Introduction

The M&A market in Israel witnessed significant shifts in 2023, a year marked by unprecedented challenges, most prominent of which being the catastrophic terror attacks on October 7 and their aftermath. These events have profoundly impacted the nation in every conceivable way, leaving an indelible mark on its society, economy, and overall sense of security. These effects have reverberated through all sectors, with the M&A market being no exception. This article aims to delve into some of the key developments and trends that have characterised the Israeli M&A market during this tumultuous period, beginning by examining the immediate impacts on the market and how the events of 2023 have reshaped investor strategies and deal flows.

The Israeli M&A Market Amidst 2023 Adversities

Market overview

The immediate repercussions of the events of 2023 on the Israeli M&A market were multifaceted, impacting investor sentiment, disrupting market operations, and prompting a re-evaluation of strategic priorities. The conflict itself has had a profound effect on Israel’s tech ecosystem, mobilising thousands of tech workers and start-up founders and severely limiting the initiation of new deal flows, particularly from foreign investors. This has likely stalled major transactions, underscoring the extensive impact of the conflict on the economic landscape.

Amidst an already difficult landscape shaped by the global M&A trends of 2022 – which included soaring interest rates, rising inflation and the Russia-Ukraine conflict – the unique domestic adversities of 2023 have had a compounding impact on the M&A market in Israel, which faced a pronounced downturn in 2023, with the total value of deals plunging by nearly half to USD9.8 billion, marking the lowest since 2014.

The average value of deals also saw a decline, falling to USD131 million from USD202 million in the previous year. The frequency of M&A transactions also saw a reduction, with the total number of deals dropping to 110 in 2023, down 23% from the previous year and reaching its lowest point since 2015. This decline in deal value and the number of transactions signals a broader trend of a re-evaluation of market opportunities in the face of Israel’s geopolitical and domestic uncertainties.

The war’s impact also affected the timing and completion of deals. In 2023, only one deal exceeded the USD1 billion mark, signalling a cautious approach to large-scale investments. Conversely, the proportion of deals valued at up to USD100 million increased sharply, accounting for 75% of all transactions, compared with 62% in 2022. This shift suggests a market adapting to the prevailing uncertainty by focusing on smaller, perhaps less risky, investments.

Despite the challenges of 2023, significant M&A activity continued, showing that investor confidence remains robust.Transactions involving foreign investors, however, dropped in 2023 by 41% to approximately USD6.7 billion, as international investors adopted a more cautious stance, concerned by political tension, judicial reform and the outbreak of war, with some foreign investors retreating from the Israeli market to assess the unfolding situation and its potential long-term impacts.

These challenges set the stage for a pivotal shift in transaction dynamics, as detailed in the following section of this article.

A shift towards Israeli-Israeli M&A transactions

The reduction in international investment activity catalysed a notable shift towards more localised transactions. Israeli buyer-Israeli seller deals gained prominence, reflecting a strategic pivot to leverage domestic opportunities and mitigate the uncertainties associated with cross-border engagements during times of geopolitical strife.

While this inward shift to a more localised transaction focus underscored the resilience of the Israeli business community by demonstrating a capacity to adapt and sustain economic activity despite substantial market adversities, it also highlighted some regulatory and antitrust challenges in a market known for high concentration levels, as explored below.

Resilience and growth of the cyber sector

Unlike other sectors that were adversely impacted by the strain of 2023’s challenges, particularly the devastating events of 7 October and their subsequent impact, the cyber sector in Israel not only endured but flourished. This sector had already been a focal point of significant investment interest, both domestically and internationally, demonstrating robust growth well before these incidents. However, the events of 2023 acted as a catalyst, intensifying the focus on cybersecurity due to a sharp increase in cyber threats.

Throughout the year, the number of cyber-attacks more than doubled, with a total of 3,380 incidents recorded. These attacks targeted critical infrastructure, including attempts to compromise strategic assets such as hospitals and government systems, which underscored the acute need for advanced cyber defences. This surge in cyber threats significantly elevated the strategic importance of the cybersecurity sector, driving increased M&A activity as companies sought to bolster their defences against an evolving threat landscape.

In 2023, the Israeli cyber sector saw M&A transactions reach an impressive aggregate value of USD7.1 billion. Notably, 19 out of 45 M&A transactions, accounting for 51% of the total deal value and totalling USD3.8 billion, were centred in the cyber sector. This concentration of high-value deals in cybersecurity – with all major deals valued over USD200 million exclusively in this sector – reflects not only the heightened demand for cyber solutions but also investor confidence in the resilience and future growth potential of these companies.

The significant M&A activity in the cyber sector during a period of overall economic uncertainty highlights its unique position as a resilient and thriving segment of the Israeli economy. The cyber sector’s ability to not only withstand but thrive during such tumultuous times speaks volumes about its critical role in national and corporate security strategies, its innovative capacity, and its appeal to investors looking for stability and growth in otherwise uncertain times.

