MSP M&A Trends: Recurring Revenue Is The Hot Ticket

‘Typically an MSP will have three-year contracts with clients so that business is pretty safe for three years, even if there’s a recession. It’s very difficult for the end customer to divorce itself from an MSP, so that makes these companies very valuable,’ says John Holland, managing director of Corporate Finance Associates.

The merger-and-acquisition sector of the IT industry has been red-hot for the past two years, but that all may change.

With a potential recession and higher interest rates, experts are predicting a dip in M&A. But that depends on the business.

“The great ‘land grab’ of MSPs will likely continue in 2023,” John Holland, managing director of Corporate Finance Associates, told CRN. “So many private equity firms feel an imperative to be in that MSP space. Larger MSPs are backed by private equity firms that are highly motivated to scale these recurring revenue businesses through acquisition. Similarly, the ‘land grab’ of telecom agencies will continue.”

Laguna Hills, Calif.-based Corporate Finance Associates is an investment banking firm with decades of experience in executing mergers and acquisitions in the IT and telecom services industries.

And according to its latest report, “Mergers & Acquisitions in the Technology Services Industry in Q4 2022,” the numbers seem to show a shaky 2023 and, possibly, 2024.

The number of IT services M&A transactions increased from 435 in 2020 to 675 in 2021 to 656 in 2022, according to the report. The company with the most M&A deals in 2022 was Dublin, Ireland-based Accenture with 25, followed by The 20 MSP and Upstack with 12 each, and Converge Technology Solutions and Ernst & Young with 10 each. The aggregate value of IT service M&A transactions increased from $36 billion in 2020 to $72 billion in 2021 but dropped to $51 billion in 2022.

“The Federal Reserve started raising interest rates in March 2022 and continued raising interest rates throughout 2022 and early 2023,” he said. “Rising interest rates elevate the cost of capital of acquirers, whether those acquirers are private equity firms or large corporations. Therefore, rising interest rates tend to subdue M&A volume and diminish valuations of IT services businesses in the same way that higher mortgage interest rates cause home prices to decline.”

Last year, Holland said there was a “little bit of a slowdown” because the Federal Reserve started increasing interest rates and kept doing so throughout the year.

“We don’t know if there will be a recession in 2023,” he said. “And if there is, we don’t know how bad it will be. Normally what happens is you see the IT services companies stop growing in terms of revenue and the customers start pulling back, cutting their IT budgets.”

Here are five things to know about M&A in the MSP industry and what’s to come in 2023.

Interest Rates Are Rising

In an effort to avert a pandemic-driven recession, the U.S., Canadian and other governments around the world executed aggressive fiscal and monetary policies throughout 2020, 2021 and 2022. Those policies provided vast liquidity and unusually low interest rates that fueled M&A transactions during those years to a level vastly above the pre-pandemic level.

Last year, Holland said there was a “little bit of a slowdown” because the Federal Reserve started increasing interest rates and kept doing so throughout the year.

“In the housing market, what happens when interest rates go up is house prices go down and there’s less activity in the housing market,” Holland said. “It’s safe to assume that that’s probably going to happen in the IT services space with M&A in 2023. The possible exception is with these MSPs that got all that recurring revenue because they’re just so hot.”

Annual Recurring Revenue Is The Name Of The Game

“Typically an MSP will have three-year contracts with clients so that business is pretty safe for three years, even if there’s a recession,” Holland said. “It’s very difficult for the end customer to divorce itself from an MSP, so that makes these companies very valuable. A lot of acquirers out there are hunting for these kinds of companies. I think that will continue regardless of the state of the economy.”

The hardest-hit business will be VARs, he predicted.

“The types of businesses I think that are going to suffer in M&A and that are not going to attract as much interest, or that are going to go for lower values, are the value-added resellers that work on a project-by-project basis,” he said. “These businesses are not as attractive to acquirers because they’re riskier to a recession. If the economy slows down and if interest rates are up, then you’ll see less activity in M&A concerning VARs.”

Outside Industries Are Getting Into IT

Holland said accounting firms acquired a multitude of IT services companies in 2022 specializing in data analytics, cybersecurity, and ServiceNow, Salesforce and cloud offerings.

“There has been a confluence of industries rushing into the IT services space over the past few years,” Holland said.

Other outside companies, like construction engineering companies or those that build nuclear power plants will design physical security for a nuclear power plant. “And I think that they’ve decided that it’s important to go into cybersecurity because it’s related to that of physical security. We see a little bit of that going on.”

Everyone Is Getting Into Cybersecurity And IoT

Holland said he believes what’s happening is “technology is permeating into all sorts of industries and all sorts of aspects of society.”

“One example is the Internet of Things,” he said. “There are these consultancies that focus on factory automation, and now they’re really excited about the Internet of Things. When you’ve got the Internet of Things managing these factory processes, then you’ve got a security risk. So they have an imperative to get involved in cybersecurity. It’s just that there’s a confluence of things. IT is no longer in its own box; it touches everything. I think the M&A activity reflects that.”

Even With High Interest Rates And Lower Capital Costs, Strategic M&A Will Continue

“The Wall Street consensus is that the Federal Reserve will continue to raise interest rates for the next few months,” Holland said. “Therefore, we expect the volume and aggregate value of M&A transactions across all industries worldwide to decline in 2023. The higher cost of capital will likely reduce the prices that acquirers are willing to pay for businesses.”

But even with that in mind, there are still compelling reasons why private equity firms and larger companies will execute acquisitions as they look to facilitate geographic expansion or development of important practices like data analytics, cybersecurity and cloud solutions.

“Private equity firms and large managed services providers will likely continue the ‘arms race’ of acquiring and rolling up MSPs that have very attractive recurring revenues,” he said.