Interest rates

Opinion: Why your MSP’s valuation can withstand higher interest rates

By way of introduction, FOCUS Investment Banking MSP team has been the catalyst and advised on managed service provider (MSP) transactions with 47 parties over the past 2 ½ years, including four in May 2022, each sold at healthy valuations.

Unlike the public stock market

Unlike the public stock market, where the tech-heavy NASDAQ is down about 30% from its November 2021 peak and the S&P 500 is down 20%, we are seeing little to no decline in valuations and an increase the number of MSPs and private equity groups seeking $10.0-35.0 million in EBITDA (earnings before interest, taxes, depreciation and amortization) who wish to discuss with us the sale and/or the purchase of MSP.

For 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 for up to $1 billion, but in this space it’s hard to do… but because our fund is open and flexible we can start smaller (eg $25.0m EBITDA) and build from there. As another point of reference, we currently have multiple sell-side assignments “in the market” with over 30 signed Non-Disclosure Agreements (NDAs).

Is it a function of our drive and skill as investment bankers, or is it a function of MSP owners running for the top exits and exiting 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 deliver value through mergers and acquisitions for both parties to the transaction,” said Stan Gowisnock, Managing Director and Chief Executive Officer. technology services team at FOCUS. “Capital is abundant as the sector continues to post impressive returns and remains an attractive target for investment as a whole. As companies seek to improve internal efficiency to bolster valuations and profitability, outsourcing IT and other teams remains paramount. Engaged business missions, with capital aimed at improving the customer experience, is a long-standing formula that continues to work even in uncertain times.

MSP valuation factors: asset scarcity, organic growth and cash flow interest expense

Undoubtedly, there is some angst in the industry as the Federal Reserve raises interest rates, which aims to slow the economy and could impact corporate earnings. Yet, at the same time, there are a growing number of highly sophisticated private equity groups that are keen to buy MSP platforms (see New platforms explained. We are aware that there are more potential buyers with capital than ever before looking to buy MSPs. Private equity has a lot of committed capital and they want to deploy it in MSPs. In fact, the biggest problem is that there is a huge shortage of attractive assets to buy (see “Data Signals” Provide Top MSP M&A Targets for Private Equity for the best ideas).

Comparison of the MSP valuation with the Rolex Daytona watch?

So the question is, is the private MSP market heading to the public stock market, or is it operating on its own, which will create even frothier valuations like that of the Rolex Daytona watch? stainless steel – which is particularly valuable due to its rarity (each Rolex store only receives one per year).

To get answers, we spoke to several of our business partners well positioned to take the pulse of the market. patrick scared is managing director at Alliance Bernstein Private Credit Investors, which provided financing for some of MSP’s largest recapitalizations, including Thrive, Coretelligent and Ntiva. We also spoke to Reed Van GordenHead of Origination and Managing Director at Deerpath Capital Managementone of the leading lenders to lower-middle-market MSP platforms (many of whom FOCUS has advised).

Both told me that they had seen only minor changes in the private MSP market so far and believed that MSPs had different characteristics that would help them avoid the same fate as corporates. listed technologies.

“We continue to believe that IT MSPs are on the defensive because they are a necessary service that won’t negatively impact the recession,” Van Gorden told me. “Many non-essential businesses will face faster declines in profits and some will go bankrupt, but these are essential businesses.”

“Consumer service” may come under less pressure than business services

“Companies that have [been] and are affected by inflation or supply chain constraints may have issues. But when it comes to companies that operate in the service sector, they can do well,” said Brian Garfield, chief executive of Lincoln Financial. “I think what’s happening is that companies that are consumer-facing are probably going to be pressured more than those that aren’t as consumer-facing, like business services and software.”

Lincoln Private Market Indexwhich tracks changes in the enterprise value of US private companies, primarily those owned by private equity firms, rose 1.7% in the first quarter, “signaling that private markets continue to offer investors more stability during volatile times,” the company said in a press release. . “This stability was primarily a function of steady earnings growth rather than multiple performance.”

Source: LINCOLN International

What the experts have to say

Van Gorden acknowledges that there is a disconnect between what is happening in the public markets of tech companies and the private market of MSPs, but says there are strong reasons for this.

“Companies that have really been beaten in the public market are mostly companies that don’t make money, they don’t have enough cash. We’ve gone from a world where we highly value companies that can grow quickly using capital, but now we’ve moved to a world where we value companies that can grow without using capital.

“MSPs specifically have really good margins, they’re pretty profitable and have pretty good cash flow,” he said. “So it protects them. I think some people are waiting for private valuations to drop to match the situation in public markets, but we just haven’t seen it.

Fear was also confident that MSPs would avoid anything resembling a crash in stocks of publicly traded tech companies, although there may be some adjustment in the private market.

“The secular tailwinds and strong MSP fundamentals indicate that this is a place where deals should be able to be made and spreads between bids and asks should be reasonable,” Fear said. “So we expect the deals to continue, maybe not at the pace of 2021, but at a reasonable pace.”

Joe Rondinelli, director of Frontenac, who is the majority owner of one of the most successful MSPs in the United States, had this to say: “The thing to watch more [than demand for platform investments] is the impact of interest rate hikes and inflation on the underlying customer demand of an MSP, compared to corporate finance having higher interest costs when a redemption. The former will have more impact on the valuation than the latter.

“Best ranking”

“Some companies may struggle a bit more and face potentially weaker demand and higher borrowing costs,” Fear said. As a result, some investors may choose to “top grade”, i.e. only make A and B transactions, i.e. those involving the best and the best companies, those which have the strongest fundamentals.

“No one is admitting that they rank trades in order of A, B and C – i.e. good, best and best – but almost everyone we talk to on the equity and credit side says that they’re not doing the C or good deals right now, they’re focusing on the best and the best,” Fear said. “These deals might not miss a beat because there are strong fundamentals, healthy growth rates and a lot of capital there. For the best and the best companies, there’s a lot of debt and equity capital at a spread not too different than before.

Both Fear and Van Gorden noted that interest rates on private equity-backed MSP deals have risen since the start of the year, but remain extremely low, especially compared to rates in the broader market for business loans.

Rates on PE-backed MSP agreements are typically floating rate loans with benchmark rates tied to LIBOR (London Interbank Offered Rate) with a 1% “floor”. Now that the 1% floor has been breached, increases in LIBOR have a direct effect on borrowing costs.

Source: discount rate

“If people compare this to the more liquid, heavily syndicated lending markets, where the lending spreads are wider, we may need to make some price adjustments to narrow that spread,” Fear said. “Are the risks to growth and the risk to execution a bit higher than they were? The answer is probably yes, but it still doesn’t matter to the overall equation. If this becomes more important, the overall leverage capacity will decrease and this will affect valuations. But we don’t see it yet. What we haven’t really seen either are people saying they need to reduce their debt because debt service is going up.

In other words, private lenders will continue to “lean” into the MSP market

Both men also noted that their companies are far from exiting the MSP market.

“We have plenty of capital available, more than enough to finish this year,” Van Gorden said. “So we’re in great shape.”

“We are excited to be a player that will hopefully be able to increase market share at times likee this while other players are withdrawing,” said Fear. “We will continue to have an appetite and be a stable ship in choppy waters.”

For more information, please contact Abe Garver, FOCUS Managing Director and MSP Team Leader, at [email protected] or 646-620-6317.

By Abe Garver, MSP Team Leader and Managing Director at FOCUS Investment Banking. Read more guest blogs from FOCUS here. Regularly contributed guest blogs are part of the ChannelE2E referral program.