The mergers and acquisitions (M&A) year: Past and future
This blog is for educational purposes only. Obtain professional advice when you’re considering any M&A transaction.
As expected, M&A in 2018 in the MSP space was even more active than 2017. Our fearless prediction is that—barring some sort of macroeconomic change—2019 will be as busy,
But multiples will change.
Some years back, we predicted that the valuations for MSPs would, over time, bifurcate into two groups: lower valuations for MSPs who operate at lower Operational Maturity Level™ (OML) and higher ones for those at higher OML. That split in valuations (and deal structures) has been gradually occurring. In 2019, we believe it will accelerate. More on this in a moment.
First, a look back at what happened in 2018:
- By our count, five of the roughly ten larger Private Equity-backed consolidation plays procured their “platform” MSP in 2018. The remaining five or so have not. The reason for the approximate number here is that it’s hard to tell exactly how much funding some of the remaining ones have: Can they really take down a sizable platform ($30mm or so in revenue) or are they limited by funds to shop for smaller platforms?
- The remaining five will pay premiums in valuation and deal structure to secure one of the (now fewer) remaining largest and most profitable platforms. They need a large amount of funding, meaning they must ‘deploy’ as much as that cash as reasonably possible, as fast as possible. Larger doesn’t necessarily denote more profitable—it’s entirely possible to build a $30mm unprofitable MSP—but to be a platform, the MSP must also be running at high OML. This executes the scaling of revenue, quality, and margin and deliver on the new owner’s business plan. Hence, higher OML MSPs, especially larger ones, will command higher multiples in 2019.
- Meanwhile, the five Private Equity (PE) firms who have their platforms will move into the second phase of their strategies: buying ‘bolt-ons’ to integrate into their platforms. The common strategy is to buy lower OML (i.e. lower profitability) firms and materially lower multiples, and less rich deal structures. Their plan is that this delivers an immediate, double arbitrage in value. How?
- I paid 10x for my platform, and it operates at top quartile EBITDA, that is, 18%. Because it’s high OML when I bolt on a lower OML, lower profit MSP, those acquired customers will soon be ran at higher OML, and the profit will go from median (8% EBITDA) to best in class. The $5mm bolt on will go from delivering 8% (or $400k in EBITDA dollars) to 18% or $900k, which will be multiplied by 10x, as opposed to 5x that I paid for it. So, the value of that $5mm firm went from the $2.5mm I paid for it, to $9mm once it’s merged into my platform. Good work.
- As a result of these PEs going into their ‘bolt-on phase,’ multiples will not accelerate as fast for lower OML MSPs on the market. They may drop.
- This will likely result in some lower OML MSPs, who have decided to sell, becoming anxious and being willing to accept an even lower valuation before it drops further.
- Meanwhile, MSPs who are too small to be substantive platforms, but would like to become one themselves, will simultaneously drive towards higher OML and will start or continue to do smaller acquisitions, to bulk up more quickly and be attractive to one of the remaining five PEs (or newcomers) who don’t yet have a platform. They won’t have the money to pay a higher multiple, nor will their strategy allow them to. So, while they too will be acquisitive, they, like the PEs with platforms, will be shopping at lower multiples. Throughout 2018, we saw many smaller MSPs (between $4mm and $15mm) buying smaller MSPs. This will continue.
- Meanwhile, we are now starting to see “mergers of equals” among MSPs. This is two, three, five, or more roughly like-sized MSPs deciding to come together in a merger to form a platform-sized asset. We expect to see more of these in 2019.
A few moderating notes:
- In “normal” M&A years, perhaps 1% or 2% of MSPs sell their companies. In 2018, this may have reached 3% or even 4%. So, while this is a rough doubling of deals, the great majority of MSPs have no intention to sell in 2019, or even in the next 5 years. Certainly, the noise level around M&A is high, and that will continue. And perhaps 4%, 5%, or even 6% will sell in 2019. That’s a massive number of deals, and you’ll no doubt be hearing chatter about those, as well as about the conversations that took place that didn’t result in a deal. But more than 90% of MSPs won’t be involved in either buying or selling in 2019 and beyond.
- While the nice folks who operate Private Equity firms are generally very intelligent and successful, many will make mistakes in operating their MSPs. There are a series of common errors that PEs make when trying to integrate and grow MSPs to scale. There are some less common errors as well. Some PEs will succeed directly, some will have more trials and tribulations on the road to a successful exit. Some will not succeed at the MSP game, and they will sell at lower multiples, probably to the PEs who are successful. Being a solution provider is not an easy business, and being an MSP is one of the hardest business models. Many of the success factors are counter-intuitive.
Lastly, we will close this blog with the same suggestion we always give: Run your company at high OML, and thereby get best-in-class bottom line profit and growth. That way, you’re generating 18% after owner fair market compensation, and you have the richest set of options no matter what you decide to do. You have an 18% cash machine, the proceeds from which you can reinvest in the business or, to diversify your risk, invest elsewhere. And you have a valuable and attractive asset in case you do want to entertain being acquired.
We thank you for your readership in 2018, wish you well in your endeavors in 2019, and may you and yours be safe, warm, and happy.