Here's What MSPs Should Know Before Accepting Private Equity, Selling Their BusinessHere's What MSPs Should Know Before Accepting Private Equity, Selling Their Business
Several industry experts preview their CP Expo session on private equity and M&A blueprints for MSP leaders.
March 14, 2022
We have all done some level of MSP dealmaking, so we know the details of what goes into them. But, what MSP leaders need to know about private equity, especially considering all the activity in the market lately, requires partners to drill down into the nitty-gritty.
In their session on this topic at the MSP Summit, April 11, co-located with the Channel Partners Conference & Expo, four executives will share what MSP leaders need to know about private equity (PE). They will begin with new platforms – the lifeblood of private equity – and will address what are called add-ons.
Know this: The competition for standalone MSP platforms has been fierce over the past two years. Why? Because there is a limited supply of companies in the $2.5 million-$6 million range seeking private equity groups. The good news is, it’s a seller’s market. This is forcing private-equity groups to get more creative than ever as money pours into the channel.
This session will also look at how to judge if a company is a cultural, strategic and financial fit; also, how M&A can fill employee and leadership gaps or help inactive shareholders exit while increasing capabilities/footprint and reducing customer concentration.
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We asked the session leaders – Juan Fernandez, co-founder/CEO, MSP Growth Coalition; Michelle Accardi, CEO, Logically; Cristian Anastasiu, managing partner, Excendio Advisors; and Colin Knox, CEO, Gradient MSP, to weigh in ahead of the show. See the insights from Knox and Anastasiu below.
Channel Partners: What are a few of the key things that MSP leaders need to know about private equity?
Gradient MSP’s Colin Knox
Colin Knox: It generally involves a change of control investment or full acquisition with employment retention. And it often involves a remaining equity position for executives.
Determine how to maximize your value, if being acquired by a PE firm, or an MSP that is PE-backed. This could be unique geographic coverage, specialization in a vertical or technology stack, or high profit. PE strategies are built on leveraged financing plans against the earnings of the total combined business. So profit is very important to them.
Cristian Anastasiu: Private equity groups, also called financial buyers, are in business to produce significant ROIs for their investors. As a result, the financial aspects of a business are very important to them, especially when compared to strategic buyers.
PEs are different from strategic buyers …
… in a few distinctive ways:
The financial aspects of a business are critical. Think high profitability, low customer concentration, mature systems and processes, market share, etc.
They expect business owners to roll over equity, resulting in the business owner becoming a minority investor post transaction.
They expect the owner to continue with the business until the next liquidity event. This typically happens after 5-7 years, but that period can be shorter or longer.
If the company is a platform, there is a high probability that the legacy, name and culture of the business will be preserved. This is unlike when a strategic buyer acquires a company.
The capital structure post-transaction often includes up to four times EBITDA in debt. Because of that, the owner “owns” debt in the new business in addition to equity.
The PE owns and manages multiple companies in various industries at different stages. Consequently, sometimes the decisions they make are not based on optimizing that specific company. Rather, their total portfolio.
PEs differ in their requirements for minimum EBITDA for platform acquisitions. Some will consider companies with EBITDA as low as $1 million-$2 million. Others have $4 million-$5 million as a minimum threshold, while others require $10 million or more in EBITDA.
PEs are buyout firms, as opposed to growth capital firms. There are more than 4,500 PEs in the U.S. currently. Also, there are PEs and family offices that have dedicated funds raised prior to pursuing acquisitions. There are also fundless or independent sponsors. These people raise the funds necessary for an acquisition specifically for that transaction. They also search funds, whose objective is to acquire and then actively run one single business.
CP: Why are new platforms considered “the lifeblood of private equity?”
CK: That’s because a profitable and scalable model with a proven ability to sell multiple services or products to an existing customer base shows significant upside in adding both new services/products through acquisition, or more customers through acquisition, allowing the investors to get an exponentially larger return by moving quickly. There are tens of thousands of potential tuck-in acquisitions that are available. But there are many fewer candidates that could be the platform as the foundation.
Colin Knox and Cristian Anastasiu are two of more than 100 top speakers at the Channel Partners Conference & Expo/MSP Summit. Register now to join 6,500 fellow attendees, April 11-14. You can also interact with more than 300 key suppliers and technology service distributors.
