IT services M&A in the time of a pandemic
Between March and May 2020, Accenture announced nine M&A transactions. During the same period, India’s oil to telecom conglomerate Reliance, raised almost $13 billion in eight investments, with Facebook investing c.$6bn for a 9.99% stake. Even the stock markets have recovered fairly well after the initial crash.
Looking at these, one would think the COVID-19 pandemic has hardly had any impact on the deal market. But this may not be the right picture. Because most of these transactions were in the works before the crisis.
In the private markets, there has certainly been a marked effect on investments in new projects, including M&A.
Cash flow and future projects have seen the biggest impact...
In the IT services market, the most significant impact of the crisis has been cash flow. For the bigger companies, this impact is somewhat mitigated due to large mission-critical projects, that have stable cash flows. These projects cannot be shut down overnight.
The impact is far more severe for mid-market companies with less than $100 million in revenue. With their own cash flows down, large enterprises are re-negotiating payment terms and rates with their IT vendors. While this has not had a direct impact on revenues (which are on an accrual or as-worked basis), working capital management has been challenge for CFOs of mid-market companies.
Large enterprises are also consolidating their vendors, which are benefitting bigger players at the cost of mid-market players.
Also, this has effected one of the key areas where mid-market companies differentiated themselves from the bigger players – niche, high impact projects in newer technology areas. With such projects being shut down or put on hold, future revenue outlook has become uncertain.
How does this impact M&A?
Uncertain cash flows and future projects make it near impossible for mid-market companies to provide reasonable projections – something which is critical in M&A discussions. Most transactions in this sector allocate a meaning portion of the valuation to earnout payments that are dependent on future revenue and profitability margins. Companies are just unable to provide these in the current environment.
Discounted billing rates are leading to lower Gross and EBITDA margins – another important metric in determining the valuation of an IT services company.
In this environment, entrepreneurs may be better off weathering the storm till growth kicks in again. Consequently, a lot M&A discussions which were in their early stages have been put on hold.
Even for certain buyers with leveraged balance sheets, cash conservation is key. Hence making expensive inorganic investments right now may not be the right decision.