies have also been used for many years to improve efficiencies in middle and back-office processes related to various investment banking areas like trading, sales, risk management, wealth management, and securities underwriting.

As AI technology has advanced and GenAI/LLM models have evolved, various startups have emerged to leverage these capabilities to offer innovative solutions to corporate investment banking (M&A) and other areas, creating step changes in speed, accuracy, and efficiency for M&A teams.  Some examples include:

• • Development of target lists for business development: Using Gen-AI/LLM to scour high volumes of company, market and transactional information from proprietary databases to generate high quality, relevant target lists for marketing, empowering business development teams.
  • Development of target buyer/investor lists: Gen-AI/LLM powered search engines to determine the “most likely” list of strategic buyers or financial sponsors from potentially millions of entities globally, based on specific search criteria. These can be powerful tools for investment banking support teams to improve transactional processes.
  • Increasing due diligence efficiencies: Leveraging NLP and Gen-AI models to examine large volumes of documents in a data room for specific items of interest, reducing costs and analysis time of due diligence teams.
  • Development of pitch decks and client presentations: Use of Gen-AI technology to automate the drafting of pitch decks, including market research, competitive information, financial analysis, and valuation comparisons.

Despite all of this, AI will not be a cure-all as investment banking is “part art, part science” due to the inherent nature of M&A processes, which involve subjectivity and decision-making based on many factors. Sometimes there is no prior data or negotiation. There will always be a need for a “human in the loop,” but the junior end of the workflows in investment banking will benefit from the adoption of AI technologies.

About Gaurav Bhasin

Gaurav Bhasin is a Managing Director at Allied Advisers, a global technology-focused investment bank, with headquarters in Silicon Valley (and a presence in Los Angeles, Tel Aviv, and Mumbai). He has closed over 80 transactions across a broad range of technology sectors for clients globally. He was recently recognized in Silicon India’s list of the top 100 companies managed by American Indians and named among the top 100 Managing Directors in Finance in San Francisco. He is also a member of the Forbes Business Council.

Allied Advisers is a global boutique advisory firm that specializes in investment banking for entrepreneurs and investors in the technology sector. Based in Silicon Valley and with offices in Los Angeles, Tel Aviv, and Mumbai, the firm provides strategic advisory services, including M&A and capital raising, to entrepreneurs and investors of technology growth companies worldwide. Allied Advisers bankers have successfully completed technology transactions with Fortune 50 buyers and top-tier private equity firms for their clients globally.

Tags: Investment Banking