At Cogent Growth Partners, this year is starting in sharp contrast to 2016, when some say political uncertainty put a damper on mergers and acquisitions, and sales of anything else requiring significant capital.
Rick Murphy pushes back on notions that the tech services space is experiencing a “wave” of consolidation, though he acknowledges 2017 is showing all the signs of a banner year.
The founder of seven-year-old Cogent Growth Partners has played a role in roughly 80 mergers or acquisitions involving IT services firms. In his experience, M&A activity in the MSP space tends to be heavy and pretty constant.
That changed last year, Murphy said, when there was a noticeable lull in deals amid speculation that the contentious election was sowing uncertainty; putting a damper on M&A and sales of hardware or anything else requiring a significant capital outlay.
“We did fewer deals last year than in previous years,” he said. “I think product sales were, across the board, down.
“It was the year of the pause button.”
Less than a month into the new year, Cogent’s pipeline of business is filling up with more and bigger clients, Murphy said.
“We’re already very busy this year,” he said. “We’ll end up doing more deals. It’s going to be a good year.”
Murphy’s company helps buyers and sellers coordinate due diligence, and walks clients from letters of intent, to consummation of final agreements.
During his time in the business, Murphy has occupied a front row seat to the evolution of the industry, watching as IT firms grew less reliant on revenue from hardware sales and more reliant on recurring revenue.
Anecdotally speaking, companies he sees are earning margins of around 20 percent on product sales, compared to margins of 40 to 70 percent for project work or services that generate monthly recurring revenue.
Still, the vast majority of service providers today continue to move at least a small percentage of hardware, Murphy said.
“A lot people are VAR-ish,” he said, citing the value-added reseller model.
“Almost everyone we work with sells some product,” Murphy added. “The gross margin contribution from product is not what the gross margin contribution from services is.”
The M&A process typically begins with an initial inquiry stage, during which owners try to get an idea of what their businesses are worth and whether selling makes sense.
“Most of those candidate companies are not really sellers yet,” Murphy said. “They’re M&A curious; they’re feeling it out.”
That careful consideration is understandable, given many IT services firms comprise 60 to 80 percent of their owners’ net worth.
That percentage climbs even higher for owners who routinely reinvest the bulk of their profits back into their MSPs, a decision that carries important – if often under-appreciated – consequences.
“If you’re reinvesting it, most – if not all – of their net worth is tied up in the company,” Murphy said. “The guy that’s pulling it out and stashing those profits somewhere, his percentage is less.”
He cited the example of one client who runs a $40 million company, with EBIDTA in the 15 to 18 percent range. The owner draws a salary and occasionally pulls some money off the table, but mostly just pours the earnings back into the company.
The decision to reinvest or draw profits can ultimately affect the value of an M&A deal.
“If you’ve been taking money off the table, it shows that your company makes money,” Murphy said. “You can demonstrate that to the buyer and that looks attractive.”
“If I’m constantly reinvesting, it raises an important question for a buyer,” he continued. “If I buy the company, do I need to keep investing in the business like you do, or can I run the business a different way than you’ve been running it and take some of that free cash flow?”
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