After an M&A deal closes – and there are breaches of any of the Representations and Warranties from the Seller – the Indemnification provision protects the Buyer from the resulting damages. In most cases, a portion (10% of the transaction value) is held back from the Seller to pay for these financial losses.
Indemnification provisions, which are enshrined in the Purchase and Sale Agreement, are an ideal way for a Buyer to mitigate risk. But at the same time, Sellers aren’t too pleased with having a significant amount of cash they expected from the sale of their business held in escrow in case of a breach.
In short, Buyers want very “broad” Indemnification provisions, covering any potential loss, while Sellers strive to narrow the scope of what breaches are covered, the amount to be potentially paid out in case of a breach, and how long Indemnification provisions can be enforced – the survival period.
As you might expect, Indemnification – and all the elements that go into it – is one of the most hotly contested deal points when an M&A deal is being negotiated.
As an advisor in an M&A deal or an owner/founder who is selling their company, it’s important to understand just how important Indemnification is – it’s definitely not an afterthought but rather a critical part of negotiations with the Buyer. It could have a tremendous impact on the amount of money you take home after a deal closes and have ramifications for years down the road if any liabilities pop up that the Buyer blames you for.
Here’s a quick analogy to break this down into simple terms:
You want to buy a Tesla. You ordered it, gave the dealer your specs, and put down a down payment. You don’t want to show up at the dealership and be given a Nissan Leaf. If that happens, you want your money back. That’s the mindset of the Buyer.
But, from the Seller’s point of view… they sold you a car. Once you drive off the lot (the deal closes), it’s not their problem anymore. They want no liability for what happens after. They expect the Buyer, after having done their due diligence, to assume all the risk.
Reps can be divided into fundamental and non-fundamental, with fundamental being core reps covering the basic operations of the business, like stock ownership, authority to sell the company, or tax issues. Of course, this isn’t set in stone. Buyers want to move as many reps into the fundamental category as possible (such as intellectual property), with Sellers resisting that effort. For good reason…
In general, survival periods can run from six months to two years on non-fundamental reps. However, when considering so-called fundamental reps, the survival period is longer.
Of course, that’s where negotiation comes into play again. Buyers and Sellers will often disagree on what constitutes a fundamental rep. For example, environmental liabilities can be very expensive and time consuming to clean up… and often these issues don’t come up until long after closing. Buyers would prefer these to be fundamental reps.
Some items are subject to survival periods negotiated separately. For example, say the target company is the subject of a government investigation – that may or may not go to the courts. Buyers will advocate for a survival period for “special” Indemnification provisions for any related reps and warranties that is indefinite – because the legal process could be very slow.
Not only do Sellers want to limit the time Indemnification provisions are in force and which types of claims can be brought, they also want to “cap” how much they might have to pay out in case of a post-closing breach.
The indemnity cap is typically a percentage of purchase price. A portion of that cap is held in escrow for at least a year or until the survival period ends. That’s money that the Seller doesn’t get to take home or distribute to shareholders at closing. The feeling is that the money might never come home because Buyers will find any reason to retain it.
Indemnification is such a contentious topic that it can slow down or even shut down deals entirely. There is a way to sidestep all of this.
Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and the insurer covers the Buyer’s damages. And unlike other types of insurance, this coverage is affordable (costing less than ½ of 1% of the transaction value) and more widespread than ever, with about 20 insurers now offering this coverage, even for deals under $20 million.
Savvy PE and VC firms, as well as corporate strategic buyers, are recognizing its benefits to smooth out deals and mitigate risk and increasingly making it a must-have in their M&A deals.
With IP becoming a standard fundamental rep, R&W insurance is ideal for small technology companies, at $20M or less, being sought after by larger firms. And if the Buyer is not interested in R&W coverage, which can often be the case for big companies, it is possible to insure only the IP reps in the deal. The premiums are just $125,000, with $30,000 in underwriting fees. A small price to pay for the Seller’s peace of mind.
If Indemnification has your M&A deal hung up, or if you’re a Seller concerned about this issue because you’re about to put your business on the market, I’d invite you to speak with me about Representations and Warranty and other types of M&A focused insurance that could protect you.
You can reach me, Patrick Stroth, at firstname.lastname@example.org or (415) 806-2356.
In the world of tech, a lot of companies, especially the smaller ones and startups, their financials are quite opaque. You never know on the surface if one is about to go under or go unicorn.
Austin Leo, VP of USI Insurance Services, highlights a specialized type of insurance, once reserved for large manufacturers, that can help larger companies identify who to do business with… especially those with the least risk of going under before they pay their bills.
And that’s just one benefit.
It’s a great example of insurance coverage that adds tangible monetary value… even when you don’t have a claim. Austin walks us through the many ways these policies help and how they work in real-world terms.
Tune in to find out…
Patrick Stroth: Hello there, I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here: that’s a clean exit for owners, founders and their investors.
For most people, insurance is something that you pay for, but you hope you’ll never use. Even when it works, people are still not happy because something bad has had to happen in order for you to put your policy to use. Now there are insurance products out there that provide tangible monetary value without the policyholder ever having to suffer a loss. Rep-and-warranty insurance for M&A transactions provides this very value-added capability, and that’s what inspired me to pivot our program here at Rubicon M&A insurance to focus on insuring M&A transactions.
