Every Corporate Finance Adviser worth their salt releases a commentary on the IT services market at least once a year – for the very obvious reason that IT services continues to be a resilient market which is, as a generalisation, of significant interest to private equity investors, private equity-backed consolidators and overseas trade buyers.
So here is HMT’s 2021 offering, and hopefully, through the liberal use of acronyms and compound words with “tech” at the end – such as fintech, edtech, regtech and alarmingly now, femtech – or “a-a-S” as in SaaS, IaaS and even AaaS! – we will communicate our expertise to a receptive population of would-be vendors and inveigle ourselves into the technologists’ “club”.
Peppering our comments with references to AI, Cyber, Cloud, UC&C and even, for the bravest, SDE, hopefully gives us the licence to engage with business leaders in the sector to persuade them that HMT is the advisory firm in which they should place their trust when the time comes to transact.
The truth is, in IT services as in every other sector, the deals market can be temperamental and unpredictable. What is hot in technology is not always what is desirable for private-equity investors and acquirers and it is therefore important to maintain a focus on what is actually being bought and sold, and why.
The IT services market in its broadest sense has seen a large amount of deal activity during the last twelve months. This is not surprising given that the pandemic has had a neutral-to-positive impact on the sector overall. For one thing, IT businesses tend to be more natively virtual than most, making the transition to home-working a natural one. In addition the imperative for everyone else to transition to virtual working has created a spike in demand and has, as a side-effect, broken down what opposition had previously remained to the public cloud, video conferencing, the necessity for robust endpoint data security and digital payments. The performance of many IT services businesses has been strong, despite the generally challenging market conditions.
One of the factors driving deal activity in the sector is the much vaunted “wall of cash” sitting in private equity funds. Internationally this private equity “dry powder” is estimated to total around $1.5 trillion; which equates approximately to the GDP of Australia.
Not only do private equity funds have vast amounts of money to find a good home for, but almost every mid-market PE fund in the UK has already invested in an IT services platform. These investments were predicated on their capacity to buy and build, i.e., to buy more IT services businesses to increase the scale and capacity of their original investment (and deploy some more of that $1.5tn).
In addition to the IT services appetite of private equity and their existing platform investments, trade buyers internationally are under pressure to grow through acquisition and the relative value of sterling in recent years has seen an influx of overseas buyers for IT services businesses, which remain relatively good value, even at high multiples.
In short, the underlying market drivers have created intense competition for high quality IT services assets, which means that for the right business, current multiples are resilient, if not increasing.
Which brings us to the killer question; what is the “right” business?
And here is the danger zone for an adviser. Tell the truth or blag it? No-one wants to hear that they have spent the last few years focusing on things that buyers and investors do not like. It is a fickle market and yet investors and acquirers behave in a broadly consistent way. This tends to drive “bubbles” where businesses of a certain sort become intensely attractive to a whole range of buyers at the same time.
Think of PE funds and consolidators like starlings murmurating; if one heads off in a given direction, then broadly speaking, they all follow (sorry PE friends, but it is true). Businesses tend either to be desirable, or a drug on the market. Knowing which is which is the job of an experienced adviser!
As in all sectors, scale assets are the most sought after. For an IT services business the value of EBITDA is the first indicator of attractiveness, with annual recurring revenue a close second and growth potential definitely in the mix. Margin will be used as a proxy for the quality and differentiation of the service offering and sub 10% net margins are likely to signal something quite generic. The closer to an old school distributor a business is, the lower the value likely to be attributed to it, though if a business has real scale then a very low margin might be overlooked in light of the opportunity to add bulk, and perhaps to make synergy gains.
Whereas, even as recently as three years ago, pure consultancies were difficult to place, there has been a mindset shift amongst acquirers and investors. We have seen considerable acquisition appetite for specialist consultancies – particularly those offering digital transformation or with deep capabilities in a niche area – be they linked to a vertical, a specialist market like Government or a high value software vendor like SAP. With most specialist consultancies well aware of the importance of embedding their know-how into toolkits or even Apps to reduce individual dependencies, there is no reason to believe that this newfound acceptance of the consultancy model will pass.
With a scarcity of IT services assets on the market, Consolidators will consider acquisitions that add either breadth or depth to their offering. At HMT we have seen a particular appetite to acquire public cloud capabilities, especially AWS and Azure. They are often focused on one vendor, Microsoft or Cisco for example, and will specifically seek out specialist capabilities in areas adjacent to their existing suite. A recent example of this was the acquisition by Content & Cloud (An ECI backed consolidator) of Sipcom. Sipcom added both digital transformation capability and a specialism in Microsoft collaboration and unified communication tools.
