“M&A” stands for “Mergers & Acquisitions,” but in many cases prospective Buyers and Sellers pass right over “Mergers” and move inexorably to “Acquisitions.” Service Leadership has often counseled that both, in the right circumstances, are equally valid approaches, and that merging, indeed, can prove more advantageous to the right group of like-minded Managed Services Provider (MSP) owners.
Without revealing who and other particulars, we’ll use as our example, a recent engagement in which we counseled a group of MSPs through the process of deciding if, and how, they might come together as a merger of equals.
Even at the financial performance of the average MSP, building a Managed Services company has been a productive endeavor for owners.
Based on the Service Leadership Index® – the Solution Provider industry’s leading financial and operational benchmark – and our continual exposure to the Solution Provider M&A market, we estimate the stock value of the average MSP to have appreciated since 2008, faster than any of the major public stock indices.
With that in mind, how could a “self-merger” of like-minded MSPs yield even higher value creation performance?
Let’s start with the economics of being a selling MSP in today’s market. A well-performing MSP might get, on average, 7.3 times adjusted Earnings Before Taxes, Interest, Depreciation, and Amortization (EBTIDA), perhaps as much as 8.0 to 8.5 times if it’s a particularly attractive MSP – i.e., with greater than average recurring Revenue and profitability.
Best-in-Class (BIC) MSP EBITDA currently runs 18.4% of Revenue1, so with, say, $5M in Revenue, an MSP owner would be looking at an exit value of $5M x 18.4% x 7.3, or a $6.75M valuation – and at 8x, $7.4M. Not a bad exit.
But we should ask ourselves, “What are all those private equity firms doing buying up MSPs at these valuations?” The answer is pretty simple:
The underlying reason is that the value of larger, more profitable MSPs rises sharply, as larger (better funded) Private Equity Group (PEG) Buyers are able enter the bidding at $5M in EBITDA, and again at $10M. The ability of these larger PEGs to pay, and to do so with greater levels of debt, increases with EBITDA, which allows them to pay higher prices.
These factors mean that the individual MSP owner, with less than $5M in EBITDA, is often selling to a PEG Buyer (or PEG-backed national/regional MSP) who will roll their MSP into a larger entity that is 50% to 100% more valuable, per dollar of EBITDA.
Not a bad deal ... for the Buyer.
What would happen if that same selling MSP (i.e., $5M and 18.4% EBITDA) resulted from four like-minded, similarly performing MSP owners, who instead merged into a single entity?
Not a bad argument for the self-merger approach.
There are at least two additional important advantages in considering the merger approach:
Clearly, for those MSP owners who are thinking about their value creation options, a “self-merger” of equals is a strategy that should be considered. The group we advised decided these were compelling outcomes, and that they wanted to proceed to the next steps.
We won’t cover the usual aspects of M&A synergies and risk mitigation here. They’re important, but there are specifics particular to the group self-merger that are equally important to discuss.
This last point is crucial since the merging owners have to do the heavy lifting of post-merger integration while continuing to grow organically and securing the synergy benefits of merging.
We have advised a number of prospective merger groups as they’ve gone through the process of deciding if and how to merge, often successfully, but with some ultimately– and wisely – abandoning the idea. What are the lessons learned from these cases?
The keys to success lie in identifying the hard issues up front and resolving them before moving on to planning for the actual merger. The five greatest challenges are these:
At this point, the issues of fit, valuation, consolidation and leadership/organization were resolved within our example group. They now moved to the detailed planning required to ultimately execute a successful merger. This included:
Not surprisingly, the process of working through all of these tasks often works best if moderated by a neutral party – if not, then one of the principals must facilitate the process which puts that individual in a potentially awkward position of trying to be an unbiased moderator while simultaneously advocating for his or her own interests.
The most lucrative exit for the shareholders of the merged company, after perhaps 2 to 5 years, is likely to be to a large PEG. What will the PEGs, or any other experienced Buyers, most likely want to see as a track record for the merged MSP?
