By Rick Murphy
CEO and Managing Partner
Recession-resistant IT Services M&A Rolls On
Thanks to the IT Services market’s “essential” status, inflation, the war in Ukraine and the current labor shortage are not adversely affecting the sector’s M&A activity too badly so far. The good news for IT Services companies and their potential buyers is that this sector appears to be recession-resistant, as in the past.
However, lingering supply chain challenges are having an impact, especially for IT Services companies that are project-focused with hardware resale as a component. Chip shortages mean that these IT Services companies likely have contracted engagements that can’t be easily fulfilled right now. The inability to deliver the hardware components will likely have a cascading effect on the delivery of related labor-based services as well -- especially in hybrid computing environments. In many cases, it’s supply chain woes, not customer preferences, that are also driving more cloud sales.
M&A Activity Still High
The IT Services M&A market continues to be as busy as it was in 2020 and 2021, and 2021 was our most active year yet. We are seeing a robust pipeline of potential transactions as larger companies seek out smaller businesses to acquire.
Sellers who are running a lean, tight business are able to demand strong purchase prices. However, those who are “running fat” will need to trim their operations to become more valuable and secure interest from potential acquirers. Also, we think the demand for “fixer upper” IT Service companies will decline and prices for these underperforming companies will decrease, as the focus on more mature and strong performers intensifies (think “safer bet” for the buyers).
Cash-rich Acquirers Want Recurring Revenue
Pent up demand from the investment community, including larger operators, PE platform companies and the private equity (PE) firms looking for platforms, continues to fuel the sellers’ market in IT Services, and we expect that trend to continue. While not every acquirer has the ready-cash, the ones that do want to invest it as soon as practical, to put their money to work. Today’s cash-rich buyers are looking for IT Services companies with the most recurring revenue and profit potential.
Companies that were planning to leverage a significant amount of debt to fund transactions may begin to reconsider that approach given the rising cost of debt service. We don’t expect this escalating expense to significantly shrink M&A activity in IT Services, but it will cool off the buyers who typically use a large amount of debt for a given transaction. Well-funded companies and PE firms that have a lot of “dry-powder” in cash on hand will be the ones to step in to fill the gap, and keep the transaction level fairly high.
Due Diligence Will Be Deeper
When it comes to due diligence, potential acquirers are conducting more detailed and sophisticated analyses of IT Services companies these days, to make sure macro-economics are not adversely affecting the candidate companies, their customers and their vendors. Anticipate more stringent quality of earnings analysis, market research, customer analysis (maybe interviews) and even background checks to be part of potential buyers’ more thorough due diligence approach. They will require assurances that the company they are considering can deliver on its “advertised” capabilities, recurring revenue and profit. As a result, potential buyers are leaving fewer stones unturned in their pursuit of transparency.
Tips for Sellers
If you are the owner or top executive of an IT Services business, there are two important steps you can take that will better position the company now and an improved purchase price later:
- Keep your books and records very current. Your P&L Statements, Balance Sheet, AR aging, AP aging, bank reconciliation, sales tax and ticketing system, should all be as up to date as practical. Also customer contracts, especially those that contribute to recurring revenue, should all be up to date and filed properly so you can easily produce them when needed for DD. Pay special attention to the documentation supporting free cash, net profit and gross margins. Buyers want to see that the company can consistently make money. Ask yourself how quickly you’d be able to respond to due diligence requests. If the answer is “several weeks,” realize that delay is a dead giveaway to your potential buyer that your books are not current.
- Focus on growing your sales, Gross margins and net profit before “investing” in the business. For example, don’t hire new or replacement people before you have secured the sales to warrant the added expenses. The need for infrastructure support is a strong reason to consider M&A in the first place. After all, the best people are employed already. Acquiring talent is a major driver in every acquisition we do.
These are just a few of the tips that will help you put your best foot forward when potential buyers “come calling.” Having your books up to date shows fiscal discipline, while running a lean operation indicates that you are confidently growing your business, while not funding HR positions prematurely, which are a few of the keys that buyers in the IT Services market want to see.