Gaming's fiscal cliff

Gaming's fiscal cliff
Nick Gibson

By Nick Gibson

February 25th 2013 at 4:17PM

Nick Gibson analyses the collapse in value of mergers and acquisitions in the game industry

We have taken for granted the last four years’ pattern of declining retail games sales and growing network gaming revenue, which has been at least supported, if not driven, by a buoyant mergers and acquisitions (M&A) sector and healthy injections of investment into privately held games businesses.

While 2011 saw both M&A transaction volume and value and total private placement value, reach an all-time high, 2012 saw the number and value of these transactions fall off a cliff. What are the causes of this alarming collapse in games company transactions and how will it affect the industry?

With 98 games company M&A transactions (the vast majority of them acquisitions) representing an estimated $2.1bn in value and over $1.5bn raised for privately held games companies worldwide, 2011 was an exceptional year, following an equally barnstorming 2010.

Both these years witnessed a fervour around network gaming and in particular smartphone, tablet and social network gaming. Venture capital helped fuel the initial market exploration stage for these sectors, then piled in to fund the feverish landgrab phase.

SKY HIGH

With so much capital flowing into games businesses from VCs and angel investors, valuations were driven skywards. As is often the case, this in turn led to a boom in M&A activity as the better-funded companies sought to use their augmented cash reserves and high valuations to accelerate their growth via acquisition.

With exits being achieved so frequently and often at such high valuations, investors’ enthusiasm for the sector only increased. Thus, the two corporate finance activities of M&A and private fundraisings orbited and accelerated each other to its 2011 peak.

2012 saw the number of games M&A deals tumble 40 per cent and the value of these transactions fall by 30 per cent. More remarkably, investment in privately held games companies fell by over 60 per cent to $0.6bn; a fraction of that raised during any of the previous five years and significantly worse than the wider VC industry’s 2012 performance.

However, the irrational exuberance of the M&A and private equity markets also played a key role in 2012’s dismal performance, pumping up unjustifiably high valuations for key companies that would be used by all others as benchmarks.

The same herd-instinct that drove the up-cycle precipitated and then accelerated a vicious down-cycle. Zynga’s disastrous share price performance following its overvalued December 2011 IPO, and OnLive’s dramatic collapse helped create a prevailing investor sentiment of extreme pessimism and risk aversion during 2012 that was only exacerbated by the continuing global macro-economic woes.

Was this a bubble bursting or even equivalent to the early 2000s internet stocks’ collapse? Not in my view.

RISKY BUISNESS

Clearly, VCs will largely remain risk-averse, increasingly investing only in companies with proven sustainability and clear growth trajectories. They will remain unwilling to accept rich valuations too.

This reduced activity and downward valuation pressure will continue to restrict the M&A market, reducing the exit options for games company shareholders seeking to cash out. The unfortunate collateral damage from all this is that there will be less funding for more innovative and speculative ventures and this may well remain the case for some time.

From the bottom of the cliff things do look gloomy, but eventually the capital will start to flow more freely again.

2007-to-2011 was a period that saw huge returns for many investors. I believe, therefore, that there is considerable latent demand from the investment community and, as financial markets slowly recover, triggers such as the emergence of a new market, platform or distribution method, and the arrival of new bellwethers to replace the old, apparently discredited ones, could set another virtuous circle going again.

It may not happen in the next few years but history cannot help but repeat itself.