Today, I’ve asked Austin Leo of USI Insurance Services to join me to discuss another product out there called trade credit insurance. Like rep and warranty, trade credit provides significant financial benefits without ever having to incur a loss. That’s probably why private equity firms are now warming up to this and using it on more and more of their portfolio companies. But, I’ll let Austin tell you how. Austin, thanks for joining me today. Welcome to the program.
Austin Leo: Hey, Patrick, thanks for having me. appreciate you having me on. Glad to be here.
Patrick Stroth: Well, let’s give everybody listening here some context. How did you get to this point in your career, where you’re a specialist in this very technical area of insurance?
Austin: Sure, so good question. Sometimes I asked myself that myself. So, you know, I started off my career actually working in PR, and then ended up at a company, they were a French company, that specialized in company information in the B2B sector and advertising your products in that sector to specialized clients. Ended up you know, you know, really like that part of the business, especially the information side of that. And, I ended up at an insurance firm by the name of Coface. Now, Coface is a French insurer (second-largest trade credit insurer in the world), and I started off there as an underwriter and soon found that insurance was fascinating to me. Especially the trade credit side of things, whereas you mentioned, you know, you don’t really need to find the value when a claim happens— you can do that much earlier. And we can talk about that. But anyway, ended up you know as an underwriter, a Coface. Then went to manage our global clients, and then went on to the broker sodas business with my own firm. And then, eventually joining USI.
Patrick: Well, as with a real diverse industry like insurance, there are products that can cover any number of different exposures. Why don’t we help the audience out here— what is exactly trade credit, and then who uses it, or who’s the traditional user of a trade credit insurance policy?
Austin: Sure. So trade credit insurance helps companies identify their risks, it provides companies with information on their customers, the insurance side of it really covers a company who is selling on open account terms— open account credit terms to another company— it helps them mitigate that risk against non payment, slow payment, or bankruptcies and insolvency.
So you’re selling to another company, for whatever reason, they don’t pay you or cannot pay you. That’s when credit insurance would kick in, and pay a claim on the non-payment side of it.
Patrick: So they step in and pay your outstanding accounts receivables because the client disappears or is somehow unable to pay?
Austin: That’s exactly right.
Patrick: And the traditional policy was— I can think of these where you’ve got big ARs out there were large industrial manufacturers, textiles, commodity type things. That could be the typical client of this. But nowadays, are there other clients, particularly in the tech sector, where this could be used?
Austin: Yeah, absolutely. And you’re right, Patrick. You know, a lot of companies that have used trade credit insurance are, you know, manufacturers, distributors, the commodity traders, but, you know, manufacturer or distributor of components. And that was kind of the traditional side of a user of trade, credit insurance. Use it for multiple things, you know, both for mitigation and enhancements, financing, and sales. But now we’re finding that in the tech sector, you know, a couple of things are happening, right? Tech companies tend to be a bit focused on sales, especially to companies they might not have a ton of information on, or are new to the industry.
So that leaves you, you know, at risk to non-payment, or lack of information on your companies. And as I always say, you know, a sale isn’t a sale until it’s paid or collected, right? So, it’s great that you’re sales focused and offering open account turns to other companies, but until it’s paid, it’s not a sale. So, that’s where we find tech companies benefiting from the trade credit side of things, you know, the heavy AR stack on the book, the last thing you want is for multiple companies not paying you, customers not paying you.
And then I mentioned on the information side, you know. Newer companies, prospective clients… it’s tough to pull information. I mean, of course, you know, you can, you know, Dun & Bradstreet, CreditSafe is a provider of B2B company information. The insurance companies also have big databases filled with information, and they do their due diligence. I mean the last thing they want to do is, you know, pay a claim, right? They want to be profitable. So, the information that we find from the insurers tends to be better than some of the stuff we find from, you know, like the DMV. So, yeah, I think the benefit in the tech side is, you know, data information on your prospects, clients. And then, of course, you know, mitigating the risk of non-payment or insolvency from those clients.
The other thing that we find is the financial benefit.
Patrick: Before we get into the financial benefit, I just want to go back just on a really nice use case scenario. So you have… what the service that you can provide as your insurance product can provide background checks for prospective customers. So if you’re a tech firm, you’re about to sign a major contract with a potential customer, they could turn to their trade credit insurance and say, we want to sign up this company in South Korea as a client, they’re going to pay us X dollars… and we don’t have as much information. But, the insurance company with their resources, can find out whether or not that potential client in South Korea is a good or bad credit risk. Is that is that how that works?
Austin: Yeah, that’s correct. So yes, you know, we want to sell to company A in China, you know, notoriously, it’s kind of known in China, that it’s tough to get financials. The insurers are able to do that along with banks. So yeah, you know, we expect to have, you know, 2 million open, you know, AR exposure at any given time… high AR exposure at any given time. What do you guys think? And then the trade credit insurance will come back and say, “well, you know, you know, either yes, will approve the 2 million and, and here’s why. Or we’ll do a partial approval of that.” And give you information on why, you know, maybe they’re late to pay other suppliers, and that’s in their database, maybe their financial conditions have worsened Or, you know, the last answer you want here is, is “no,” but it’s relevant, you know, information, right.
The last thing you want to do is try to turn bad credit into good credit. Never works out. We’ve seen it time after time. So, yes, the credit insurance information… or I’m sorry, the credit insurance companies are all members of the Berne Union, and they share information with one another.
So you’re seeing the information that you know, the bank’s get…. the insurance gets, but you might necessarily not.
