By way of introduction, FOCUS Investment Banking's MSP Team has been the catalyst for and advised on managed service provider (MSP) transactions with 47 parties over the past 2 ½ years, including four in May 2022, that each sold at healthy valuations.
Contrast to Public Stock Market
In contrast to the public stock market, where the tech-heavy NASDAQ is down about 30% since its November 2021 peak and the S&P 500 is down 20%, we are seeing little to no decrease in valuations, and an increase in the number of MSPs and private equity groups seeking $10.0 -$35.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization) that want to have conversations with us about selling and/or buying MSPs.
As an example, last night I received an email from the head of one of the largest private equity groups in the world saying, “We can write a check of up to $1 billion, but in this space that is hard to do…but because our fund is open ended and flexible, we can start smaller (e.g., $25.0 million of EBITDA) and build from there.” As another reference point, we currently have multiple sell-side assignments "in-the-market" with in excess of 30 signed nondisclosure agreements (NDAs).
Is this a function of our momentum and our skill sets as investment bankers, or is it a function of MSP owners running for the exits at the top and getting out before the market turns? Or is there something else going on here?
“Despite several tumultuous months in the broader market, MSPs continue to buck the trend, and are providing value through M&A for both sides of the transaction,” said Stan Gowisnock, Managing Director and Technology Services Team Leader at FOCUS. “Capital is abundant as the sector continues to show impressive returns and remains an attractive target for investment as a whole. As corporations are looking to improve internal efficiencies to bolster valuations and profitability, outsourcing of IT and other teams remains paramount. Committed missions of corporations, with capital directed to improve customer experience, is a long-standing formula that continues to work even in uncertain times.”
MSP Valuation Drivers: Scarcity of Assets, Organic Growth & Interest Burden on Cash-Flows
Undoubtedly, there is some angst in the industry, as the Federal Reserve raises interest rates, which is intended to slow the economy and could impact corporate earnings. Yet at the same time, there is an increasing number of highly sophisticated private equity groups that are eager to buy MSP platforms (see New Platforms Explained. We are aware of more potential buyers with capital than ever before looking to buy MSPs. Private equity has a lot of committed capital, and it wants to deploy it into MSPs. In fact, the biggest problem is that there is a huge scarcity of attractive assets to buy (see 'Data Signals' Provide Best MSP M&A Targets for Private Equity for top ideas).
MSP Valuation Comparison to Rolex Daytona Watch?
So the question is: Is the private market for MSPs headed in the direction of the public stock market, or does it operate under its own steam that will create even more frothy valuations like that of the stainless steel Rolex Daytona watch – which is particularly valuable due to its scarcity (each Rolex store receives only one per year).
For answers, we spoke to several of our business partners well situated to measure the pulse of the market. Patrick Fear is Managing Director at Alliance Bernstein Private Credit Investors, which has provided the financing behind some of the largest MSP recapitalizations, including Thrive, Coretelligent and Ntiva. We also spoke to Reed Van Gorden, Head of Origination and Managing Director at Deerpath Capital Management, a leading lender to lower middle market MSP platforms (many of which FOCUS advised on).
Both of them told me they’ve seen only minor changes in the private market for MSPs so far, and that they believe MSPs have different characteristics that will help them avoid the same fate as publicly-traded technology companies.
“We continue to believe that IT MSPs are defensive as they are a necessary service that will not have an adverse recessionary impact,” Van Gorden told me. “Many nonessential companies will be challenged by more rapid declines in earnings and some will go out of business, but these are mission-critical businesses.”
“Consumer Facing” May Face Less Pressure Than Business Services
“Companies that have and are impacted by inflation or supply chain constraints may have issues. But in terms of companies that are in the services business, they may do well,” said Brian Garfield, a managing director at Lincoln Financial. “What I think is occurring is that businesses that are consumer facing are going to see the pressures probably hit, more so than ones that are not as consumer facing, like business services and software.”
Lincoln’s Private Market Index, which tracks changes in the enterprise value of U.S. privately held companies, primarily those owned by PE firms, rose 1.7% in the first quarter, “signaling that private markets continue to provide investors more stability during times of volatility,” the company said in a press release. “This stability was primarily a function of steady earnings growth rather than multiple performance.”
What The Experts Have to Say
Van Gorden acknowledges there is a disconnect between what's going on in the public markets to tech companies and the private MSP market, but says there are some solid reasons for this.
“The companies that have really gotten beaten up in the public market for the most part are companies that are not making any money, they don't have sufficient cash flow. We have gone from a world where we gave a lot of value to companies that could grow fast using capital, but now we've gone to a world where we value companies that can grow without using any capital.”
“MSPs specifically have pretty good margins, they're pretty profitable and have pretty good cash flow,” he said. “So that protects them. I think some people are waiting for private valuations to decline to correspond to where the public markets are, but we just haven't seen it.”
Fear was also confident that MSPs would avoid anything similar to the crash in the shares of publicly-traded tech companies, although there may be some adjustments in the private market.
“The secular tailwinds and strong fundamentals for MSPs indicate this is a place where deals should be able to get done and that bid-ask spreads should be reasonable,” Fear said. “So we would expect deals to continue, maybe not at the pace of 2021, but at a reasonable pace.”
Joe Rondinelli, Principal at Frontenac, which is the majority owner of one of the most successful MSPs in the U.S., had this to say: “The thing to watch more is how interest rate hikes and inflation impact underlying demand from an MSP’s client base, versus the corporate finance of having greater interest expense in a buyout. The former will impact valuation more than the latter.”
“You may have some companies struggle a little bit more and face potentially lower demand and higher borrowing costs,” Fear said. As a result, some investors may choose to “top grade,” that is, doing only A and B deals, meaning those involving the Best and the Better companies, those with the strongest fundamentals.
“Nobody admits that they rank order A, B, and C deals—meaning Good, Better and Best—but almost everyone we talk to on the equity and credit side say they are not doing the C, or Good, deals right now, they're focusing on the Better and the Best,” Fear said. “Those deals might not miss any beats, because there are strong fundamentals, healthy growth rates, and a lot of capital out there. For the Better and the Best companies there is plenty of debt and equity capital at not too different a spread than before.”
Both Fear and Van Gorden noted that interest rates on PE-backed MSP deals have risen since the beginning of the year, but still remain extremely low, especially compared to rates in the wider corporate lending market.
Rates on PE-backed MSP deals are typically floating-rate loans with reference rates tied to LIBOR (London Interbank Offered Rate) with a 1% "floor." Now that the 1% floor has been exceeded, increases in LIBOR have a one-to-one effect on borrowing costs.
“If people compare this to the more liquid, broadly syndicated loan markets, where loan spreads are wider, we may need to make some pricing adjustments to narrow that gap,” Fear said. “Are the risks to growth and the risk to execution a little higher than they were? The answer is probably yes, but it's not material to the overall equation yet. If it becomes more material, then overall leveragability is going to come down and that will filter through to valuations. But we are not seeing that just yet. What we also haven't really seen are people saying they have to reduce leverage because debt service is going up.”
In Other Words, Private Credit Lenders Will Continue to “Lean in” to the MSP Market
Both men also noted that their firms are far from backing away from the MSP market.
“We have plenty of capital available, more than enough to finish out this year,” Van Gorden said. “So we are in fine shape.”
“We are excited about being a player that hopefully can increase market share during times like this as other players pull back,” Fear said. “We will continue to have an appetite and be a steady ship on choppy waters.”
For more information, please contact FOCUS Managing Director and MSP Team Leader Abe Garver at [email protected] or 646-620-6317.