Antitrust Implications

Overview

As mentioned above, amidst the turmoil and heightened risk aversion from international parties, the Israeli M&A market in 2023 experienced a notable shift towards localisation of transactions, as Israeli businesses increasingly sought partnerships and consolidation opportunities within the local ecosystem. This trend towards Israeli-Israeli transactions, while bolstering resilience against external shocks, has inadvertently led to an even more concentrated market environment. Given the relatively small size of the Israeli market, there exists only a limited pool of buyers and sellers capable of engaging in substantial M&A activities without the involvement of foreign entities. This dynamic has amplified concerns regarding market concentration in an economy already known for its highly concentrated sectors, and has heightened the challenges faced by the Israeli Competition Authority (ICA) in maintaining a competitive market landscape.

This increased propensity for local transactions has necessitated a more cautious approach from the ICA, which is tasked with the dual objectives of fostering market growth and stability during a period of significant adversity, and also adhering to its foundational mandate to protect competition and prevent monopolistic practices and/or the increase in market dominance by a few entities. In addressing this delicate balance, the ICA demonstrated particular vigilance in its scrutiny of transactions that could exacerbate market concentration.

Transactions impacted by antitrust constrains in 2023

The implications of this shift and of the ICA’s cautious approach has impacted the market landscape in 2023, and were notably reflected in several key transactions underscoring the regulatory hurdles encountered in 2023.

These impacted transactions include the tender for the privatisation of the Israel Post, which attracted significant interest from major entities, including three of the largest banks in Israel. However, the Committee for the Promotion of Concentration recommended against the banks’ participation in the bidding process. A decision that underscores concerns about exacerbating concentration within the banking sector.

In the infrastructure sector, the involvement of large corporations such as Electra Group and Shapir Group in the light-rail tender was closely examined for potential competitive issues. While the antitrust committee did not bar their participation outright, it highlighted potential competitive issues, reflecting the broader concerns about maintaining a level playing field even in times of market consolidation.

Another notable example was the attempted acquisition of Isracard, Israel’s largest credit card company, by Harel Finance, a major institutional investor. Valued at approximately ILS3.3 billion, this deal represented one of the largest domestic transactions of the year. However, the ICA’s rejection of the acquisition in January 2024, citing concerns over competition and information sharing, showcases the regulator’s vigilance in preserving a competitive landscape within the financial services sector. For similar concerns regarding transfer of information, the ICA opposed to a proposed acquisition of StoreNext by Fortissimo, resulting in its withdrawal.

These examples demonstrate the strategic challenges companies faced in navigating the regulatory landscape of 2023. To address these challenges, companies would have to increasingly seek creative solutions which would align with regulatory expectations, while continuing to pursue growth objectives. This would include structuring deals to mitigate antitrust concerns, as Israeli market players and regulators continue to grapple with the implications of the increased concentration of the Israeli market’s unique landscape.

Tax Implications

Overview

As Israel grapples with a high financial deficit, the tax landscape for M&A transactions has become increasingly complex and stringent. The Israel Tax Authority has intensified its efforts to maximise revenue, adopting a more aggressive posture in scrutinising and taxing M&A activities. This shift is motivated by the urgent need to bolster public finances without stifling economic growth, a balancing act that presents numerous challenges for companies, employees and investors alike.

In an unprecedented move, the Israel Tax Authority has instructed assessment officers to closely monitor the business press and conduct real-time audits of significant M&A transactions. This proactive approach aims to uncover any potential tax liabilities early, ensuring that all parties involved in these transactions are fully compliant with tax obligations. The scrutiny extends beyond the transaction’s immediate financial aspects to include control mechanisms, shareholder rights, and other elements that could affect tax liabilities.

Intensified review of M&A transactions

A notable shift in the ITA’s approach is the increased focus on company founders, who are now frequently called to hearings for a comprehensive review and reassessment of the transactions reported. Unlike in previous years, where the reporting of company sales was generally accepted at face value unless flagrant aggressive tax planning was evident, the current year has seen a paradigm shift. The ITA no longer takes these reports at face value but instead undertakes a meticulous examination of every detail, actively seeking discrepancies or undervalued aspects that could justify a reassessment of tax liabilities.

This change reflects a broader strategy to close loopholes and enforce a more rigorous examination of reported transactions, moving beyond mere compliance to active verification and enforcement.

Tax treatment of option-holders

The tax treatment of company founders and employees following M&A transactions has seen significant changes, with the Tax Authority shifting its stance on entitlement to benefits such as tax deferrals for share components received in acquisitions, including the benefit pursuant to Section 102 of the Income Tax Ordinance.

This benefit, which was considered as standard practice and was consistently granted by the ITA under various tax rulings issued in connection with previous M&A transactions, entitled option holders, subject to meeting certain conditions, to enjoy a favourable tax rate of 25% in connection with a share sale, without them having to comply with certain requirements, such as a two-year blocking period or a predetermined vesting schedule, which would have otherwise applied.

