IT M&A Expert: Over $5 Trillion In Transactions Completed In 2021

Tim Mueller, president of martinwolf M&A Advisors, says he’s ‘still very bullish on the marketplace’ as he outlines the factors solution providers looking for growth should keep in mind when determining whether to build, buy or sell their business.

A Host Of Decisions To Be Made

While MSP and solution provider valuations are near their highest levels, whether to engage in M&A activities or invest in organic growth remains a key decision for those looking at how to grow their business.

Tim Mueller, president of martinwolf M&A Advisors, a Scottsdale, Ariz.-based M&A advisory firm specializing in the midmarket IT industry, Tuesday told an audience of IT solution providers during the Best of Breed virtual conference that a lot of questions arise from founders, boards and shareholders on the right timing to either build organically or engage in a merger or acquisition. The Best of Breed virtual conference was hosted by CRN parent The Channel Company.

Mueller said that M&A activity has been on the rise thanks to easy access to capital, attractive interest rates, a strong economy and interest in recurring revenue opportunities.

“We’re still very bullish on the marketplace, even with rising inflation, interest rates, the Ukrainian invasion, and other world geopolitical events. ... You saw a rise in the U.S. [economy], and unemployment decreased in 2021, making for really a ripe market for mergers and acquisitions,” he said.

Mueller has been watching solution provider valuations and M&A activity for years. He was the founder of IT ExchangeNet, or ITX, which advised channel companies focused on the small-business market looking to acquire or be acquired. Those companies had values as low as $5 million.

ITX in late 2020 was acquired by martinwolf, which offered M&A advisory services on IT services, IT supply chain and software companies in the $30 million to $500 million range.

“We’ve done over 200 transactions over the last 25 years,” said Mueller. “And we’ve done those on multiple continents, cross-border experience in 20 different countries.”

Here is what Mueller had to say about the factors solution providers looking for growth should keep in mind when determining whether to build, buy or sell.

IT M&A Booming

Mueller, citing a study by PricewaterhouseCoopers, said M&A activity in the IT space in 2021 was up by over 50 percent compared with 2020, with over $5 trillion in transactions completed in 2021 versus $3.8 trillion in 2020.

“We haven’t seen numbers like this really since 2007. ... [And] we’re still very bullish on the marketplace, even with rising inflation, interest rates, the Ukrainian invasion and other world geopolitical events,” he said.

A primary reason why 2021 M&A activity was so strong was easy access to capital, Mueller said. Private equity companies had over $1.5 trillion in ready funds at very attractive interest rates even as the economy itself across the board was strong.

“You saw a rise in the U.S. [economy], and unemployment decreased in 2021, making for really a ripe market for mergers and acquisitions,” he said.

Another big M&A driver, particularly in IT services, was the shortfall in skilled labor, leading to a lot of acquisitions when they could immediately bring in skilled labor to help integrate new projects and grow the business, Mueller said.

However, he said, the main factor impacting IT M&A is digital transformation as companies are looking for help in those efforts.

“And to help them are the IT services businesses, managed security businesses, as well as managed security MSPs, which are our cybersecurity companies,” he said. “So all in all, digital transformation is really driving more growth in the IT space. And to do that, you’re also seeing quite a bit of acquisitions.”

About 48 percent of mergers and acquisitions in 2021 were driven by private equity, which was up from 25 percent only three years earlier, Mueller said.

“So you see private equity getting much more aggressive, particularly in the IT space, where they’re either building off of a platform or they’re buying a company that can become a platform under which you then roll in new acquisitions,” he said.

Growth Option No 1: Build

Mueller said solution providers looking to grow have three options: build, buy or sell.

Building one’s business organically is relatively simple, Mueller said. It allows the business owner to keep his or her fingerprint on the business if the owner understands that the financial resources needed to grow the business are available.

“If you’re looking to grow more than 10 [percent] or 15 percent per annum, then you really do have to have the patience and the financial wherewithal to get that deal done,” he said. “But remember, buying versus build is not mutually exclusive. You can continue to build the business, but when a target acquisition comes along that can accelerate your growth, you can pivot very quickly to become a buyer if build is really more of your strategy to begin with.”

“Thoughtful” organic growth needs to stem from a company’s strategy as set out by the founder or board of directors, Mueller said.

“It really does require a very deep and skilled management team that starts from the top down at the CEO, but includes business development, execution teams, delivery teams, all working in concert, so that there really isn’t an ability to have a misstep when you just decide to grow organically,” he said.

Even so, most of the companies that martinwolf works with underestimate what it takes to build a service or to build a product from scratch in order to become a “leader,” Mueller said.

“[It] requires a lot more infrastructure, and so you need to make sure that that infrastructure is in place in order to ensure that it could handle that growth,” he said.

