Channel investors, Channel partners, Mergers and Acquisitions, Mergers and Acquisitions, MSP, Private equity

Friday’s Exit Strategy: Private Equity Chases MSPs On Short Runway

Private equity firms and boutique investors continue to scour the market for potential MSP (managed services provider) acquisitions and investments. But there are major challenges on both sides of the negotiating table.

PE firms and well-funded investors have dialed ChannelE2E multiple times in recent weeks, seeking MSPs with at least $20 million in annual recurring revenues, and EBITDA margins of at least 10 percent -- but more ideally, 20 percent.

The problem? For the most part, those MSPs simply don't exist on the sell-side of the table. My opinion certainly isn't unique. The pundits at HTG Peer Groups, Service Leadership and TruMethods shared similar sound bites during the IT Nation 2017 conference in November.

Private Equity: The Clock is Ticking

Now, for the next twist: Private Equity firms typically need to spend an allotted amount of money within a fixed window. For some PE firms the clock is ticking on that spending window. MSPs in the $5 million to $15 million annual recurring revenue (ARR) range sense this, and they're holding out for somewhat higher valuations, according to multiple sources close to three pending deals.

MSPs at the $10 million ARR level and higher see themselves as potential "platform" plays -- the type of MSP that a PE firm could acquire before rolling or tucking smaller MSPs into the platform business. But some PE firms think the true platform story starts with MSPs that are $20 million or higher in ARR.

It's a bit of a disconnect.

Sticking Around... For Now

Still, PE firms aren't souring on the sector. The highly fragmented market, they believe, is ripe for consolidation even as it grows. Plus, the MSP business model -- built around ARR -- is somewhat akin to cloud services and subscription software models that many investors crave.

While cloud and software companies can generate valuations of 10 times EBITDA or more, MSPs typically don't attract such lofty valuations because most lack their own intellectual property.

A typical small MSP ($5 million or less in ARR) can fetch 5 to 7 times annual EBITDA, and larger MSPs with healthy profit margins can fetch 8 times annual EBITDA, ChannelE2E believes. And now, sources are pointing to 9X or 10X EBITDA multiples for some of those larger players.

In some ways, it sounds like we're moving closer to a market bubble -- though market peaks are essentially impossible to predict.

Who Has the Leverage: Buyers or Sellers?

For now, big MSPs with healthy profit margins are in the driver's seat. But several factors could shift the pendulum of power back to PE firms. The big concern on Wall Street involves recent tax breaks coupled with increased deficit spending -- which can become a lethal combination for businesses, consumers and the overall economy.

Yes, annual recurring revenues are sticky. But they won't remain as sticky if the economy hiccups and SMBs start cutting jobs. In that scenario, MSPs could see their per-user contracts shrink.

Market demographics could further complicate the situation for MSPs. Thousands of MSPs are owned by Baby Boomers -- the generation of folks born between 1940 and 1963. Those Boomer entrepreneurs now range from age 55 to 78, and they'll need company exits in the next few years.

Right now, the clock is is ticking for PE buyers that need to put their money for work. A growing number of MSPs realize that fact. Those MSPs feel confident about their 'growing' valuations -- but they shouldn't get arrogant. Economies change. Business and personal dynamics change.

If you listen closely, the clock also is ticking for MSP owners whose net worth is tied up in their businesses.

Joe Panettieri (@JoePanettieri) is co-founder and executive VP of After Nines Inc. and its IT media platforms — ChannelE2E and MSSP Alert. His great grandfather arrived to the United States from Italy around 1917, charting the way for three generations of entrepreneurs.

Joe Panettieri

Joe Panettieri is co-founder & editorial director of MSSP Alert and ChannelE2E, the two leading news & analysis sites for managed service providers in the cybersecurity market.