AI makes tech valuations complicated for asset managers

Separating potential from hype is challenging

Mergers and IPOs in the tech sector could see a continued comeback in 2025. After years of post-pandemic disruption, a rebound in tech market activity is already underway, with market conditions finally stabilizing after inflated pandemic valuations and subsequent corrections.

Mergers and IPOs are rebounding

The market for tech M&A and IPOs has been volatile in recent years. Activity surged during the pandemic in 2020 and 2021, driven by low interest rates and the rapid demands for digital transformation. In 2021, the U.S. set a record with 1,035 IPOs.

But the market soon slowed as investors became skeptical of sky-high valuations, and rising borrowing costs, coupled with economic uncertainty, further dampened their enthusiasm. That slowdown only recently showed signs of a thaw.

In the first half of 2024, the number of IPOs was 83% higher year-to-date than in 2023, powered by a few large deals, lower interest rates and signs of success in recent IPOs.

“The outlook for the IPO market for the second half of ’24 and early ’25 does appear positive,” Seidensticker said.

M&A also is expected to pick up as private equity firms start spending their substantial cash hoards. Two-thirds of professionals in the field are expecting to see more deals over the next six months, though some were waiting for the U.S. presidential election to pass, according to Grant Thornton’s most recent M&A pulse survey.

Technology is a likely target. Deals are also becoming more workable because valuations have come down, relative to the eye-popping highs of the pandemic. Valuations are now reflecting multiples of earnings that are closer to pre-pandemic levels, with a median 17.4x multiple of enterprise value to projected EBITDA for the year ahead, compared with a five-year average of 17.5x.

 "In the first half of 2024, multiples have shown a sign of stabilization,” Seidensticker said.

The new complexity of AI

AI is already boosting the markets.

“There is a lot more market emphasis on technology than we've seen over the past 10 years, including the surge in AI,” Seidensticker said.

But the extent of AI’s effects remains unclear. Previous technological leaps — such as the personal computer, the internet, the smartphone and social media — resulted in increases to market returns of about 200 basis points, the panelists said.

“The general trend for both the software AI companies and the hardware AI companies has been very, very positive,” said Grant Thornton CFO Advisory Services Principal Todd Patrick. But the value boosts and market successes won’t be evenly distributed or equally long-lasting. 

AI also is opening new opportunities for downstream users — businesses across sectors that are unlocking new automation and efficiency. But its use also comes with questions about how long the competitive edge will last.

Smaller companies that find efficiency gains in AI might see only a temporary advantage, with innovation giving way to compressed margins as their competitors adopt similar strategies.

“For many industries, the benefits of AI currently center around lowering costs as opposed to increasing revenue,” Patrick said. “While on the surface, this would appear to indicate future increased margins, if all companies in these industries are able to utilize similar AI, the net result could be lower prices and lower inflation as opposed to greater profitability levels.”    

What to expect in different parts of the tech sector

The explosive 2010s and early 2020s market came with a “growth-at-all-costs” mentality, Seidensticker said.

Today, more investors are “looking for efficient, organic growth and evidence of profitability when mature,” Seidensticker said. But the effects of AI and other changes in the tech market will diverge across different parts of the tech sectors.

Here’s what to expect, and how to identify value.

Semiconductors: Makers and sellers of semiconductors — the key component of computer chips — are seeing some of the strongest growth and highest values. Semiconductors are a critical and constrained resource for the entire industry, from AI server farms to increasingly intelligent vehicles and the growing internet capabilities of just about every gadget and appliance.

This year in particular has seen a surge, due in part to the CHIPS And Science Act and its incentives for domestic production, paired with stiffer tariffs on imported chips. Larger companies have been buying smaller semiconductor businesses, and revenue multiples have risen to 10.9x, compared with a historical median of 3.5x.

Higher-than-historical valuations offer both a tempting sign of momentum and a reason for caution. When considering investments, be cautious of a company’s long-term ability to maintain its supply chain, and its vulnerability to further policy changes. In general, domestic production may be a safer bet than reliance on foreign supply chains, as policymakers are likely to continue discouraging imports of chips as they try to build the U.S. industry.

Also, the ability to produce semiconductors doesn’t translate to success on its own. It’s worth considering whether companies have a strategic focus on a promising niche, such as AI or autonomous vehicle components.

Software: Valuations are stabilizing at levels near the five-year trend, “which indicates a balanced view of growth and profitability in the software sector,” Seidensticker said. “This current trend suggests a return to more stable and sustainable valuation level levels.”

After a previous focus on hype and growth, investors now are looking for long-term value, especially in terms of annual recurring revenue and high customer retention. That may favor larger companies that can afford to make accretive acquisitions.

“Smaller acquisitions are a very good method to make incremental improvements to existing software products and increase talent pool very quickly,” Seidensticker said.

Meanwhile, smaller companies may struggle with the high costs of attracting new customers, unless they have a good plan to make those customer relationships stick.

IT services: As usual, IT services — the companies that plan and implement technology infrastructure for other organizations — don’t have the same shiny luster as emerging technologies such as AI. Their valuation multiples are hovering around 1.3 times projected 12-month revenue. But that stable pricing environment can also offer a less risky and more predictable investment target.

“This subsector does consistently have lower multiples than the other technology sectors, and that's primarily due to lower margins and much higher levels of competition,” Seidensticker said.

Grant Thornton’s panelists said there’s clear, continuing demand for the digital transformation services offered by these companies, especially cloud computing, AI and cybersecurity. The companies that have established themselves as leaders in these niches are likely to continue their strong performances. Once more, the trends are encouraging acquisitions by the largest companies.

One key is to look for those companies positioned to maintain or grow their margins.

Hardware: The picture is more complex for hardware producers in general, compared with their colleagues in the semiconductor industry. Makers of computers, networking equipment and data center hardware are all facing intense price competition that is driving down margins. As a result, revenue multiples are running significantly lower than historical averages.

“We believe that this is being driven by the effect of fierce price competition in this industry,” Seidensticker said.

In response, these companies are looking for growth in high-margin niches such as cloud computing and specialized software — offering both risk and opportunity.

Asset managers should look for hardware companies that are taking those kinds of strategic steps to diversify and secure recurring revenue.

Hardware companies also face greater public and regulatory pressure to improve their sustainability, especially through e-waste recycling and other efforts to reduce waste.

Looking ahead

While the market might be ripe for mergers and IPOs, there’s plenty for investors to consider, and the rise of AI is just one of many factors that they will weigh in the aftermath of the U.S. election, asset managers will need to navigate significant geopolitical uncertainty and potential shifts in economic policy. Tax reforms, regulatory adjustments and fiscal policy changes could alter market conditions and valuations.

Additionally, geopolitical tensions could lead to shifts in international trade policies, disrupting supply chains and affecting production — and prices.

“Asset managers should factor in these uncertainties by stress testing valuation models, diversifying portfolios to mitigate risks, and staying informed about potential policy changes and their implications,” Patanella said.

Being prepared for various scenarios in this environment will help asset managers manage both downside and upside risks. Strategic recommendations for asset managers include:

• Maintaining agility
• Prioritizing open communication with clients
• Using data and analytics to make informed decisions