Growth Option No. 2: Buy

The second way to grow is to acquire other companies, but it requires taking a very serious look at one’s management capabilities, Mueller said.

“The pros include instant customer base, infrastructure, customers’ cash flow,” he said. “The cons? You’re really taking over someone else’s business that you now have to transition, do a conversion, and put your own fingerprints on. This too requires a very strong management team that has the ability to multitask. It’s almost two full-time jobs for this management team. One is to continue the growth of the business on one side, and on the other side is being able to identify, do the analysis, do the due diligence, and then integrate that business into yours as part of a buying philosophy.”

Businesses typically underestimate what’s involved financially, including legal and accounting costs, the cost of an advisor, some employee legacy costs that one assumes with an acquisition and so on, Mueller said.

“One of the positives is that you do get some economies of scale,” he said. “Your back office can scale your staff, you may be able to combine some offices and cut down on real estate costs. But overall, there are quite a bit of benefits by being a buyer in this.”

Growth Option No. 3: Sell

There are several possible reasons for an owner to sell his or her business, including shareholder pressure, the need to mitigate risk, economic uncertainty, or even a feeling that running a business is no longer challenging or enjoyable, Mueller said.

“In most cases, entrepreneurs have a majority of their net worth tied up in their business,” he said. “And this gives you an opportunity to unlock that value and to be able to then move forward with some surety that there’s some more money in the bank account.”

Timing is a critical variable as market valuations often influence the decision to sell, Mueller said.

“We’ve seen the last several years the highest valuations that we’ve seen in over a decade for IT-enabled businesses,” he said. “And while a lot will be determined by the economy and interest rates going forward, we do feel bullish that that we have quite a bit to offer still in the marketplace for high valuations.”

However, Mueller said, it is necessary to prepare months, if not a couple of years, ahead of time.

“[You have to ensure] that your books are in the right place and that your customer concentration is not out of whack,” he said. “Buyers want to see customer concentration between 10 [percent] and 15 percent. And as you might imagine, they don’t want [a single customer] to be a high percentage 40 [percent] or 50 percent of revenue. Because if you lose that one customer, what kind of business did they buy?”

Drivers Of Valuations

Of the top drivers of valuations, the most consistently important one is revenue growth, which should be at least 10 percent to 15 percent per year, if not more, Mueller said.

Gross margin is also key, especially when talking about IT services, and should be at least 50 percent or 60 percent to attract buyers, he said.

Customers are the third top driver, as buyers are looking not only what customer logos a solution provider can offer but also proof that revenue is not concentrated on a single customer, Mueller said.

Cash flow still remains king, he said. “We want to make sure that there is a strong cash flow involved in your acquisition because the buyers will count on that to be able then to have the cash to run the business post-acquisition,” he said.

Being in growth markets, such as Software-as-a-Service, managed security services, and managed services is also very important, Mueller said. “Those are the three fastest- growing markets, and they command the highest valuations,” he said.

Other top drivers including possession of proprietary intellectual property including technology or processes that offer differentiation, a strong management team able to lead if the founder CEO decides to exit, the digital infrastructure used in the back office, brand recognition and reputation, and the ability to scale for growth, he said.

“We talk a lot about brand recognition and reputation,” he said. “It’s more than just your website. It’s how people perceive the brand when they say your name, so that does have some value. Even if the buyer ends up changing your name to theirs, the brand that you have developed with your customers and influencers is very important.”

Valuations Vary

Mueller, citing information collected by martinwolf, said the valuations of IT services providers and North American IT solution providers vary depending on how they are measured.

Large IT services providers in North America have estimated 2022 values of an average of 2.0 times their revenue. The average over the last 12 months was 2.2 times revenue.

When measured based on EBITDA, the estimated 2022 mean was 12.5 times EBITDA, which was down from the average of 12.8 times EBITDA measured in the last 12 months.

For North American IT solution providers, the estimated 2022 value as a multiple of revenue was 0.75 times, which was down from 0.88 times as measured over the last 12 months.

When measured based on EBITDA, the estimated 2022 mean was 11.2 times EBITDA, which was down from the average of 14.6 times EBITDA measured in the last 12 months.

How One Solution Provider Sees Valuations

Chad Hodges, president and founder of HSB Solutions, a Sacramento, Calif.-based provider of resources for government technology projects, told CRN that valuations depend on a lot of factors.

“They depend on a company’s repeatable revenue and on intellectual property that affects your differentiability, which what buyers really look at,” Hodges said. “Buyers want to know that if the founder leaves the company, there’s still value.”

When looking at services, buying companies are looking for things that can fill gaps in their current portfolio, Hodges said.

“It’s definitely easier to fill in gaps than it is to create something new, unless you have the cash and the time to do it right,” he said.