London – September 24th, 2021: The move to the cloud has been accelerating driven by companies seeking long term benefits, massive investment from the hyperscalers, the move to digital transformation and competitive vendor pricing. The arrival of Covid led to increased demand for secure and reliable systems for home and remote workers and greater need to for digital transformation. During this time M&A activity in the sector increased significantly.
To gain an understanding of both the current state of the market and the character of emerging trends WTA Partners was delighted to welcome a panel of leading industry figures to a virtual seminar on Thursday 23rd September and an audience of mainly senior MSP executives and private equity house representatives with an investment interest in the sector.
Why has there been so much M&A activity in the sector
After a brief welcome by Jeffrey Jenner, the first of the guest speakers Nigel Redwood, former Nasstar CEO and now Cloud Service advisor, identified four main drivers for this growth in activity: economic; hyperscaler activity; buyer ambition and seller needs.
Nigel described a ‘perfect storm’ generating high levels of M&A activity comprising strong growth in global business with Western economies doing well, low interest rates both encouraging borrowing and discouraging saving and a wealth of Private Equity (“PE”) capital availability. The last was particularly important with more of this capital finding its way to the technology sector as PE was generally avoiding the Covid impaired areas such as commercial property, retail, hospitality and travel.
Next, he looked to the impact of the Hyperscalers and their multi-billions of investment providing end users with new opportunities for innovative cost effective solutions and low capex needs, creating enormous opportunities for MSPs to meet the growing and more complex demands.
This same opportunity and growth lead to sector skills shortage, for many a reduction in margin and EBITDA meaning the better funded companies saw part of the solution in acquisition and synergy savings. At the same time owners saw it as good reason to exit and not deal with these new challenges just as the outlook for CGT and Entrepreneurs Relief seemed less benign.
Nigel concluded by showing just how many trade buyers and PE houses were competing in the sector along with the accompanying level of M&A transaction activity.
The buy-and-build strategy: an insider’s perspective
Following Nigel, to the virtual podium was Kerv Group CEO, Alastair Mills, probably the sector’s most experienced M&A entrepreneur having acquired 35 businesses.
Alastair raised the importance of the leverage buyout model (“LBO”) and the necessity of understanding how the LBO model works to perform effective M&A. He identified the key considerations for achieving equity accretion including organic growth, cash generation, multiple arbitrage, use of debt and cost synergies.
He stated very clearly that the traditional model of M&A activity, based upon multiple arbitrage, aggressive cost synergy and driven by opportunism is broken. Instead he suggested seeking longer term goals met by a more though out and strategic process.
Alastair emphasised too the importance of engaging high quality, emphatic and effective M&A and legal advisors. Crucially he identified the importance of “shared and common values” with these professionals and shared experiences of damage inflicted by overly aggressive legal representation which alienates and incenses an acquiree by misreading the need for gentle and measured engagement rather than acting aggressively.
The challenges for a small MSP and why we sold
Matt Newton, MD of Oosha, shared his experience from the founding, development and growth of the company. He contrasted the difference between early days of growth moving towards their current position as the business shifted towards virtual desktop products, managed services and service desk offerings directed at professional services practices and particularly solicitors and accountants. Oosha’s journey included correcting early mistakes, becoming one of the first in their geographical location to focus on sectors, dealing with the aftershock from 2008 financial crisis, avoiding a race to the bottom by not competing on price but offering quality of service, and more latterly, the challenge of scaling operations to meet demand.
Matt also explored the mindset of the seller, with reference to the key question: ‘why sell’? To this he pointed specifically to his experiences; the five founders having different interests and ambitions including some wishing to retire. After explored partnering with PE, the answer was to sell the business to a party who would allow those needing to exit to go but provide others, like himself with ambition, opportunity to grow. Matt was another speaker who highlighted the importance of engaging the best advisor and specifically, in this case, one who would be sensitive to the differing goals of each member of the ownership team and being able to manage the situation.
Why private equity is so keen on the sector
Nicki Boyd, founding partner at Apiary Capital, kindly stepped in at the last moment when one of her partners had to pull out at the last moment when his wife went in labour. Not being prepared for this, she did extraordinarily well in dealing with the topic and describing what the journey would be like for an investee MSP.
Nicki began by assessing the market including its rapid growth and high level of M&A activity. She noted over the last fifteen years the convergence in the sector bringing multiple service line offerings into a single business, the move to outsourcing and the lack of appetite for end users – customers – to expand capacity in-house as complexity increased. She then spoke of “The Cloud migration journey”, moving to an agile process of tailored support for organisations and how MSP customers tended to be “sticky” so more likely to ‘stick to the provider’. The Covid impact has created a greater attraction from PE to the space and its resilience. She reinforced earlier comments made that PE houses had to find ways to deploy capital when a number of sectors turned unattractive.