This acquisition illustrates two further characteristics which acquirers might value – an established overseas footprint (Sipcom gave Content & Cloud its first US presence), and capabilities which clearly reflect current and anticipated market demand. In the wake of the first lockdown, high quality collaboration and unified communications capability is at a premium.
IT services businesses which focus on out-of-favour sectors (like hospitality or retail) might find themselves ignored in favour of businesses which focus on more resilient verticals. Right now there is a real appetite for service providers with a focus on central government. Doubtless this will reverse at some point and there are many organisations which will ultimately benefit from the inevitable investment in the digital transformation of both banking and retail which has, eventually, to follow the pandemic.
Acquirers divide over their desired end customer base. IT services providers tend to focus on either enterprise (large company) end users or SME end users. Some providers might be inexorably locked into a single vendor and others might seek to offer a range of IT services relevant to their client base. Enterprise-centric acquirers will not tend to be interested in acquiring SME focused targets and SME focused acquirers are unlikely to acquire an entity focused on a different market segment. There have been some interesting extensions to the pool of potential acquirers for SME-focused IT services providers in recent years, as the printer and print management companies have sought to diversify ahead of the long- predicted advent of the paperless office. For example in 2019 Sharp Business Systems acquired SME focused IT Services company Complete IT, allowing the Japanese giant to launch a European IT Services Division.
The traditional IT acquirers are also joined now in this acquisition market by the larger professional services firms, seeking to extend the range of their conventional audit, tax and consultancy capability. Deloitte, for example recently acquired Focus IT for an undisclosed sum. Focus offered extensive consultancy and managed service capability across the Oracle platform, providing clear client overlap for the accountancy giant. EY has hoovered up a number of SAP consultancies for the same reason.
For a UK IT services business to be of interest to one of the major Systems Integrators or a large overseas acquirer, it usually has to be either very big or very clever. These potential acquirers have very clear M&A strategies and their M&A activity is targeted on filling specific gaps. They rarely “bite” on an asset with less than £5m of EBITDA, though there are exceptions to every rule.
An interesting case study here is Cognizant. In 2020 the Nasdaq floated SI went on a buying spree with all of the targets clearly complementary to existing portfolio capabilities but focused on strengthening it’s cloud solutions portfolio. Building on its SalesForce business, it acquired El-Technologies , Lev and Code Zero. Collaborative Solutions gave them cloud capability in Workday and HR Advisory and the acquisition of New Signature saw the beginning of a dedicated Microsoft group.
It is difficult, if not impossible, for a mid-market services vendor to know whether their business is likely to be on the wish list for a Deloitte or a Cognizant. More often than not it is luck not planning that puts these companies in the right place at the right time. What is clear is that for this kind of acquirer, a laser-like focus is attractive. If Cognizant sets out to acquire a consultancy focused on Azure (for example), they want that business to be substantial and that focus to be exclusive. If the target fits their wish list precisely, then they will be happy to pay to fill that strategic gap. Legislating for that as an exit route is difficult.
There are clear areas of focus at the moment for IT services investors and acquirers; AI and machine learning capabilities, automation, data analytics tools, secure cloud migrations and high value managed services. Cyber-security assets have been hot for a while and most consolidators will already have added them to their services suite. Something approaching a third of all deals done in 2019 were for security services providers, a broad church encompassing everything from identity verification to network security and anti-malware. A focus on security is likely to be sustained as dependency on IT systems only ever increases and the threats to those systems becomes ever more sophisticated.
As a general trend, successful IT services businesses are becoming ever more focused on a specific vendor, a specific vertical, a specific market segment or a specific solution. Acquisition strategies accordingly are also increasingly focused. M&A directors and boards know what it is that will add value and will only be interested in companies that tick their specific boxes. Buyer lists for active mandates should be getting evermore narrow and targeted if disposal processes are to be successful.
All of that said, the owners and management of IT services businesses will not go very wrong if they build scale, focus on growing their annual recurring revenues and optimise their net margins. Companies with EBITDA in excess of £2m will continue to be at a premium in a sellers’ market.
Within the last 10 months we have advised on numerous deals in the IT sector at HMT, including the investment in secure data platform provider Aker Systems, the acquisition of Technology Solutions Group Limited by connectivity and cloud-based software provider Gradwell Communications and the £10million MBO of networking consultancy and managed services provider, Trust Systems.
We would be delighted to have an exploratory conversation with any business owner looking for advice so please do get in touch with us on 01491 579740 to talk to one of our experienced team.