Patrick: Wow, so then, not only are you protecting your client from from a perspective loss, but you’re just giving them that that background information so that they can make a better decision that’s got to improve, you know, they’re not necessarily I think, guaranteeing this AR is out there. But, they are really protecting those.
That’s got to make a company’s lenders really happy. I mean, you had just referenced me there is a financial benefit, I can imagine, you know, with their, with their lenders, companies, lenders would love if the company had this kind of protection.
Austin: Yeah, and you bring up a good point, Patrick. So, yeah, the lenders, they love trade credit insurance. Especially when there is ABL: an asset-based lending facility in place. You know, companies… everybody thinks about their assets, right? You know, you have the people, you have your property, you have your inventory, all of those are insured, right?
A lot of times companies don’t think about your receivables as an asset. And they are, and in some cases, they’re the largest asset a company has. So the lenders love it when the foreign receivables are insured with trade credit insurance because it allows them to include those into the borrowing base of an ABL. It also allows them and their credit folks in the bank to feel comfortable raising advance rates, which is really key. You know, you could have a company that has a facility that’s getting, you know, an 80% advanced rate on their assets. With trade credit insurance, the bank can bump that up to 85%-90%.
We’ve seen companies that have gotten, you know, 1 million-2 million, just an increase in working capital, just from having a trade credit insurance policy.
Patrick: Wow. And so, in addition to mitigating risk on the one side, you’re now improving their accessibility to more cash. And that’s got to be just a great benefit that offsets any costs. And this can also be used in a couple of other things, not just for increasing your cash flow, but does it impact on other operational things like your sales?
Austin: Yes, yes, it does. So, you know, you could have you can have a group of customers, right? Where your credit folks internally, within the organization say, “we’ve looked at the financials based on the information that we have, you know, credit report financials, we’re comfortable granting $2 million dollar limit for them in credit.”
Whereas you there could be a credit insurer saying, “you know, that’s great. You know, we have information, we can justify a $4 million limit, and would be willing to include that in a credit insurance policy and underwrite that and ensure that.”
So, I mean, in essence, you know, you can go above and beyond what you might be comfortable doing internally, from a credit standpoint. And you’re just having a partnership with the credit insurance company, letting them take on that risk and really risk transferring that which in turn, you know, you can sell more to a customer… you’re obviously going to increase your sales, depending on how many times a year you do that, and what the open account terms are. So yeah, we’ve seen companies, I mean, in general— we have statistics on this, based on what the insurers provide— companies can increase their sales by 20%, just by using the trade credit piece.
Patrick: Okay, so that’s benefit three. Benefit one was protecting yourself with the information on prospective customers that you can get from the trade credit insurance company. Number two is improving terms from your lender, so they can get more cash flow probably improve their lending rate, and then you can increase sales. So all those are tangible, testable, you can do with evidence and so forth.
So that really is something. Do you have any case studies or just use examples in the technology sector? I know, you’ve been writing some tech company lately, you share with us some examples of that?
Austin: Sure. So, you know, we had a tech company that we’re working with, that had a private equity company go in, and partner with them, right. One of the things that were not making them look, so financially sound was the bad debt reserve that they had on their balance sheet.
So, you know, tech company, as I mentioned, you know, tech companies can be so much focused on sales. So they, were, but to the wrong companies, right? So, piled on a ton of AR, which turned into bad debt, which, you know, when you have bad debt, you have to keep a bad debt reserve on your balance sheet, which negative negatively impacts working capital.
So, what we did for them, is, we were able to use credit insurance as a way to take out that bad debt reserve, right? You can completely remove that from your balance sheet, transfer that risk to the insurer. In addition to that, they had, you know, two or three clients that were a concentration risk. So the three clients made up about 70% of their business. So what we did, and what the lender liked and in the private equity company, they liked that removing that risk of concentration, right? Because God forbid something happens to you know, one or two of those three big clients completely would put them out of business. So we’re able to transfer that risk.
And then from a financial standpoint, they were able to get additional working capital, from some of the foreign receivables and increase to their advanced rate on their ABL facility. So the working capital paid for the credit insurance policy times ten. And the main thing that, you know, we’re sitting down, we’re talking with the CFO, and he goes, you know, what I don’t want is to detract from sales, right? We’re a sales-focused organization, that is where we want to stay focused, we need to grow. So the tool that they really liked was, you know, using one of the large insurers for their database, and even before selling to a company, a new customer— they were able to go into the online portal of the insurer, putting the company’s name, where they’re located, and the credit limit needed, they would know before they even made the sale, if that would be eligible for trade credit insurance. Which gives them a competitive advantage, right? So you know, the information, the lending, and then removing the bad debt reserve off their balance sheet, completely changed this company. It was actually amazing to see what we’re able to do for them.
Patrick: Yeah, the one thing is private equity firms are notorious when it comes to insurance, they really do not like spending any dollars on premiums unless there is some real value coming in. So, it’s a real validation for you to have private equities firms now becoming more active and really warming up to that. Have you seen a growing trend of that with private equity?
Austin: Yeah, absolutely. I mean, you know, when private equities go in, and they invest in a company, they want to make sure that they’re getting the best return on their investment. Right. And they don’t want to spend any more money than needed. That’s for sure. So yeah, yep.
You know, we’ve seen I mean, yeah, there’s a way for us to do a financial benefit review. Right? So, before you even get the trade credit insurance policy, there’s a questionnaire that we have, there are things that we like to review, to see if it would be, you know, cost-effective or cost-prohibitive to the, to both the company and then the PE firm.