The prospective deep-pocket Buyers, will want to see that the leadership has created a company that has continued to grow at a good pace, and has generated not only increased profitability from the initial synergies, but sequentially improving profitability from there.
They will certainly want to see material organic (i.e., non-M&A) growth. The Service Leadership Index shows that, from 2008 through 2018, the top-line Revenue CAGR of the average MSP has been 8.6%. The prospective Buyers will want to see consistent organic growth in existing markets and in any new markets opened without an acquisition (i.e., in “greenfield” markets), above that average rate.
Because the prospective Buyers are likely to want to accelerate that growth with even more acquisitions, they will also want to see that the merged MSP has been capable of successfully buying and integrating other, smaller MSPs along the way.
With these three characteristics exhibited:
The merged MSP will provide the most compelling case to prospective Buyers and thereby likely earn the highest price.
The project plan we suggested, advised on and facilitated for our intrepid group of MSP owners is shown in the chart below.
Note there were two decision points (red text) at which the owners were required – by good business judgment – to make a conscious decision to either continue forward or stand down.
In mergers (and acquisitions), one can only decide to take the next step; one cannot decide at the outset that one will go all the way to a closed deal.
To be more specific, the chart below shows the deliverables that Service Leadership provided during each of the above phases.
Our example group, did indeed choose to proceed at each of the two decision points, and have successfully merged. They are generating the targeted synergies. In addition, they have been surprised at the level of attention they have already received from PEGs. Despite some attractive offers, they have so far decided their future value will be materially higher, and are staying the course to tackle the phases described above, albeit, they are of course open to conversations.
In summary, for the right group of like-minded MSP owners, in the right conditions, a merger can prove to be a materially more lucrative approach than simply being acquired. However, the owners of prospective merging MSPs need to make sure that:
Service Leadership welcomes the opportunity to discuss the prospects of a group self-merger with interested owners and executives of MSPs worldwide. Please feel free to contact us at any time, to discuss with a Service Leadership Senior Client Advisor.
Service Leadership is dedicated to providing total profit solutions for IT Solution and Service Providers, directly and through industry consultants and global technology vendors. The company publishes the leading vendor-neutral, Solution Provider financial and operational benchmark: Service Leadership Index®. This includes private diagnostic benchmarks for individual Solution Providers and their business coaches and consultants. The company also publishes SLIQ™, the exclusive web application for partner owners and executives to drive financial improvements by confidentially assessing and driving their Operational Maturity Level™.
Service Leadership offers advanced peer groups for Solution Providers of all sizes and business models, and individual management consulting engagements for Solution Providers from US$15mm to US$3bb in size worldwide. In addition, Service Leadership provides global IT vendors with advanced partner enablement assets, partner ROI models, management consulting and advanced peer groups, as well as executive and industry best practices education and speaking. Please visit www.service-leadership.com for more information.
Notice: All materials published (electronically or print) by Service Leadership are proprietary and subject to trademark and copyright protections, regardless of where and how it is sourced. The terms and concepts of SLIQ™, Service Leadership Index®, (S-L Index™), Predominant Business Model™ (PBM™), Operational Maturity Level™ (OML™), Normalized Solution Provider Charts of Accounts™ (NSPCoA™), Total Cost of Managed Services™ (TCMS™) and Service Factory™ are proprietary to Service Leadership, Inc. All Rights Reserved.
1 Per the Service Leadership Index: www.service-leadership.com/solution-providers/service-leadership-index-reports
2 We should note that self-mergers of companies with different PBMs – such as a VAR and an MSP – though riskier, can be successful if best practices are followed. The first and foremost is that they both already pursue the same Target Customer Profile (TCP), that is, target customer size range. A merger of a mid-market VAR and a small-business-focused MSP, for example, has a low chance of success for a number of reasons. But if both have been focused on the mid-market, chances are materially better, though still less than merging VARs with VARs or MSPs with MSPs.
Service Leadership, Inc.
5800 Granite Parkway, Suite 460
Plano, TX 75024