Why Acquisitions by Public IT Service Companies are Declining

During the first quarter of 2014, publicly-held organizations accounted for 29.4% of the transactions involving IT Professional Service Organizations (ITPSOs). This percentage is consistent with results following the 2008-09 recession during which time publicly-traded firms accounted for an average of 31.2% of deals per quarter.

However, this percentage stands in stark contrast to the acquisition activity among public companies following the 2001-02 “dot-com” recession. During the recovery and growth period (2003-07) following the Internet Bubble, publicly traded firms accounted, on average, for 54.3% of quarterly deal flow.

Why has there been such a dramatic change in M&A activity among public companies from one post-recession phase to the next?

The Unstated, Driving Force Behind M&A

To fully understand the difference in public company-driven M&A activity, it is imperative to understand the driving force behind an M&A transaction from a buyer’s perspective. Typically, organizations will represent (in press releases etc.) that the primary motivation for a particular acquisition is to:

• Expand geographically,
• Increase available service offerings,
• Strengthen the existing management / sales / delivery team, and / or
• Diversify the current customer base

In fact, any and all of these reasons may be true. Further, any and all of these reasons would justify an organization’s post-transaction contention that it has increased its ability to address current / future market opportunity. However, these “competitive enhancers” are generally the result of a particular transaction rather than its driving force. Buyers do not need to acquire offices in other locations, acquire new service offerings, acquire additional employees, or acquire new customers. Organic growth strategies exist to accomplish all of these objectives. Buyers can “build” them.

Buyers choose to acquire for one reason: leverage.

The Significance of Leverage

Leverage is the created “synergy” that allows a merged entity to take disproportionate advantage of available market opportunity. When created through a unique combination of buyer and seller, leverage provides the “it” factor that allows an organization to capitalize on “quick-strike” opportunities that facilitate the proverbial 1+1 equaling 3. Leverage encapsulates the power behind the economic concepts of supply and demand. Consequently, when present, leverage renders an organic-growth, “build” approach impotent.

The Impact of Perceived Risk

For buyers, leverage not only creates disproportionate opportunity it also mitigates risk. Typically, buyers desire to pay themselves back in 3-4 years following the close of a transaction. Leverage in a transaction provides a buyer greater confidence in its ability to achieve this internal Return on Investment (ROI).  This confidence, however, is predicated on a buyer’s belief that it can utilize the acquired asset in a market that provides a suitable opportunity for financial return, one with sufficient “demand” to justify the transaction.  As it relates to the most recent economic recovery, herein lies the rub: public companies perceived an increased risk to ROI due to a lower level of confidence in future IT spending growth.

This concern was been well founded. As compared to the most recent recovery, the recovery following the “dot-com” recession was well-defined. Once it began, the uptick in IT spending was both pronounced and pervasive. There was a rising tide that lifted all boats. The recovery following the “Great Recession,” however, was / is more appropriately characterized as one of “slow growth.” While there have been scattered pockets of higher growth, the same “recovery” has not been experienced universally.

Due to this fact, buyers have been less keen on taking M&A-related risks. Additionally, buyers have been more conservative in the valuation of potential acquisitions (required to ensure appropriate ROI). A comparison of quarterly M&A volume, as well as general valuation levels for ITPSOs during the past two recoveries, supports these facts.

The Effect of Risk and Public Disclosure

While it is possible to argue that transaction-related risk has increased measurably for all buyers during the most recent recovery, there is a stark difference between private- and public-company risks. That difference is the requirement for public disclosure (of both potential risks and the results of risks taken). The very idea behind public disclosure is to promote accountability, to impact behavior. In regards to public company M&A activity, the increased risk of having to disclose an underperforming acquisition, due to the “slow growth” recovery, has certainly impacted behavior.

Conclusion

Given the relatively conservative projections for short-term IT spending growth, it is unlikely in the near-term that public companies will return en masse to the activity levels of 2003-2007. Similar broad-based acquisition opportunities that allow for organizational leverage do not currently exist. However, public companies will remain focused on those isolated segments within the broader IT services market that include both leveragable organizations and the opportunity for disproportionate market growth.

Mr. Snyder is one of Forum’s Expert contributors. If you enjoyed his commentary, please read more in The Lyndhurst Partners Review: A Summary of Quarterly M&A Activity for IT Professional Service Organizations 1Q, 2014