So yeah, we’re seeing private equity use tree credit insurance a lot more. You know, over in Europe, the trade credit insurance market is like 60% to 70% of companies use trade credit. Here in the US, it’s about 12% to 15%. So I think it’s just, you know, a lack of knowledge… a lack of people out there in the marketplace really educating people on trade credit. And we’re starting to see that come around. So, yeah, private equity firms are getting very keen on it. And understanding the benefits and utilizing the trade credit, you know, from the financial benefit, and from a risk mitigation benefit. For sure.
Patrick: Well, it’s all it’s also nice, because even before they have to commit to securing a policy (there is an application process) but they can find out dollar-for-dollar, how much more they can make before the even have to get a policy, I think that’s a really nice element. We see the same thing and do it proposing terms of rep warranty where you can go ahead and get the terms of a deal set up and we can already kind of model “well, here are ways that you’re going to be able to exit the transaction with more cash than you would if there were no insurance.” I mean, and usually, the financial benefit is a multiple of whatever the cost is.
So it’s as a lot of people say, once they learn about trade credit a little bit more just as with rep and warranty, the same to word description they just say it’s a no brainer. And that’s why I really think the more people that learn about this, and see how it’s being deployed is a real benefit. What’s the application process? What is there a minimum eligibility requirement? What’s the process? So if someone were to reach out to you, how would they get started?
Austin: Sure. So no, there’s no minimum requirement for trade credit. There used to be. But as we’ve seen, you know, I was talking to a client of mine 10 years ago, there’s about, you know, maybe 10. In insurance companies who’d be willing twice, right trade credit. Now, there’s about 25, or 26, we can go to, which kind of, you know, change the market and added a ton of additional capacity into the marketplace and softened the market as well, which is good for prospective buyers.
So no, listen, not a very labour-intensive application process. Basically, they want to understand, you know, who is your company? What do you guys do? Have you had losses in the past? Who are your customers? You know, one of the benefits from going through the application process is, as I mentioned, you have lots of markets to go to, you have lots of insurers who have big databases full of information. Basically, you get a free review of your top 20 customers, by multiple sources. So you could have five or six trade credit insurance companies saying, here’s what we think about all of your top 20 customers, here’s how we would risk rate them. And if we see any problems, here’s what we see. So it’s a nice kind of due diligence process, as well, as you know, looking into the product itself. So no, essentially, you know, you can reach out to me, we have our own application that all the insurers accept, and we’d be happy to guide you through the process and see if it’s something that’s right for the company.
Patrick: How long does the process take?
Austin: Generally, applications, you know, sitting down working on it, I’ve had clients fill it out within, you know, 20-30 minutes. I’ve had clients take months to get back to me, but I think it’s due to other priorities. But listen, you know, I think, you know, sitting down, it should take no longer than 20 minutes to maybe an hour if you have all the information necessary.
Patrick: Well, the other issue is just how long does it take for the insurance carriers to processing? Assuming full submission, complete submissions out there to you go to the 20 markets for them? How long is it approximately… weeks? Days?
Austin: No, it’s… you know, Patrick, it’s relatively quick. If we have a filled-in application, and we submitted to the market, we expect to have responses back from the insurers within a week to 12 days. So, you know, two weeks if you’ll all of the markets have quoted, and will sit down with people and talk about the pros and cons to each.
Patrick: Well, that’s that is it, there is no reason for someone not to reach out because just having the information will… even if it’s a no-go, that that information, I think, is a tremendous use to business owners out there and management firms and so forth.
Austin, these products are tailor-made for each and every particular client, there’s not a lot of heavy lifting, the cost is a fraction of what the benefits are. So there’s no reason why you shouldn’t be flooded with people reaching out. How can our audience get ahold of you so that they can see if this is a fit for them?
Austin: Sure, so you can feel free to contact me via LinkedIn, which is Austin Leo. You can reach out to me at Austin.Leo@USI.com or there’s always the phone which is 908-240-5145.
Patrick: Excellent, Austin. Thank you very much for helping me bring in another value add that doesn’t require somebody suffering pain in order to get benefits. So thanks again.
Austin: Patrick, thanks for having me on. I appreciate it, it was a pleasure.
It’s a landmark moment in the world of M&A. Marsh JLT, the world’s largest insurance brokerage, has announced they successfully placed the first Transactional Liability policy at a $1 Billion Dollar Limit, the largest such policy ever written. As impressive as this may seem, it’s only a matter of time before a larger policy Limit is placed on an even bigger transaction. This is just one of the many data points outlined in the Marsh JLT 2019 M&A Trends report.
The biggest takeaway is that if you have a billion-dollar deal – you need look no further than Marsh JLT. They have the resources and experience to handle these very opportunities. I’ve always believed the world needs the Mega Brokers like Marsh JLT because “someone” has to insure Disneyland!
This is just one indication of how the benefits of transactional insurance, especially R&W insurance, is being recognized by Buyers and Sellers and made an essential part of a growing number of transactions, even for transactions going as low as under $20M.
According to Marsh JLT’s June 2019 Transactional Risk Insurance Report, which looked back at trends in this space in 2018, there are 25 firms offering this specialized type of insurance. That’s a sizeable increase from the handful offering this coverage just a few years ago.
More policies are being written as well, with Marsh JLT alone experiencing a 40% increase in policy count, from 359 in 2017 to 504 in 2018. The median transaction value for those insured deals was $135M. The size of the average R&W policy placed is about 10% of the transaction value.