Excendio Advisors’ Cristian Anastasiu
CA: PEs are in business to produce significant ROIs for their investors. They initially raise money with the promise of returning 10%-20% or more annually. PEs are not maximizing the return if the funds are not invested. A new platform is the first investment a PE makes when they decide to expand. The PE’s goal is to grow that business, both organically and through add on acquisitions. Then, they sell it after a period as a larger business at a higher multiple.
PE knowledge is initially somewhat limited; even if they’ve studied that industry. Investing in a larger business first reduces the risk for several reasons. Larger businesses are expected to be more stable, scalable and less dependent on their founders. They are also expected to have mature policies, systems, and processes, etc. It will then be easier to add smaller acquisitions to the platform. These will then be able to integrate and to some extent “upgrade” and improve the add on acquisitions.
CP: Why has the competition for standalone MSP platforms been fierce over the past two years?
CK: It’s a race to market share — acquiring as many end-customers as possible through the acquisition of as many quality MSPs as possible. This is a land grab strategy — to land, expand, retain. While there are tens of thousands of potential tuck-in acquisitions, they are hard to find and even harder to qualify. So, when one is, it can often turn into a rapid bidding war and highly competitive process to acquire them.
CA: Typically, PE platforms are expected to have at least $3 million-$5 million in EBITDA, although that number depends on the PE and their investors. A majority of MSPs have an EBITDA of less than $1 million and only a few having EBITDA higher than $5 million.
As a result, the PE interest in the market is …
… high: High market fragmentation (which means consolidation opportunity) and the MSPs’ recurring revenue nature, i.e., predictability, are two key criteria for areas PEs like to invest in. The market is also relatively “young,” with the first exits of PE investments happening as we speak, as they approach their five-year hold period.
The key reasons for this space still being fragmented are a) it is still a young industry and b) most MSPs were founded by technical people, with limited sales and managerial background, which has impacted their ability or interest to grow organically. Most MSPs are focused on small businesses, and while the effort to win a new customer remains the same, the annual revenues a new MSP customer generates are relatively low when compared, for instance, with the VAR or systems integration business.
CP: It’s a seller’s market, forcing private-equity groups to get more creative as money continues to pour into the channel. What does this look like for the rest of 2022? Beyond? How can MSPs navigate this?
CK: We’ve already seen an increase in M&A activity throughout 2021, and a hot start in 2022. As the economies rebound even more from the pandemic, I believe this will accelerate for a period until the most attractive candidates have been acquired. Then, there will be a slow down in a couple years. While the cadence of M&A may subside, I believe the valuations will continue to hold strong due to a remaining imbalance of supply and demand.
As I mentioned before, focus on specialization and profitability. Make your business a more attractive and valuable opportunity for acquisitive MSP platform companies. Secondly, make your business more visible to those seeking to acquire MSPs. Attend industry events, participate in industry forums and social conversations, and engage more with your vendor partners. Also, introduce a PR strategy that includes sharing notable news about your business on the wire.
When you are ready for an exit, engage with a good M&A lawyer and investment banker. You may shudder at the cost, but it is worth it.
CA: The level of activity in the MSP space will continue to be high for years to come, given the expected high level in supply (the number of MSPs is in the thousands) and demand (both money and the number of PEs interested in MSPs is growing). However, it is not clear if we will continue to see the same high valuations for platforms and some add-ons. An important test will be the exit or recap of some of the early MSP consolidation plays, which we anticipate this year.
Will the original PEs be able to sell those businesses at the level they expect, as some are predicting? Hyper valuations proved to be unsustainable in the past. Recent valuations in the MSP space remind many of the “irrational exuberance” of this time period. Are multiple in the mid- and high-teens justifiable and defendable?
To build a cohesive business out of many smaller parts, there is a lot of work and structural changes needed. What is the impact and reaction from customers and employees as small, entrepreneur-led MSPs become part of a larger, regional or national enterprise? Generally, there are not a lot of synergies between MSPs, like cross-selling, which would support higher valuations: MSPs have similar offers and their SMB customers do not have large IT budgets nor needs. But many fundamental business factors point to a continued strong M&A market: stickiness and predictability, and the fact that more small businesses recognize the mission-critical nature of IT services.
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