In recent years, businesses have faced the challenge of navigating the economic difficulties caused by the pandemic. Despite these obstacles, the global economy has demonstrated remarkable resilience, with many companies not only surviving but thriving in the new digital landscape.
The key to success for many of these companies has been the adoption of modern cloud-based solutions, with 61 percent of businesses moving their workloads to the cloud in 2020 to take advantage of its flexibility, scalability, and cost-effectiveness. One notable SaaS application that has gained significant attention is Unified Communications as a Service (UCaaS), with customer interest surging by 86 percent at the onset of the pandemic. This has created a favorable environment for buyers and sellers, leading to a surge in technology mergers and acquisitions (M&As) in recent years.
Technology M&As were on a rampage in the first half of 2022, with 513 buyouts occurring in the first few months alone, up 78 percent from the same timeframe as last year. According to ChannelE2E, 110 of those deals were MSPs, and 153 M&A deals during that span involved private equity firms. Some of these deals consisted of PE (Private Equity) firms acquiring a “platform” MSP while preparing additional tuck-in purchases. In other cases, these firms worked behind the scenes to tuck more MSPs into existing platform investments. There was tremendous promise for the rest of the year, but did that trend continue?
Based on data released by Founders Advisors, MSP and IT services M&A finished the year strong with over 800 M&A transactions in the United States, with around 45 percent of those private equity-related and around 55 percent strategic acquisitions. Despite the high levels of M&A activity, the MSP market is still highly fragmented, meaning opportunities exist for acquirers to continue consolidating the market.
It was an excellent year for MSP M&A, and with the high volume of private equity-backed platform acquisitions in 2021 and 2022, 2023 is also expected to be an above average year for add-on acquisitions as platforms look to grow through acquisitions, meaning there are substantial exit opportunities for MSPs of all sizes. The data backs that up as well, and 73 percent of dealmakers in North America believe that M&A will increase in 2023 – over half see the need to pursue digital transformation as a key deal driver of M&A.
One of the primary M&A trends is recurring revenue, but that’s only the tip of the iceberg. While M&A has been scorching hot for the past few years and opportunities for MSPs of all sizes are widespread, could that soon change? Let’s tap into that below.
Trends Impacting MSP M&A
Everywhere you look, it feels like you’re met with rising costs, volatile markets, and uncertainty, but will that translate to a slow down of M&A? Well, it depends on the business. MSP M&A will continue throughout the year because many private equity firms feel that they need to be in the MSP space.
Let’s examine some of the headwinds and trends influencing MSP M&A this year and beyond.
Land Grab of MSPs Will Persist
According to John Holland, managing director of Corporate Finance Associates, the great “land grab” of MSPs will persist throughout 2023. Recurring revenue is king, and larger MSPs backed by PE firms are motivated to scale these recurring revenue businesses through acquisitions. He went on to say that the land grab of telecom agencies will also continue.
The common theme between MSPs and these other agencies is that they all have recurring revenues. Since it’s not on a project-by-project basis, MRR is extremely attractive. Since a typical MSP has a three-year contract with a client, it means that business is safe for at least three years, even if a recession hits. It’s quite challenging for end customers to divorce themselves from an MSP, meaning these companies are incredibly valuable. Most acquirers are searching for these specific companies, and this will persist no matter what the economy looks like moving forward.
Rising Interest Rates
It’s not only home and auto loans affected by soaring interest rates. The type of transaction used by companies in M&A deals when acquiring or selling a business is notably influenced by federal interest rates. Whenever there is a fluctuation in interest rates, it is common to observe a corresponding alteration in the balance between cash and stock offerings in M&A deals.
The increase in interest rates may result in a greater prevalence of M&A deals featuring both cash and stock offerings. Consequently, buyers and sellers should familiarize themselves with the advantages and disadvantages of employing either cash or stock in an M&A transaction to minimize tax obligations and ensure a successful merger or acquisition. As interest rates rise, decision-making in M&A deals is affected by the source of funds and the related carrying expenses.
Recurring Revenue and M&A Go Hand in Hand
Why does private equity love recurring revenue? Predictable and steady cash flow that recurring revenue provides makes this particular business model a safer bet for buyers. It’s also more appealing because the recurring revenue model is also easier to vet. In a business based on individualized customer agreements, each contract must be reviewed during due diligence, and recurring revenue businesses that sell a standardized offering means that customers all sign the same agreement. The buyer can review the subscription language only once and be ready to go.
Since MSPs typically have three-year contracts with clients, the business is safe for timeframe regardless of a recession. For that reason, it becomes incredibly challenging for customers to split from the MSP. Most acquirers are searching for this type of company, which will continue no matter the state of the economy. It’s a safe bet, and because of the economic headwinds moving forward, something that MSPs are seeking. Recurring revenue is critical because it provides stability, predictability, and long-term profitability. MSPs that can build a solid recurring revenue stream are better positioned to grow their business and improve their bottom line.
Small to Midsize Deals Will Dominate the M&A Landscape
The majority of M&A transactions, comprising thousands of deals with a value of less than $500 million, continue to dominate the M&A landscape. This trend is expected to persist as companies seek M&A as a means of achieving strategic goals, such as expanding their market presence, creating new growth opportunities, and filling capability gaps. Unlike mega-deals, small to midsize transactions are generally less risky, require less financing, which is beneficial in times of rising interest rates, and face less regulatory scrutiny, making them more manageable to complete.
Dealmakers in various industries may avoid pursuing deals that could face regulatory obstacles, as prolonged pre-close periods often result in numerous direct and indirect expenses. However, in specific sectors, such as banking in Europe and telcos in developing economies, struggling assets may lead regulators to be more lenient towards large consolidation deals.
Looking Ahead: The Future of MSP M&A is Bright
According to Datto, MSPs are experiencing a golden age. In Datto’s Global State of the MSP Report, 90 percent of MSPs believe it’s an excellent time for the industry. Despite substantial changes occurring in the MSP market, with change comes opportunity. During times of economic downturn or recession, more money is infused into technology to accelerate businesses and innovation thrives.
Covid had a substantial and positive impact on the MSP market, and new players are coming in from various industries because they see the revenue potential. Many industries lost revenue during Covid, and they’re looking to rebound. Private equity is very interested in recurring revenue. Since we’re seeing many new industries enter this space, M&As will continue to burn hot throughout 2023 for MSPs. Despite the economic downturn, a strong dollar and recurring revenue will always prevail.
After an incredibly successful year, the financial outlook for MSP M&A moving into next year looks even better. The demand for managed services remains strong. MSP M&A in the UC space, among others, will likely continue as businesses look to streamline their communication systems and MSPs look for opportunities to expand their service offerings and customer base.
Want to learn more about the strategies MSPs are using to combat these unfavorable economic conditions? Download our eBook, 8 Strategies of the Fastest-Growing MSPs, to learn more and how a UCaaS & CCaaS solution is right for your business.