Industry-wide, the number of M&A insurance policies rose for the fifth straight year, according to the Marsh JLT report, driven by strategic acquirers who are gaining confidence with this product. The number of R&W transactions conducted in this sector increased by 21% from 2017 to 2018. PE and other financial acquirers are already comfortable with this insurance, with PE being the majority users.
Of the policies written, 99%, were Buy-Side R&W, leaving only 1% as Sell-Side R&W. Buy-Side policies continue to represent the vast majority because they provide broader protection (i.e. covering Seller fraud) and because they best facilitate a “clean exit” for Sellers, with no indemnity obligation and less, if any, money held in escrow.
This allows the Seller to have most of the sales price in hand when the deal closes so they can move on to new investments or distribute funds to shareholders and investors. That’s the reason why Sellers, in many cases, are more than happy to pay for this coverage.
Looking at trends and what the future holds, it’s clear that the increase in usage of R&W is the direct result of three factors that aren’t changing anytime soon:
It’s also important to note that Underwriters have more experience than ever in writing R&W and other transactional risk policies. This allows this component, including due diligence, to become a seamless part of an M&A deal.
All this is taking place with a very healthy M&A environment as the background. The Marsh report notes that global M&A activity jumped 11.5% from 2017 to 2018 to $3.5T, even as the total number of deals actually fell. That’s the fifth year in a row that deal values have topped $3T. PE firm buyout activity, meanwhile, was valued at $557B, which is the highest level in 10 years.
Expect to see increased use of R&W and other transactional risk insurance in the rest of 2019 and beyond.
The great news for specialty firms, such as Rubicon M&A, is that Marsh’s growth into the billion-dollar deal level opens a wider gap of underserved deals as there are far more sub-$135M deals out there with the exact same needs for protection and service. We’re thrilled to have Marsh JLT out there to serve the mega-deals. We’ll handle the rest!
To discuss how Representations and Warranty insurance can impact your next M&A deal, contact me, Patrick Stroth, at email@example.com or 415-806-2356.
After culling through a decades-worth of data on IT services companies, Colin Campbell, Associate Director at Livingstone Partners, sees the potential for a market downturn on the horizon.
He shares what trends he sees that point to this potential slowdown, as well as how Buyers and Sellers approach M&A deals to account for it.
Colin says that Strategic Buyers are being quite selective in companies they target and tend to go after the company aggressively once they “fall in love,” wanting to move quickly and are willing to pay a premium.
This is in contrast to Financial Buyers (like private equity PE firms) who may have a wider appetite for acquisition targets, but factor into their analysis the possibility that values may level-off or decline due to an economic slowdown or other factors – they are mindful of the potential downside when pricing a target.
In our conversation, we take a deep dive into the above concepts, as well as…
Patrick Stroth: Hello there! I’m Patrick Stroth.
Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. And, we’re all about one thing here: that’s a clean exit for owners, founders and their investors.
Today, I’m joined by Colin Campbell, Associate Director at Livingstone Partners. Livingstone Partners is an independent M&A advisory firm with a proven track record of delivering exceptional outcomes for private and public businesses and financial sponsors. Colin recently published a piece titled “Does An Old Bull Need To Learn New Tricks?” which outlines possible changes in the M&A sector for tech. Which is counterintuitive to the current thinking of late of the unending robust market for M&A in general, and tech in particular. And if slow down is in the cards, well… what middle-market companies do about it?
Colin, thanks for joining me, and welcome to the program!
Colin Campbell: Thank you, Patrick. I appreciate it.
Patrick Stroth: Before we get into this report that focuses largely on the IT services companies… tell me about you, give our audience a context for you. How did you get to this point in your career?
Colin Campbell: Sure. So, I’m a multi-time entrepreneur. I’ve started a couple of businesses over the years, I’ve been an operator, I was in private wealth management for many years, focused on estate planning, asset management. And, I think at some point, I had experience from a private wealth management standpoint, guiding my clients through mergers and acquisitions, and decided that that was really an interesting part of the business. And, I think an aspect that really sort of captured my attention.
And so, at some point, I pivoted towards an M&A role coming out of USC, so I did USC undergrad at Marshall School of Business, and then graduate school, also at USC Marshall School of Business. And now, in my spare time, when I’m not advising middle-market businesses on sell-side transactions, I’m also an adjunct professor at the Marshall School of Business.
Patrick: Well, you’ve kept yourself pretty busy there! Now, with this report you recently published, “Does An Old Bull Need To Learn New Tricks?” (which we’ll link to at our show notes here at RubiconINS.com)… what led you to focus on the report? Where did this come from, and give us an overall genesis of what led up to this report?
Colin: Yeah, so, we spend a lot of our time talking to business owners that are contemplating a transaction in the next 36 months. And, at the same time, by virtue of the processes that we run, and then staying current on the market, we’re talking to a lot of buyers. And, what we find is that there are some interesting trends going on right now, not only from evaluation perspective but also from the overall economic timing, the catalyst as to what’s driving some of these transactions, and felt like in many instances, there’s a bit of a disconnect between sellers and buyers and the thought processes. So, we thought it made sense to do a little deeper dive, look at it from a historical context. And so, we pulled all the transaction data for the last 10 years in the IT services space and tried to start drilling down into what sort of conclusions can we start to extrapolate from the data?
