MSP platforms show resiliency as valuations rise
Interest in managed services as an investment opportunity continues as larger private equity funds enter the market, seeking attractive here-and-now cash flows.
MSP platforms are attracting capital, conducting add-on acquisitions and enjoying healthy valuations -- even in a challenging economic environment.
Platforms are private equity-backed structures that serve as the foundation for regional or national MSPs. Platforms often expand through a series of add-on acquisitions, folding in smaller service providers. Investor interest in MSP platforms took off in 2018, in tandem with the enterprise need for digital transformation, and has steadily grown since then. Those that launched a few years ago are now recapitalizing for the next wave of growth. And new platforms are entering the market.
Indeed, 2022 could see a record number of platform launches, according to Abe Garver, managing director and MSP team leader at Focus Investment Banking, an M&A advisory firm with headquarters in Vienna, Va. He anticipates 25 platform launches by year's end; the previous record was 21 in 2018.
Platforms grow in value
MSP valuations, meanwhile, are also on the upswing, in contrast with other IT sectors. Garver cited publicly traded SaaS companies, some of which have struggled with profitability, as an example of a sector that has recently experienced a fairly sharp drop in valuations.
"For MSPs, we have actually seen valuations go up this year, almost with every transaction we have done," Garver said.
Abe GarverManaging director and MSP team leader, Focus Investment Banking
Trent Hickman, managing director at VSS Capital Partners, a private investment firm based in New York City, said MSPs at the high end of the quality range continue to achieve premium valuations. He defined MSP quality as not just financial performance, but the quality of customers, the quality of services provided and the strength of contracts.
That said, the current economy isn't one in which a rising tide lifts all boats. "The companies that are not quite as strong may be less likely to achieve the same kind of lofty valuations we saw a year or two ago," Hickman said.
Marty Flaherty, executive director at GP Bullhound, a technology advisory and investment firm, also emphasized the importance of quality in solid MSP valuations.
"Investors are willing to pay good multiples for businesses that are high quality and solve a mission-critical need," he said, citing security and data protection as examples. "Their focus is still on profitability, recurring revenue, and customer retention and expansion."
Private equity sparks platform growth
The rise of platforms ranks among the key MSP trends in recent years and has been an important source of the industry's growth. The expansion track begins with the first private equity investment establishing the MSP platform. The platform then makes add-on acquisitions of smaller service providers to supplement organic growth.
The platform strategy helps entrepreneurs create a regional operation, building off an established hub. That's the case for Cantey Tech Consulting, an MSP based in Charleston, S.C. The company earlier this month acquired Palindrome Consulting, its first acquisition since receiving an investment in 2021 from LNC Capital Partners, a private equity firm specializing in midmarket business services companies.
Cantey Tech's primary expansion emphasis is on the Southeast, although the company has considered deals from Texas to Virginia. Palindrome is headquartered in Hollywood, Fla.
"We are really focused on a geographic strategy," said Willis Cantey, president at Cantey Tech. "We think there is plenty of room to grow there," he said of the Southeast, noting the region's population increase.
MSP platforms recapitalize
Such add-on deals naturally lead to bigger MSPs and, increasingly, bigger investors. Garver, whose company advised Cantey Tech on the LNC Capital and Palindrome transactions, said an MSP platform will make four to five add-on acquisitions before reaching a size that attracts the next, larger investor. That firm recapitalizes the MSP, buying out the original financial partner.
Entech, an MSP and cybersecurity services provider in Fort Myers, Fla., follows this trajectory. The company last week said it has recapitalized with Prospect Partners, a private equity firm specializing in pre-midmarket companies. Entech aims to accelerate its acquisition strategy in the Florida market.
Synoptek, an MSP based in Irvine, Calif., recapitalized in September. In that transaction, Sverica Capital Management, the company's previous private equity partner, sold a majority stake to Quad-C Management.
Drake Star, a New York City investment bank that advised the MSP on that deal, cited Synoptek among the more than 365 digital services M&A transactions it tracked in the third quarter of 2022. The digital services sector includes managed services as well as other areas such as business process outsourcing and digital transformation services. Drake Star identified more partner ecosystem deals in Q2 -- 375-plus. But the firm's Q3 deal volume update cited continuing momentum "despite the current macroeconomic climate."
Service providers show resilience
The economic environment, which has seen layoffs among the top tech firms, appears favorable to MSPs. Service providers offer customers the ability to offload IT functions that are costly to maintain in house when times become tough. "The more businesses start to struggle, the more they downsize employees and outsource to MSPs," Garver said.
Outsourcing "should be a tailwind to the broader MSP market," Flaherty said.
Cantey cited cybersecurity as another factor driving MSP demand. "Next year, security compliance will continue to drive growth, along with the requirements of cybersecurity insurance, which are getting stricter," he said.
MSPs, of course, can't completely override economic conditions. Hickman said MSPs aren't necessarily countercyclical, growing faster during a downturn than they would otherwise. Rather, it's more the case that the stronger MSPs can more readily navigate the economic crosscurrents. A significant recession would cause some MSP clients to suffer, which would create negative pressure for service providers, he said. On the other hand, another group of clients might view outsourcing as more attractive due to the potential for cost savings.
For MSPs, the negative and positive elements could "balance themselves out to a significant degree," Hickman said.
Groups eyeing MSP deals will be on the lookout for resiliency and paying close attention to the sales pipeline.
"Investors, across the board and also in the MSP and SMB space, are scrutinizing sales cycles, looking for signs of elongation, and trying to figure out how that will flow through future earnings and new deals," Flaherty said.
Investors are also "digging in on specific end-market dynamics, especially given the fact that we may enter a recession," he added. As for specific verticals, Flaherty said retail, for example, might receive a higher level of scrutiny than other markets such as education.
Larger funds pursue limited supply
The increasing demand for services -- and the resulting boost in monthly recurring revenue -- helps keep MSP platform valuations healthy, a pattern also observed two years ago amid the COVID-19 economy. The arrival of investors with deeper pockets also plays an important role. Garver said he's seen the size of private equity funds in the market for MSP platforms expand from $500 million a few years ago to $1.5 billion today. Those larger private equity firms, however, demand larger and larger MSP assets, which are in limited supply, he said. This imbalance helps keep valuations on the upswing.
"There's more private equity dollars trying to come into a smaller amount of potential investment targets," Garver added.
Private equity groups might find ways to work around MSP size limitations. For example, an investor could pursue a merger-of-equals deal, purchasing and combining two MSP platforms to engineer the asset size it seeks to fund, Garver noted.