MSP buyers focus on margins as AI reshapes M&A market

Buyers of managed service providers are focusing on gross margins, customer retention and predictable recurring revenue as uncertainty around artificial intelligence affects technology merger and acquisition activity.

Joel Cox, Partner at DLA Piper, shared his assessment of the M&A market in a conversation with AJ Tills, Chief Customer Officer at Exaba, and Richard Kennedy, Revenue Lead at Exaba. The discussion covered technology M&A, acquisition criteria, sale preparation and the growing role of data sovereignty.

Cox said technology M&A has become tougher as buyers assess how AI could affect their investment strategies. Private equity firms have become particularly cautious, while strategic and listed company buyers are also moving more carefully.

"What my private equity clients are most focused on now is understanding who the winners and losers from AI will be. The benefit of being an MSP with a high number of customers is that you can hedge your bets," said Joel Cox, Partner, DLA Piper.

Cox said MSPs could position themselves around sectors expected to attract investment over the next two to three years.

"But if you can strategically focus on obvious winners, or obvious sub sectors, I think that will hold up well in two to three years," said Cox.

Capital shifts

Defence technology, deep technology, semiconductors, data centres and AI-native businesses are among the areas attracting investment. Cox said MSPs serving companies in those sectors could become acquisition targets as capital moves through the technology market.

Cox said buyers continue to assess recurring revenue, net retention, growth rates and gross margins when evaluating businesses.

"Beyond that, it's the fundamentals of business. A lot of people see the AI challenge as just another business challenge. If you're focused on the right services, you've got good recurring revenue, and you've got good fundamentals in net retention, growth rate and gross margin, those are what our buy side clients are looking for," said Cox.

He also identified employee retention and customer churn as factors affecting the sustainability of a business.

"It's simple things like keeping teams together and avoiding churn. Arguably those two, people and churn, get harder in the AI era. But if you do them well, by providing a good service and a good culture, you've got a growing, sustainable business and you're more likely to get a good M&A outcome as a result," said Cox.

Enterprise customers can also influence valuations. MSPs providing mission-critical services alongside broader strategic support can appeal to strategic and private equity buyers.

Cox cited Australian technology services company Versent, which grew to about AUD $150 million in revenue before being sold to Telstra for about AUD $267 million. He said its relationships with large enterprise customers and work across cloud migration, security, DevOps and digital transformation were factors in attracting bidders.

Sale preparation

MSP owners considering a sale should begin preparing at least two years before entering a process, according to Cox.

"On the first question, I'd take at least two years to prepare. I'd be meeting a couple of corporate advisers, people like Allier Capital in Sydney or Blackpeak Capital, who've done a lot in this space. There are similar advisers in New Zealand we could recommend," said Cox.

He said the preparation period should be used to improve financial performance, business strategy and company culture before approaching potential buyers.

"Ideally you take two years because you want your metrics, your financial performance, your culture and your business strategy fine tuned for a sale. That's where you'll maximise your outcome. You'll also de-risk the position rather than putting all your eggs in one basket," said Cox.

Preparing for several categories of buyers can expand the potential market for a business.

"If you take two or three years to grow and tick the boxes for a roll up player like Constellation or Evergreen, a private equity fund and a strategic, you've got a much bigger buyer universe and you're more likely to succeed," said Cox.

Customer concentration and contractual change-of-control provisions can create obstacles during a transaction. Cox said MSPs should ideally avoid having too many customers individually representing more than 5% of revenue.

Employee turnover can also affect a deal. Equity schemes can help retain key staff, although their structure can become relevant during an acquisition when buyers assess employee retention and key-person risks.

"The last thing I'd say, Richard, is that gross margin and net retention are just so important to buyers. Where you've got churn, or you're not getting those numbers right, even doing bolt on M&A yourself can pollute them. That can be catastrophic for a sale, because the M&A becomes a distraction, the numbers look bad, and one plus one doesn't equal three or four, it equals half," said Cox.

"It comes back to being well prepared, focusing on those key metrics, and running strategy and the everyday business to increase your buyer universe," said Cox.

Sovereignty focus

Data sovereignty is beginning to enter acquisition considerations as technology companies develop AI systems and work with sensitive data.

Cox said sovereignty had yet to become a major factor in MSP transactions he had handled. He said it had become a greater focus for deep technology companies and software businesses developing AI.

"When I think about data sovereignty, and I'm an M&A lawyer, not as deep in the tech as you are, one aspect is having data locally, being able to service defence tech or government clients, and being able to give assurances about where the data is located," said Cox.

Another consideration is whether company data can legally and practically be used for AI development.

"The more important aspect, and the forefront of this space, is that the data has to be legally permissible to use for AI strategies, and structured and accessible in a way that an AI build can realistically happen. That's where I see the big value proposition for IT services businesses going forward," said Cox.

Enterprise organisations will require infrastructure and managed services as they develop AI applications and agents, according to Cox.

"A number of my clients, and all the large banks in Australia, the smaller banks and everyone else in enterprise, need to rebuild all their apps to reflect an AI world. They need to build new products and agents, and then they need the ongoing managed services for all of that," said Cox.

He said these projects would depend on suitable compute infrastructure and data that can legally be used for AI.

"But it requires compute capacity and data that is strategically considered, accessible and legally usable to build private models to underpin those new apps and AI, and that can be serviced and managed to the high expectations enterprise will have. So I'd say data sovereignty becomes really important," said Cox.

AI could also shorten parts of the acquisition process. Cox said tools are beginning to make due diligence and the preparation of customary transaction terms faster. He said the underlying process of buying and selling businesses remains broadly the same.

Buyer timing

Sale processes have become more targeted as potential acquirers devote resources to AI strategies and capital requirements.

"Two years ago our sellers with investment banks would go out to 150 buyers. It was a broadcast, like selling a house. You'd get 20 bids, allow four into the data room to confirm, then sell," said Cox.

Current processes can involve a smaller group of prospective buyers.

"Now it's much more about a small audience. You might only go to five to ten buyers, depending on your circumstances and profile," said Cox.

Cox said potential acquirers may be occupied with their own AI strategies or capital raising, requiring sellers to work around their timetable.

"There might be a natural acquirer, but they're so busy, with their AI strategy taking all their corporate development team's time, or needing to raise capital first, that you have to work in with their timetable. So the sale process can take longer," said Cox.

Preparation allows sellers to respond when the circumstances of a potential acquirer create an opportunity.

"Get ready, and if the natural acquirer needs something, because they're about to IPO or do a trade sale and need to bolt on more revenue, or they need a cybersecurity player to complement their platform, that's where you get the best outcomes in the current market. I wouldn't postpone. But it's about being well prepared and taking the time to tick the boxes," said Cox.