MSPs And Private Equity: What Makes An MSP Stand Out From The Pack?

‘I think cultural fit is something that is extremely important. And in terms of the technical stuff, we look from a customer perspective at what customers want. We want to see really good retention rates. We want to see a diverse customer base,’ says Briton Burge, principal at Rosewood Private Investments.

Private Equity 101

Private equity is becoming an increasingly important force behind the growing consolidation among MSPs. The past couple of years have seen dozens of MSPs either merge or get acquired, and those deals increasingly have been done with private equity firms providing the funding.

This has been most evident in the rising number of platform acquisitions, which happen when a private equity firm acquires one MSP with the intention of using it to do more MSP acquisitions. They then roll up several smaller MSPs into a larger MSP that can leverage its size to compete in what has traditionally been a very fragmented market for managed services.

Indeed, there are likely now over 100 platform MSPs vying in this fragmented market, said Abe Garver (left, in photo), managing director and MSP team leader at Focus Investment Banking, a Vienna, Va.-based midmarket investment bank. Garver, speaking on a panel at CRN parent The Channel Company’s XChange 2022 conference, said it started in about 2014 with some of the first private equity investments into MSPs and really took off in 2018 when Evergreen Services Group made the first of four platform acquisitions.

Garver was joined on stage by Karl Muehlberger (center), chief compliance and audit officer at DSM, a Lakeland, Fla.-based MSP with a state and local education focus, who discussed his company’s journey to working with private equity, and Briton Burge, principal at Rosewood Private Investments, a Dallas-based private equity firm that in late 2020 acquired General Informatics to use as a platform for further acquisitions.

There are big changes coming to the MSP sector, and outside money is driving a lot of those changes. Read on to learn more about how private equity is driving it and how MSPs can take advantage of these firms’ hunger for recurring revenue.

Why MSPs Are Attractive To Private Equity

The MSP space right now is extremely popular with private equity for two broad reasons, Burge said. One is MSP market dynamics, and the other is MSPs’ business models and the value propositions in general.

“On the market side, we’re talking about a massive total addressable market but also a very highly fragmented one,” he said. “And from a private equity perspective, that’s important because it provides multiple avenues of growth, both from an organic perspective of increasing sales efforts and things like that. But also from an inorganic perspective: Where else can you go out and acquire a number of businesses to create a larger platform in an otherwise highly fragmented space?”

There are a lot of positive tailwinds in the market from the past five to 10 or more years in terms of increasing IT complexity and the need for businesses of all sizes to be competitive, Burge said.

“And it’s very difficult for them to do so on their own,” he said. “And so that goes to the business model of the MSP, which is really adding value to the customers, helping them be more effective and efficient in running their business. We view it really as a mission-critical service, and that creates a lot of stickiness.”

Private equity also loves recurring revenue, Burges said.

“We all know that MSPs function with hopefully a good bit of recurring revenue in their overall stack,” he said. “That provides a lot of visibility and stable and steady cash flows.”

Burges said Rosewood Private Investments had developed this way of looking at the market before the COVID-19 pandemic, and in late 2020 closed its General Informatics acquisition.

“I feel very fortunate that we did in many ways because in just over a year the amount of MSP M&A activity increased incredibly in the space, and multiple private equity-backed platforms have been formed since then that we’re going up against, both from a competitive perspective and also from an M&A perspective,” he said. “But it’s a very exciting time. And I think there’s a lot of runway left in the market.”

What Makes An MSP Stand Out To A Private Equity Firm?

Geographical focus, new services, the ability to cross-sell services, and new potential niche or vertical markets are primary focuses when evaluating a prospective MSP acquisition, Burge said.

“And then, of course, I think cultural fit is something that is extremely important as we build these businesses and make sure they operate with the same core values,” he said. “And in terms of the technical stuff, we look from a customer perspective at what customers want. We want to see really good retention rates. We want to see a diverse customer base.”

Burge gave as an example Rosewood Private Investments’ acquisition of General Informatics, where he said the private equity firm was impressed with the MSP from a services portfolio perspective, a customer and retention perspective, a recurring revenue perspective and a culture perspective.

“Mohit ‘Mo’ Vij, who was the founder, built a fantastic business that was really a pillar of the community,” he said. “And we were lucky to find Don [Monistere, president and CEO of Baton Rouge, La.-based General Informatics (pictured)] during that process and bring him on board to really help us scale that business. And we saw a platform potential in General Informatics as a catalyst to go and partner with smaller groups across the Southeast, which has been our focus so far. And then as I think about add-ons, a lot of the same things pop to mind. At the end of the day, it’s all about fit.”

How EBITDA Figures Into Acquisitions

Garver said that six months ago, when Focus Investment Banking started becoming a catalyst for building MSP platforms, investors were looking for $2.5 million to $5 million of EBITDA. Now, he said, his firm has six different groups that are asking for between $8 million and $15 million of EBITDA, depending on the size of the fund the private equity group raises.

“So somebody that’s raised $2 billion, as an example, is going to make 10 platform investments,” he said. “And they can’t go with $2 billion and make a platform investment into a $2.5 million EBIDA MSP and grow it. So they need to start at, call it $8 million of EBITDA. And so there‘s this huge scarcity of assets.”

That has led to private equity firms pushing MSP mergers before the investment is made, Garver said. One of the platform transactions currently under a signed letter of intent is a merger of two MSPs to get to a size large enough to get to $2.5 million, while in another case three MSPs merged before the private equity investment was made, giving it a total EBITDA of $4.2 million.

