Q2 IT services M&A trends & sector update

The IT Services M&A market has been humming along and what we’ve seen so far this year doesn’t seem off-key. Middle-market transaction volume is strong and valuations are generally in line with historical averages. Simply put, there are plenty of public acquirers with money to spend on the right prospects.

As the second half of 2019 comes to a close, our decidely bullish market has begun to take on a bearish shape. If you’re an operator in the IT Services sector with succession planning on your mind, you’ve got to ask yourself the question: “Do I feel lucky?” As we’ve learned from countless asset classes (stocks, real estate, tulips…), nothing goes straight up in value forever.

Livingstone’s IT Services practice analyzed over 4,700 transactions that occurred between 2009 and June of this year, in the categories of Data Processing/Outsourced Services, Internet Services/Infrastructure, and IT Consulting and Other Services.

Not all transactions had publicly available data, so Livingstone leveraged its proprietary research, unique industry intel, and detailed analysis to form insights into the evolution of the IT Services landscape over the last decade on the basis of deal volume, deal value, and public company valuations.

Our aim is to provide operators greater context for their fit in the larger IT Services ecosystem. Below is the one-byte version.

Deal volume remains strong, with IT Consulting leading the field

The joke that everyone is a tech company really isn’t so much of a joke these days. IT is being infused into the full spectrum of industries, whether you are a marketing services agency driven by tech on the backend or an old-line manufacturer leveraging technology, to drive scale and operational efficiencies. This trend is creating demand for consultants that can help from lift-and-shift to a complete transformational overhaul.

In IT Consulting in particular, there is a low barrier to entry, so there are plenty of potential acquisition targets for buyers and investors to consider. However, the number of competitors also makes it challenging to build scale past $30 million or $40 million. Buyer appetite remains strong, especially for differentiated businesses that stand out from the crowd. In fact, transaction volume so far this year is running apace with 2015’s 375 – the highest of the decade. Of particular interest these days are providers of ongoing services, like subscription-based business models, that can count on recurring and stable revenues or businesses that have developed unique scale or technical expertise.

Values show signs of softening, especially for Data Processing/Outsourced Services 

While supply and demand for IT Consulting and Services businesses continues to be strong, in recent years, other sub-sectors have been taking divergent paths, at least from an M&A perspective.

With less transaction volume to mute outlier trades, comparable transactions imply that Data Processing and Outsourced Services businesses are showing declining values, dropping below 10x EV/EBITDA for the first time since 2015. One consideration is that data is potentially becoming increasingly commoditized and it is growing more difficult for processing businesses to differentiate themselves with truly unique offerings and insights.

Internet Services and Infrastructure valuations are more opaque as the amount of available transaction value information is limited for the first six months of this year. Ultimately, there are a couple of themes that seem to be driving premium values in today’s market, especially in the eyes of private equity groups. Recurring revenue models, not to be confused with reoccurring revenue, that function on a subscription or contractual basis will garner a higher value than project-based or transactional revenue models.

Buyers appreciate the long-term revenue visibility and typically higher margin business, but sellers should be prepared to have their contracts and pricing heavily diligenced during the course of a process. In addition, concentration in a particular platform or channel partner, especially when a significant portion of sales are sourced from that channel partner, can be seen as a plus or a minus – the beauty is in the eye of the beholder. For many operators, it can be difficult to scale the business without committing to one partner, but that obviously comes with its tradeoffs.

Strategic buyers want something special and are willing to pay for it

The good news is that there is an abundance of public buyers. They understand the premiums the “right” acquisition targets can command – and are willing to pay it. Strategics, many of whom are battling over unique technology or channels of consumers, are intrigued by businesses that offer access to a new market or capability they can bolt onto their existing infrastructure and scale quickly. It is faster and more efficient to acquire new technology, skillsets, or market penetration than to build it out organically. They typically have substantial war chests to get a deal done and some of the more acquisitive operators can move quickly given their knowledge of the industry and their particular investment thesis.

Public companies, on average, have the additional benefit of trading at multiples in excess of the M&A markets so they can potentially buy EBITDA at a discount and realize an immediate accretive effect. Conversely, sellers taking part of their consideration in the buyer’s stock need to consider whether the equity is overvalued and just a “cheap” form of currency for the buyer or whether it will really hold its value over the long term.

The bottom line

Deal volume remains strong relative to previous years. But, 10 years into a bull market, buyers and sellers should be considering what will happen to the landscape if the bear lumbers back into town. The good news for operators in the middle market (deals <$1B), compared to larger deals, is that the M&A market will remain open and there will always be buyers with appetite for acquisitions, albeit at discounted values.

This is where we’re starting to see some signs of weakness as IT Services sub-sectors appear to be trending below their long-term average valuations. Business owners that believe they could be sellers in the next 24 to 36 months should begin thinking about what is truly driving value and how they can best prepare their business today for a trade tomorrow.