For companies operating in the information technology and telecommunications support services sector, scale is a key driver of the sale price in M&A transactions
Valuations in the IT sector continue to race ahead with leading commentators and investors expressing concern that the bubble might burst sooner rather than later. In particular, corporate acquirers and financial investors are chasing deals with companies developing innovative software, industry disrupting online platforms, and in the social media arena. Start-up and early stage businesses in these sub-sectors attract eye-watering valuations despite, in many cases, little visibility on the route plan to profitability.
So, where does this leave the diverse range of businesses operating in the IT and telecoms support services arena? Within this group we would include software and hardware distributors, consultancy and technical support businesses, and hosting and managed services providers.
Our research indicates that scale is a key driver of business valuations in this sub-sector. Based on an analysis of UK M&A transactions between 2012 and 2015, there is a clear correlation between the size of the target business measured by deal value and the valuation rating achieved.
For deals between £1m and £25m the median valuation multiple was 6.0x (calculated as enterprise value / EBITDA). This increased to 8.9x for companies valued between £25m and £100m and reached 12.0x for businesses valued over £100m.
Source: Market IQ, company accounts, Burgis & Bullock Corporate Finance analysis
The analysis illustrates a general point, but there is not necessarily a perfect linear relationship between size and value rating. Company-specific factors such as growth prospects and scalability, the level of recurring/contracted income, and quality of management will all have a major impact on the final deal pricing. For example, in the £1m to £25m group there was a deal with a value of £23m priced at 3.8x EV/EBITDA and another valued at £5m with a pricing multiple of 11.8x.
There are three main reasons why, in the IT and telecoms support services sub-sector, size is such an important factor in company valuation ratings:
- Future growth: a larger, diversified support services group with a range of product offerings should be able to generate higher revenue per customer through cross-selling and the provision of an integrated service.
- Economies of scale: this sector is generally characterised by high fixed costs and low variable costs, meaning scale is critical in driving the maximum incremental profit. In addition, a large target is more likely to attract an acquirer that can maximise merger synergies and overhead savings.
- Funding: a corporate or private equity acquirer seeking acquisition funding has a more attractive range of debt funding options for a large deal compared with a smaller one. For deals under £25m banks may be the only practical option with lending multiples of 1.5x to 3x EBITDA. At £50m or £100m, non-bank debt funds can provide unitranche loans and similar products at debt multiples of 4x to 6x.
In the diverse and fragmented IT support services sector we expect to see continued M&A activity into 2016 driven by both corporate acquirers and private equity investors.
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