“So there’s a lot of consolidation even to get to the size that the private equity group needs,” he said.

Why DSM Is Looking For Private Equity

Muehlberger said DSM started about 16 months ago when it decided to take advantage of financing markets to add inorganic growth via acquisitions to grow its business. DSM also wanted to use acquisitions to bring in a wider geographical reach and more services to sell and cross-sell to help improve margins and performance.

“Our data center, our private cloud, is a very scalable environment,” he said. “And as such, it can scale out to some rather large implementations. And we wanted to simply utilize the investment. So we found a company, a local company that we took over and started integrating it. It primarily was a test case for us to find out how do our guys react to bringing a bunch of new guys in. And how do you keep it consistent? How do you make sure the services don’t suffer?“

After that acquisition closed without the aid of private equity, DSM saw little customer attrition, Muehlberger said.

“So we were quite proud of ourselves and we thought, ‘OK, let’s do this again,’” he said. “Well, long story short, out of four offers we put out, in three of them we were kicked out. And the reason was that the winning bidder was an MSP that had PE backing. So we decided--we’re quick learners--there‘s a trend here.”

Therefore, Muehlberger said, DSM decided to find a private equity firm it could work with.

“We looked first at an investment banker that would help us to do that,” he said. “And we were looking for the experience that they have. We were looking for transactions closed, and we are looking for the book of business in terms of investors that they can bring to the party. And obviously since I’m standing here, we chose Focus.”

Don’t Forget The Exit Strategy

Muehlberger said that, assuming that DSM is not the first company a private equity firm purchases, it is important to know who is in the company’s portfolio already.

“Are these companies that you can leverage?” he said. “Are these companies in a similar business? Do they give you bigger footprint? Can you cross-sell this product either way? Because at the end of the day, what you want to do is get margins up. And how do you do this? Sell more efficiently. And that has been the big driver for us.”

The second piece, Muehlberger said, is the exit strategy.

“Because at some point in time, all these funds will dissolve and they get paid out,” he said. “So what is the length of time for this? Are you ready to do this at the end? Or are you just selling it because you want to retire?”

“In our case, we were getting the investment to build,” he said. “So we have a very specific focus and specific time requirements as to what we need over the next few years to do that. And last, but not least, is the willingness of the PE firm to continue to work with you after the acquisition. If we want buy somebody else, if we find something else, if we need significant infrastructure improvements, will they work with us?”

Impact Of Interest Rates On Private Equity Decisions

It is hard to pin down the impact interest rates have on private equity deals, but in general it isn’t good, Burge said.

“As debt becomes more expensive, by definition asset prices have to go down,” he said. “I don’t think that we’ve seen that in the market yet, for whatever reason. And interest rates have stayed surprisingly low. And to be completely honest with you, I don’t know exactly why. I expect that they will go up. And I think that’s going to have an impact broadly on the market.”

The good news from an MSP perspective is that the underlying business model and the underlying market are very strong and will continue to be important as time goes on, Burge said.

“Financial markets obviously have ebb and flow and might impact asset prices, but I think the fundamental underlying business is still very much in demand, very important from a customer perspective, and I think viable,” he said. “Hopefully somewhat resilient, although you can never be completely resilient to shocks.”

Multiples Of Revenue A Poor Indicator Of Value

Garver said he tries to discourage people from thinking about the valuation of an MSP based on revenue.

“I think you need to bring it further down the line to have positive cash flow,” he said. “And the lenders on the sell side will go to companies like Deerpath Capital Management or Plexus Capital and get what’s called a leverage read and know, OK, when somebody goes to make a bid, we know the lender will give 4X leverage, as an example.”

When looking at the valuations of MSPs, one should think more in terms of how SaaS companies are valued, which is often around the “Rule of 40,” in which the total of a company’s growth rate plus its EBITDA percentage should be greater than or equal to 40.

“And you have to have at least one year experience on customer retention because to get the SaaS kind of valuation, you have to be able to prove that your retention rate is at 80 [percent], 90-plus percent,” he said. “And that’s really what got me into MSPs. At its purest form, the way someone like Briton thinks about the valuation of an MSP is just a derivative of how everybody values SaaS companies.”

One MSP’s Experience

Sitting in the audience was General Informatics’ Monistere.

Monistere told CRN his biggest piece of advice to an MSP considering being acquired is to do your homework.

“A lot of people will talk with private equity,” he said. “These guys are great at what they do. They’re really personable. They recognize that it’s really a sales process, just like we sell every day. So I would say, do your homework before you talk to the private equity company that you’re considering. Make sure that you understand the way their leadership works and how they manage and how engaged they get.”

A lot of MSPs come into those meetings thinking they want private equity firms to be hands off, Monistere said.

“I’ve found that’s not as good as if they are an actually engaged part of your board,” he said. “These guys have expertise, not just in the financial sector. A lot of the private equity companies will build teams that have MSP knowledge and technology knowledge, so that when they are involved with you they can provide you feedback and give you ideas of what kind of challenges the organization sees.”

Garver, Burge and Muehlberger showed there is a lot of mystery in terms of what MSP valuations look like or the different tiers of investment, Monistere said.

“There is quite a bit of negotiation that goes into either selling your business or acquiring another organization,” he said. “And so, I always tell people when they ask what the multiples are today, it really does depend on whether or not you are a platform company, whether or not you have some very specific intellectual property you own, and how well do you work with the private equity company or the platform company looking for add-ons that is buying you. If your culture and your direction and what you’re doing is going in that same direction, heck, they may end up buying you for more than what you thought you could get in the market.”