During the course of 2023, employees who were granted options to buy company shares have had to face the tightening of ITA policy, as the ITA denied their entitlement to tax benefits pursuant to Section 102 and imposed upon them an increased tax rate of up to 50%, to apply retroactively. The denials of this entitlement, it appears, have been based on the creative reasoning of ITA assessment officers, rather than derived from the letter of the law or past rulings.

This approach may lead to a re-evaluation of compensation structures and the tax planning strategies of acquiring companies, especially in transactions involving stock as part of the compensation package. For employees, the tightening of policies around stock options and their taxation has raised concerns, potentially affecting talent retention and the attractiveness of equity compensation in start-ups.

Taxation of intellectual property transactions

Multinational corporations, predominantly American, attempting to acquire Israeli firms in 2023 have had to confront intricate tax dilemmas. These acquirers often aim to transfer the intellectual property (IP) of the acquired Israeli entities abroad, despite Israel’s tax incentives for maintaining IP within the country, which include a lower rate of corporate tax available pursuant to the Law of Encouragement of Capital Investments.

Following the shift of approach by the taxation authorities in Israel, in scenarios where an Israeli company and its American acquirer have entered into intercompany agreements, such as licensing agreements granting the American parent the rights to utilise the IP, Israeli tax authorities have often refused to accept these agreements at face value. Instead, they have interpreted a licensing agreement as a sale of IP, leading to taxation of the Israeli entity as if it had directly transferred the IP (or in its broader sense – FAR – functions, assets and risks). Furthermore, in instances where the IP is actually sold, tax officials may challenge and seek to increase the transaction’s valued amount, sometimes significantly above the acquisition price paid by the American entity. A large number of disputes over these matters are now escalating to legal challenges before Israeli courts.

Re-evaluation of “substantial shareholder” criteria

An exemplary instance of the ITA’s increased diligence is the re-evaluation of what constitutes a “substantial shareholder” who may be liable for a higher capital gains tax rate of 30% (as opposed to capital gains tax rate of 25% otherwise imposed on sellers). Traditionally, the assessment of whether an individual held at least 10% of the company’s share capital – qualifying them as a substantial shareholder – was based on a fully diluted basis. This method took into account the potential conversion of options and warrants into shares, often diluting an individual’s relative shareholding below the 10% threshold.

However, in a strategic shift, 2023 has witnessed numerous cases in which the ITA has moved to calculate this based on issued and outstanding share capital. This adjustment means that options and warrants no longer dilute the calculation, leading to more shareholders being classified as substantial shareholders. Consequently, these individuals face an increased tax rate, significantly affecting their tax liabilities and potentially altering the financial dynamics of selling or restructuring their holdings in a company.

Adapting to a dynamic tax environment

The evolving tax landscape in Israel, characterised by increased scrutiny and aggressive tax collection efforts, has significant implications for the M&A market. Companies, employees, investors, and their advisors must remain vigilant and adaptable, navigating these challenges with strategic foresight and comprehensive tax planning.

In response to these tax challenges, companies and investors are increasingly reliant on sophisticated tax planning and legal advice to navigate the complexities of the contemporary Israeli tax environment. These strategies are not only essential for minimising tax liabilities but also for ensuring that transactions proceed smoothly and without unnecessary delay.

As Israel continues to refine its tax policies in response to economic pressures, the ability of the M&A market to adapt will be crucial for sustaining growth and fostering innovation in an increasingly complex and globalised economic environment.

Conclusion

As Israel moves forward from the seismic events of 2023, the resilience and adaptability of its M&A market emerge as pivotal forces. Amidst a landscape fraught with political and social upheaval, the M&A sector stands at a critical juncture, embodying a market in the throes of transformation. The challenges of the past year, while testing the market’s fortitude, have concurrently illuminated pathways to recovery and growth, underscoring the indomitable spirit of the Israeli M&A landscape.

The narrative of 2023, with its blend of adversity and opportunity, has not only tested the resolve of this market but has also fostered a milieu ripe for innovation and strategic recalibration. In facing unparalleled challenges, stakeholders have been compelled to rethink approaches, adapt strategies, and forge new paradigms.

Looking ahead, the resilience, creativity, and adaptability demonstrated by the Israeli M&A market are poised to catalyse its evolution, transforming challenges into springboards for growth and innovation. As Israel navigates the aftermath of the terror attacks and contends with ongoing political and social challenges, the M&A market’s resilience and adaptability will be crucial. The trends of 2023 reflect a market in transition, grappling with internal and external pressures but also showcasing the potential for the recovery and growth of the country’s M&A landscape in the face of unprecedented adversity.

Looking to the years ahead, the resilience and innovative nature of the Israeli M&A market promise a thriving landscape of opportunities in the wake of 2023’s challenges.