And I think what we found is that, you know, there’s a longer-term trend— not only in deal size (and by that I should say multiple), and also deal count— where there are the beginning impressions that while we’ve been in a very, very long bull market, that there are indications that things are starting to slow down and potentially turn. And from our perspective, our clients are generally operators that are looking for a sell-side transaction. You know, there are important considerations to take account for when you’re thinking about what could happen to the economy, and specifically, what could happen to your particular sector in the next 12 to 24 months.
So, the idea behind the article was: let’s start to suss some of that out, let’s start to talk about what some of those trends are. And, obviously, the actual implications are going to be very specific company to company, operator to operator. But, it’s important to start thinking now for many of these business owners, how does that actually impact their specific business, given their specific situation, and their businesses nuances?
Patrick: Well, where you’re targeting this with technology when people talk about technology is as diverse as somebody talking about retail. You can have everything from widgets to items over at Tiffany’s, in the scope of the wide variety of things. And what I liked about what you add here is you are trying to broaden your research for all things, to all people in tech. You focused on a real finite specific group with the service providers. Tell us about that… is it just because those were the most numerous classes out there? Or is there a preference there? You know, most describe the categories of tech that you looked at in the service provider side, and then why those projects?
Colin: Yeah. And, Patrick, you make a great point, right? I mean, as you look across all of the various industries, even some of the most traditional ones, you’re seeing more and more technology being infused in these businesses. And, that’s ultimately impacting those valuations and those transactions. I think the reason why I tried to focus is that you can’t look at all of it in one fell swoop. It has to be distilled down more than that. And so, where I spend most of my time, is within the broader landscape of business services. We’ve drilled down into IT services, and that’s really what this is focused on.
Beyond that, I spend even more time really thinking about IT consulting and other services businesses, which is one of the three legs to the stool, if you will, in this IT services landscape. That tends to be where we spend a lot of time talking to business owners that are operating on one of the cloud platforms that are: providing consulting services, that are leveraging technology to impact other businesses, that are managed services providers, that are actively shifting their business towards a slightly different mix (from maybe an older, more traditional consulting business). And so, that’s seemed particularly relevant to my experience, and where we were spending a lot of our time these days.
So when we take this broader IT services space, and we drill down into data processing and outsource services being one tranche, internet services and infrastructure being the second tranche, and then IT consulting and services being the third… What we find is that there’s each one has their own DNA, their own trends. And, it’s important to think about, even though they do overlap, overlap in some instances, where specifically a business would lie, and then that’s going to significantly drive, how they ultimately become viewed and valued in the market.
Patrick: Why don’t you give us a quick synopsis of each. What is data processing? And then, what the predictions are based on the report from what you observed. Segregate that from internet services, and then segregate that from IT consulting.
Colin: Sure. So, data processing and outsourcing services businesses are what we might think of as your traditional data, big data business, right? They’re dealing in a lot of numbers, are dealing and a lot of data points. They’re trying to draw out really unique insights from vast quantities of data. And I think what we see here, in some of the analysis is that the number of transactions in this space is somewhat limited. And I think there’s a number of reasons for that. I think you have to look at deal volume, in concert with deal value. And what you find is that, for many of the historical years, the deal value has been very volatile. So, multiples in this particular space have been very high and very low. And, I think that’s a function of the limited number of transactions that you see in a space. And so, it’s a common interaction right between supply and demand that when there’s an imbalance in the market, it’s going to drive values either very high or very low.
Recently, we’re seeing a downtick in multiples in the data processing space. And I think there’s an argument to be made that as data is becoming ever more prevalent. And, I think there’s plenty of sources out there that say, we’re generating more data today on a daily basis than we were generating monthly, or annually, not that long ago. And, the rate of data creation is becoming such that to just be able to analyze the data is not becoming as unique, and it’s becoming almost maybe more— dare I say— commoditized to take data points, compress them together and try and pull out some insights. It’s becoming much, much more difficult to find something that is truly unique and insightful, versus something that’s become almost a little bit more regular way. So, I think that’s driving down some of the values in that space. But there are so few transactions in that sector, that I think there is room for someone to come out if they truly have something unique, whether it be unique insights or a very differentiated data set that is truly proprietary to their business, that I think that drives meaningful value in that particular sector.
Patrick: I hate to interrupt… On one thing, though, with the data processing, and just a quick question for some of us less tech-savvy folks. With the data processing, you’re processing… you’re handling raw data and organizing or analyzing that, does that then lead toward artificial intelligence? Or is AI a factor… a part of data processing?
Colin: It’s a factor of it, I think it depends on how you. And that’s where part of the complexity with trying to distil down a large data set that it tends to get a little bit murky around some of the edges. And so, there are companies that are, are effectively both a consulting and advisory practice, but leverage AI and have data processing capabilities. So, if we think about it more in its pure form— I think the data processing itself tends to be more data collection, data aggregation, and data analysis, and less the true cutting edge AI. Now, the more technology-infused and the more cutting edge of the more advanced you are, certainly, that pushes you towards a higher value because now you’re talking about something that is truly unique. It’s truly differentiated, and typically has some kind of moat around it. In terms of it’s difficult to replicate, it’s one of a kind, right, it’s something that is not readily available across the market.
Internet services and infrastructure. This is really going to be when you think of e-Commerce when you think of online, and what I would consider information services businesses. So, this is going to be oftentimes a B2C model, and it’s really online-based, I think these businesses, again, from a volume standpoint, there are fewer trades that go on year in and year out. And, the range of size of the business is very, very broad. And so, that also creates a fair amount of volatility in terms of the valuation of those businesses.