In terms of what a PE house were seeking was good quality of the management team particularly if it was a platform investment in which case PE might look to support and partner with the management team by adding non-executive directors fulfilling a non-exec role and developing a constructive dialogue to support this. Also sought were businesses able to grow along with good quality information to assess the financial and structural elements of the company.
Nicki concluded by stressing that PE’s interest and capabilities in the sector might be powerful, but so too is the need to be selective and informed in targets for investment. From the perspective of the MSP this translates to robust financial prospects and a clear sense of direction.
What makes an MSP attractive to an acquirer
Jeffrey began the next session by providing a definition of an MSP and put forward that it must have Annual Recurring Revenue (“ARR”) greater than 50% and went on to say that the higher the ARR percentage the more attractive, i.e. valuable, the MSP is. Indeed ARR was a key driver drivers of value.
Continuing, he explained that ‘well-run’ MSPs are achieving EBITDA margins of 15% so a prospective sellers should be aiming for that level of performance. The highest achieving close to 25% with those not reaching 10% probably requiring action but some buyers will see that as an opportunity and an encouragement to acquirer but will, of course, base valuation on the lower metric. But as important level achieved is consistency as that demonstrates sustainability. Next comes the rate of revenue growth and like EBITDA should be consistent over time. And the revenue should come from a good spread of customers as high customer concentration is unattractive. He then added that high customer churn was particularly unattractive as it was an indicator poor service delivery or out of date services. It is best that customers have at least fifty seats for at that level there is more complexity and complexity is opportunity for an acquirer to sell additional services. Also important is the size of the business because valuation metrics rise with size.
Moving away from quantitative measures Jeffrey identified having a strong management team in place increases the attractiveness to an acquirer as it indicates the business is more likely to be sustainable and have good procedures. It is also attractive to a buyer as they may see opportunities for synergy savings. Having both a strong management team together with a good record of growth make it appealing for direct investment by Private Equity too which opens up additional possibilities for the shareholders.
Before concluding Jeffrey listed half a dozen further attributes but these were not as important as those previously described.
Panel Q&A – Questions from the audience
Concluding the day’s events was a lively Q&A; indeed time ran out before all the questions could be answered. Of particular interest were:
- what typical PE multiples are currently for MPs with Jeffrey responding that if the MSP can deliver 50% of recurring revenue and for instance has revenue of £3-5m, valuation was likely to be 6x but the higher the revenue, the higher the EBITDA multiple. So at £5-10 million revenue, 6-8x EBITDA can be expected and between £10-20 million revenue maybe a multiple of 10-12 and even higher if performance is exceptional. He emphasised that this was an appropriation and valuation would be based on the financial performance of the business and other attributes. Alasdair added that he believes the importance of ARR has declined in recent years because of the high amount of funds chasing the sector and the importance of digital transformation which is often stalked about but rarely achieved. He sees consultancy and professional services skills of rising importance.
- Matt was asked about the challenge of keeping multiple stakeholders on side. He emphasised the importance of appointing experienced, plain-speaking and trustworthy advisors and not scrimping on this. He described that role as almost as ‘a referee’ who can stand in the middle and deliver rational and clear perspectives that go beyond potential internal conflicts of interests. For this, it came down to a personal and emotional relationship. Nigel added that attempting to cut costs with advisors was a false economy and could reduce financial gains and profit.
- Alastair was asked about origination, specifically about entering a new geographical market where the business is not known and without a local reputation. He replied the known or unknown element was of less importance and that a tip-off on the buy-side could come from a diverse range of sources. Seeking a smaller advisory firm to assist would help to identify acquisition targets.
- Alastair was also asked how he decided the level of debt and the level of equity in his buy and build. He reiterated the low cost of borrowing, from both banks and credit funds who can provide upward of £10m of investment. This was a time to maximise debt, otherwise the leverage buyout model doesn’t function properly. Once again with specialist advice from a debt advisor would help to decide the most effective usage of debt facilities.
- Next there was a discussion around the destructive effect of ‘aggressive integration’. Was there a marked contrast between buy & build PEs/trade buyers in their attitude to integration and cost savings? Matt opened with reference to his recent experience with Oosha and how important it was to reassure existing and long-term customers. Also it was crucial to maintain the highest standards of customer care to ensure organic growth and this should affect the choice of prospective buyer. Alastair added that in a situation where they are competing with a firm who can deliver synergies, a higher price would be expected. With multiples increasing across the sector, it is important to ensure that the acquirer has a commitment to their people and their life’s work. It should not be necessary to seek the highest possible price at all costs.
Close
Jeffrey closed the session and thanked the attendees and told them he would be emailing with details where they (and others) would be able to download the individual sessions as the event was recorded.
Additional information
The event was recorded and there are individual videos of each session available to view here
A more detailed view of what makes an MSP attractive based on Jeffrey’s presentation can be viewed or downloaded here
Should you wish to discuss any aspect of the session or indeed any matter do feel free to drop me, Jeffrey Jenner an email at jjenner@wtallp.com or call 020 37869001.