With private equity (PE) firms continuing to have a major impact on the MSP business, you should understand what’s going on.
So, what’s going on? First of all, I think it's clear that generally PE markets across most industries have exploded in recent years — and there are two main reasons for that.
The first is cash. There are trillions of dollars (or what we’d call “dry powder”) on the sidelines that need to get put to work, and investors are looking for big returns. The second is low-cost money. You can borrow money at such low rates that you can afford to leverage a bigger percentage of an acquisition.
So, these factors, along with segments like SMB tech (which has a growing total addressable market (TAM)), are why we’re seeing PE’s interest in the MSP space.
Unlike other companies, such as software vendors, why are MSPs valued at multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA)?
Mainly, this has to do with the business model, Software companies have very low COGS (cost of goods sold), which means they have high-gross margins, so they spend a lot more on sales and marketing. Because of this, investors don't care as much if you burn cash, as long as other metrics like your client acquisition cost (CAC), net retention, and gross margins are sound.
How and why are MSPs valued?
The simplest form of a company's value is impacted by financial arbitrage. For instance, if I'm an equity company, and I can buy a company at a 5x multiple and sell it for 10x, there's a spread there (I have the potential to make money). I can also boost stakeholder value by increasing efficiencies, accelerating organic growth, and strategic synergies that add value. Things like profit percentage, vertical focus, customer distribution, culture, management, team strength, sales results, seat price, geography, and more all play a role on the MSP side. Then, there's all the factors I mentioned on the buyer side.
Why can PE firms afford to pay what they pay?
Some of the acquisitions you read about sound outrageous, but the main driver is the multiple. The multiple that a five-million-dollar MSP would command is much lower than a $50- or $100 million MSP. If you take this multiple spread, the cheap money, and the ability to add value to the asset, you have the basic logic.
One opportunity that MSPs have today is that they can roll some equity into the deal. Let's say your MSP sells for $6 million, and you roll 20 percent of the equity into the deal. You would take $4.8 million off the table, and you would roll $1.2 million into equity in the new deal. Now, you're alongside the investors, and you're making the financial arbitrage work for you. Although there's some risk, the upside is huge. In many cases, your 20 percent will be worth more than your original 80 percent.
As an MSP, it’s important for you to have some awareness of the market forces at play, the impact of PE, and some other PE basics if you want a better understanding of your business.