How have inflation, wage inflation, and high interest rates impacted the managed services and managed security services M&A market? Demand is still high among private equity buyers looking for MSPs and MSSPs to acquire as platform companies (an initial investment that the PE firms will add onto with more acquisitions) or as add ons.
The trouble is, there aren’t enough managed service providers that are acquisition-ready right now. That’s meant a huge imbalance in demand vs. supply in the MSP mergers and acquisition market. That’s according to Abraham Garver, managed service provider managing director at FOCUS Investment Banking who spends all his time on M&A in the MSP and MSSP market.
Here are some of the factors that have been impacting the MSP/MSSP market right now:
High Wages are Impacting MSP EBITDA
MSPs have had to step up to increase employee wages without increasing revenues. They may be locked into contracts that have kept their pricing to customers the same and their revenues flat.
“Some of the MSPs that have fixed contracts in place – they are in trouble.”
(Most MSPs say they plan to increase prices in the next 6 months.)
This altered expense/revenue ratio has lowered the EBITDA that MSPs are accustomed to and thought they had. Garver said he ran into one MSP seller that previously had had $5 million in EBITDA. But wage inflation had outpaced revenue increases, resulting in EBITDA that was $1 million to $1.5 million lower than they thought it was. Because of that the PE buyer passed on the deal until the MSP could improve those financials.
Higher Interest Rates have Impacted the MSP M&A Market
Garver notes that this is the most interest rates have gone up in 27 years. When interest rates were near zero, everyone raised money. Now Garver estimates there is $132 billion in dry powder – investment money for MSP – but those investors can’t find the right investment. Is $132 billion a high number? Garver calls that dry powder number of $132 billion “sick high. Absurd high.” PE groups only get about 2% interest on that $132 billion while the money just sits there, Garver noted.
“These people are desperate to make an MSP platform investment,” he said.
When Will Interest Rates Stabilize?
The million-dollar (or probably higher) question is, of course, when will interest rates stop going up? Nobody knows the answer. The Fed is watching for things to break, like the Silicon Valley Bank crisis, before it changes its tactics. Garver speculates another breaking point may come when a whole bunch of multifamily properties come up for refinancing in the next 3 years.
What are PE Firms Looking For in MSPs?
Garver has said that bigger PE firms have gotten into the market looking for ever bigger MSP platforms to invest in. They aren’t looking for small MSPs anymore. The gold rush here was in part triggered by the Thrive MSP investment and recapitalization, which brought a return on investment of 6.6x the original investment, according to Garver. Here’s some background on that Thrive recapitalization.
Garver says that PE firms typically look for a return of 3x, and the good ones are 5x or 6x. The Thrive recapitalization was a big deal and brought a lot of attention to the MSP market from PE firms.
Two More Trends in the Current MSP M&A Market
To create these bigger MSPs to satisfy PE appetites for M&A, Garver recommends MSPs who are looking to sell consider a merger of equals first. This can drive up your valuation in and of itself, and you don’t have to add more customers to make the business more valuable.
Another trend in the MSP M&A space is that acquirers are paying cash for these deals and looking to add leverage to them later – i.e. add financing down the road when interest rates come down.
“That’s why valuations are still up,” Garver said.
More on MSP Valuations Coming at MSSP Alert Live
Abraham Garver will be one of our keynote speakers at the MSSP Alert Live event in Washington, DC, October 9-11, 2023. At the event he’ll be talking about the trends around MSP and MSSP valuations and providing insights and perspectives on how to increase your valuation and get your business ready for sale. You can register for the event here.