So right now historically, call it the last three years, these businesses have been trading high single digits, and year to date, we’ve seen actually a limited number of transactions to validate any sort of thesis around where they’re currently trading. They really tend to be predicated upon, what is the type of traffic the businesses generating? What is the type of service that they’re providing? What is the information in the case of online information commerce that they’re providing? And here, again, it blurs the line a little bit, where are they getting the data from? How are they aggregating it? how unique is it? Are there more proprietary insights that they’re able to pull out and then deliver to the consumer from their data set? So it’s, it’s a tends to be a bit more volatile space, just because there are fewer trades.
Patrick: And then we have IT consulting?
Colin: Correct. So IT Consulting… this is going to be the bulk of the market. And I think one reason being is that it tends to be more of a traditional consulting model. You have a high headcount, oftentimes there’s a little less technology development, there’s a little less proprietary technology. In this category, you might see companies that are considered the value-added resellers. These are called bars, or IT consulting businesses, that are truly doing what’s considered the lift and shift. So: helping businesses that are in more traditional industries integrate into the cloud. These are also managed service providers, which tend to be outsourced IT services providers. So if a company, maybe an industrial business, that is very tried and true, very traditional and its operations, but is now moving its back-office and ERP systems into the cloud and is looking to create a mobile application to empower its workforce out in the field, this would probably be an IT services or IT consulting business that is helping them to do the integration, and then build out that application and empower that workforce.
Patrick: And even though, unlike the other two categories, you have a lot more people involved. In terms when you said the headcount which was striking to me. You are saving… an IT consulting firm is saving a business by doing the work of hundreds of people with only two or three, but you still have two or three, that’s two or three more people than a data processing company may have to engage. Is IT consulting as a business… is the value and also the cost-driven by the depth and scope of the headcount? Is it a lot more tangible with people, then technology?
Colin: It is, right, technology tends to lend itself to being highly scalable. You tend to see that in growth rates, you tend to see that in margins. And so, in the IT consulting business, there’s maybe a bit more stability… certainly in the valuations of the companies there tends to be more stable. Partly, because there are more deals to be done. There are, you know, there’s the argument to be made that there is a lower barrier to entry into the IT consulting space because practically anybody can hang up their shingle and say that they’re an IT consultant. What I would argue is that there’s a greater barrier to excellence, where there are a limited number of folks that have truly been able to differentiate themselves, and build that requisite skill set that sets them apart from everyone else when it comes to cloud integration, app development, managed services, and really providing something that is value add to the end consumer. So in this case, it’s a B2B model, where data processing or technology as a whole is going to be highly, highly leverageable in terms that it’s very scalable, you get a lot of operating leverage. The more you can build-in from a sales standpoint, typically the much more profitable, the business becomes. In IT consulting, because there is typically a larger headcount, that it’s oftentimes about billable hours. It’s oftentimes a story of a project versus recurring revenue. And, that has a huge impact on value as businesses are looking to go to market.
Patrick: This is a little bit off-topic from your report, so I do apologize for this. But, in your analysis, I’m just curious… who was doing the acquiring of each of these categories? If you if you’re a data processing company, was it being bought by a larger data processing company? Or from others, some strategic buyer that says we need that capability, so we’re going to bring you in, we’re going to take you away from the market, and we’re going to bring you in the house? What percentage of the deals roughly involved that scenario where a strategic would go and take one of these three categories and bring it in the house thus removing them from the rest of the market?
Colin: It’s really been a mixed bag. And, I think as you go year by year, it changes. Whether it’s more of a financial buyer, like a private equity group, or whether it’s going to be a strategic buyer, like other operating businesses looking to bolt-on new capabilities. And I think what we’re seeing in some spaces, is you’ve got very large, very large operators that are creating platforms, right. Microsoft is one that comes to mind. And they’re creating an Azure platform. And, what they’re doing in many instances, is they’re out there buying businesses that have created unique technology or have captured large swathes of viewers, of users. And, they’re able to quickly onboard, either the capabilities, the technology, or the traffic, into their platform. And, that carries significant value for them. They’re not necessarily in the market of saying “we want to be a consultancy.” They have plenty of businesses out there that are able to do that on their behalf. And that’s where I think you see folks in the IT consulting space, where there are a large number of businesses that are operating with very good capabilities in the space: whether it be AWS, whether it be Microsoft Azure, whether it be one of the other cloud platforms. They’re able to cater to clients and operate on those different platforms. Whereas, you know, in data processing, in internet services… it’s less about whether or not you’re able to provide support services to a larger platform, it’s really more about your capabilities.
And I think when you see the economy has been very strong for a number of years, you’ve got strategic buyers that have built up a lot of capital. And much of that capital exists not only just on the balance sheet in terms of cash, but in many instances can be equity. And that’s where as a seller, you need to be cognizant of what the consideration during the course of a transaction is going to be and how you’re going to be compensated. Because, in many instances, we’re seeing strategic buyers, and this is across all three buckets. They can be very acquisitive, and very aggressive. But, oftentimes, they’re using their own equity. Which may, or may not, be considered overvalued at the time. They may look at that equity and say “that’s actually less expensive to me today, then maybe cash would be”
Patrick: Very interesting. So now with this report, what were the major takeaways you’d mentioned early on about a disconnect? What’s the biggest takeaway from this report?
