Blue skies ahead for the business and technology services sector

In a world of extreme volatility, the perfect storm is a familiar concept: that terrible moment when everything that can go wrong, does go wrong – and all at once.

The perfect day is perhaps less common. But it does happen: right now, for instance, conditions for business and technology services M&A could hardly be better.

Everywhere I turn, there is more blue sky despite the fact that we are very far along in the economic cycle: among investors, regulators, and lenders, nothing suggests that valuations will come under pressure anytime soon. Last year was strong; this year is on track to match that performance and may prove even better.

To begin with, the fundamentals are good. Business and technology services is a healthy, growing sector. Companies of all sizes and in most places have gotten the message that outsourcing non-core tasks to a specialist can save them money, time, and grief. Five years ago, business services was a $12 trillion industry. Today, the US Census Bureau estimates, it’s worth $15 trillion – a 23.5% increase over the period.

Tax reform and a softened regulatory environment should act as a spur for deal-making. Between overseas profits repatriated under the tax act and a newly permissive attitude toward corporate consolidation, buyers are in an even stronger position than past years.

At the moment, there is too much cash in the market chasing too few opportunities. Private equity firms, business services companies, and debt funds are all flush with cash. Many PE firms, in particular, are under pressure to put their investors’ money to work.

In addition to financial buyers and strategic buyers, there is also an important hybrid in the market: the sponsor-owned strategic buyer, the business services platform owned by a private equity group and looking to acquire complementary assets so it can grow even faster. This third group of buyers may be the most formidable competition because they combine the advantages of strategic synergies with the deal-making savvy of private equity sponsors.

But the sun isn’t going to shine equally on every business services firm. As in other sectors, investors will be quick to differentiate between the top quartile of companies and all the rest.

The most highly valued business and technology services firms will be those that have visible and recurring revenue. The more visibility and predictability that a company has around its revenue model, the higher leverage that debt investors are willing to underwrite and the correspondingly higher price that financial and strategic buyers are willing to pay. Investors are looking not so much for long-term contracts as high rates of customer retention.

The volatility of the customer segment will matter too. Service firms that serve the healthcare sector, for instance, are likely to be preferred to firms that support out-of-favor sectors, such as retail.

Demand for assets will depend too on the buyers’ preferences. In general, financial investors will prefer companies that have more customers and lower concentration. Strategic buyers, however, often look for higher revenue per client, as that figure speaks to the value a vendor provides and the strength of the customer relationship.

Leaders of business service companies that don’t have the perfect profile can still do a few things to help themselves. Perhaps the most important is to examine their revenue model and pursue strategies to enhance recurrent revenue and predictable revenue streams. In a parallel to IT’s transition from license/maintenance to SaaS, business services companies that can establish recurring revenue models will sell at higher valuations.

Two other features to emphasize are your long-standing client relationships and your intellectual property. Deep client relationships are valued for their risk mitigation and cross-selling potential, while IP offers sustainable competitive advantages.

Finally, consider that although this may be an excellent time to sell, it won’t be the only opportunity – in general, the industry keeps making itself more indispensable all the time. However, it’s worth keeping in mind that perfect days don’t last forever.

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