Our top prediction for MSP M&A: It’s a platform grab right now

The managed services provider (MSP) industry has been rapidly consolidating for the past several years as private equity (PE) firms buy up small IT firms and cobble them together into larger platforms. But that process is evolving quickly for two main reasons: there aren’t enough sellers of quality assets and PE firms have shortened how long they hold their investments. That means they need to hunt for bigger game—and with a rifle, not a shotgun—before they cash out and exit.

To demonstrate what we mean: I recently received a call from four partners at a private equity group who wanted me to help them deploy $300 million to $400 million of equity into an MSP platform and add-on acquisitions. Eighteen hours later, I received an email from another PE group seeking an MSP platform asset with around $20 million of earnings before interest, taxes, depreciation, and amortization (EBITDA).

That’s why our top prediction for the MSP market this year is this: It’s no longer simply a land grab, but a platform grab. But just because PE has a lot of money to throw around doesn’t mean they’re doing it blindly.

Size matters

What’s driving the market toward more mergers of equals? Size. PE firms want larger MSP platforms and they’re willing to pay a premium for them. That’s because the usual time period PE firms hold their investments has shortened. In other words, PE firms are looking to cash out faster than they used to, and to get the most bang for their buck in the shortest period of time requires creating an even bigger platform.

That being the case, FOCUS advises large MSP platforms and their PE sponsors to seek similar-sized platforms to merge with in order to accelerate their path to exit and at a higher valuation. In 2021, FOCUS’s MSP Team saw a 54% increase in our merger-of-equals advisory assignments; seven of the eight MSPs we advised on new platform transactions involved mergers with peers. They did so to increase their combined marketability and valuation. We currently track 69 PE-backed MSP platforms and believe there are at least 10 more platforms seeking partners.

The initial goal of most MSPs is to get to a level of EBITDA high enough to be acquired by a PE-backed platform. The platform’s goal is to become an attractive target for an even bigger PE-backed platform, which can attract a much higher valuation.

For example, a stand-alone MSP with EBITDA between $500,000 and $2.5 million would likely attract a valuation of 5x to 8x EBITDA. A PE-backed platform with $2.5 million to $5.0 million EBITDA could expect to attract a valuation of 9x to 11x EBITDA. However, a platform with $15 million-plus EBITDA might garner a valuation of 12x to 18x, quite a bit more than the smaller categories.

In the mergers and acquisitions (M&A) market, larger companies generally attract a higher valuation than smaller ones, other things being equal. However, this discrepancy has become wider recently in the MSP sector.

One of the reasons is that PE firms are more eager to cash out their holdings earlier than before, so they have less time to earn money on their investments. According to PitchBook data, U.S. buyout firms’ holding periods have fallen to 4.9 years so far in 2021 from 6.2 years in 2014.

We believe that nearly 80 PE-backed platforms are trying to grow EBITDA from the $2.5 million starting range to $15 million. Obviously, M&A is the quickest way to do that. But these platforms are not going to get to $15 million EBITDA by buying $500,000 to $1 million add-on targets.  They’re going to have to land bigger fish.

Lack of supply

However, the problem is that there are simply too many buyers and not enough sellers of quality assets; the current ratio of buyers to sellers has been increasing over time and is now about 8 to 1. Therefore, MSPs need to be bigger to stand out.

The competition for new platforms has been fierce over the past two years and there is a very limited supply of platform-sized MSPs (in the $2.5 million to $5 million EBITDA range) seeking to partner with private equity groups.

Looking ahead then, we believe MSP mergers-of-equals will dominate PE activity in 2022, as well as conversations in investment committee meetings and at M&A summits.

Abe Garver, FOCUS MSP team leader

Contact Abe at [email protected] / 646-620-6317, or visit FOCUS MSP Team’s website here.