Colin: Yeah, so from the buyer’s perspective, we’re seeing there are strategic buyers that are very, very specific right now in where they’re looking to allocate funds and spend money. And so they’re typically coming out with very targeted investment theses. That is, they’re looking for a particular type of asset or many instances, a particular asset, one type of business, one business in particular, that will augment their existing operations. When they get excited about a business, they’re willing to move rather quickly, and they’re willing to pay up for it. Remember, strategic companies are typically going to realize some kind of synergy, some kind of benefit from making an acquisition that a private equity company may not necessarily if they don’t already own a business in the space.
So strategic companies are able to be very aggressive, and typically pay a premium for a business that they love. But they’re going to be much, much more selective. Private equity companies right now are… they’re cautious. I think they’re looking at where we stand today in the economic cycle, and I think most if not all of them, when we start talking about projections and estimates, they’re looking at it from— I would even argue, a fairly realistic perspective— that is, there’s going to be a correction at some point down the road. Nothing goes up forever, right. Real estate didn’t, the stock market does not. So, they’re starting to bake in downside cases into a lot of their projections. What that’s doing is that’s changing their model that’s changing their financial return profile, to say that they maybe aren’t willing to get as aggressive. And so you’re seeing that private equity companies are struggling a little bit to compete in those cases where there’s a strategic company that’s getting very, very excited about a particular asset.
Now, there are still plenty of private equity companies out there with capital that has raised funds in the last couple years, that are looking to deploy that cash. And so, they’re being more thematic about their investment style. And I think that’s where — again, in particular, I focus on the IT consulting space— private equity companies are spending a lot of time thinking about particular platforms, whether that be Microsoft, would that be Amazon. They’re spending a lot of time thinking about what is the difference between project-based businesses and recurring revenue types of businesses? Like a managed services provider, where there’s a contractual agreement, that they’re going to get a certain amount of revenue every month from their end client, right. That carries a lot more value to the operating entity, and therefore, to the private equity company, when they can project out that revenue. They know it’s coming every month, it’s much more secure. And it gives them a lot more visibility into their long term revenue, that has a significant impact on their valuations today. And that’s where we’re seeing transactions start to occur. I think more often, and I think with higher values, is when you can substantiate there’s a high degree of recurring revenue.
Patrick: Well, I think another consideration out there is it really depends on the management or the owner/founder of the businesses that are considering themselves for an exit, to sell their company, would it be a strategic, or private equity. One of those things I recently learned about was that if you want to have an exit, you’re a founder, you want to ride off into the sunset… sometimes going to a strategic may make more sense, because a lot of times the strategic will bring you in, and they may be making some big significant changes in the short term with management. Whereas, if you come on board with private equity, they want to keep the existing management in place to help them as they add value and other areas. So that’s another consideration out there.
With this, this view of, you know, the possibility of what particularly with the financial buyers looking at building in possible downsides down the road and so forth. What steps should owners and founders take? I mean, this is a perspective that is out there, you can’t guarantee outcomes across the board, but you need to plan for contingencies. What’s your guide to them on what they should start thinking about?
Colin: So I think the first step that we always take, anytime we’re talking to a new business owner, is really to understand what is it they want to accomplish? What is their desired outcome? And you talked about a business owner whether or not you should sell to a strategic and sponsor based on his outcome… That’s exactly right. And so, is his goal to stay on and run the business for another five years? And does he want to transact in the next six months, or 36 months? And I think that’s an important consideration. When you think about what are the next steps.
I think, first and foremost, I would— and maybe I’m biased— but, I would argue that maybe the right place to start is you start with someone like me, or Livingstone, or whomever that can offer you advice as to what’s currently driving the market, what’s creating value? And what are those things that you need to be thinking about?
Because we’ve seen businesses to try to run quickly for a transaction thinking that the timing is right, something’s happened in their lives, and they want to go now. But the problem is, is that if their house is not in order, running that fast they end up stubbing their toe, they trip, and it creates bigger issues for them during the course of the transaction. Versus taking a step back, taking three months, six months, and making sure they’ve got their house in order.
Now, Patrick, you and I both know that a time that time kills all deals, right? So it’s a trade-off between? Do you want to wait six months? 12 months? And do the work necessary to make sure that your finances are clean, you understand what all the data is? And that’s probably one of the biggest issues is that a lot of companies that we see, certainly that are privately owned, haven’t really thought about… What are buyers going to look for when they come in and due diligence? And do I have all of the data compiled? Reconciled? Do I have all of my KPIs in place? And, having a conversation like that with someone like Livingstone upfront, I think can go a long way to making sure that you have a smoother process, which shortens the overall timeline to actually getting a deal done, and ultimately improves the probability that not only you get a deal, but that you get the value you’re looking for.
Patrick: I think one of the things is is that a mindset that sellers really should have is you should begin with the end in mind, what is the outcome you want? How are you going to get there? And, I think probably what really is a big killer, or time killer for deals in my experience has been, when you’re a seller, you’re disorganized, you don’t have the right answers, you’re not prepared for a serious buyer to come in. Even an unsolicited buyer comes in. If you are not serious and aren’t equipped to respond to them proactively, things can drag on and what the the biggest thing that happens with the time is those multiples, that valuation, just starts shrinking. And the longer it takes because you’re not prepared— and you and you may have the right answers — but that’s not formatted in a way that the buyer is prepared to receive them. It just kills everything. And I think that’s the great value you add, it’s almost like staging a house for an open house. You’re going to you’re going to incur some expenses to paint and furnish the house and get it all souped up and be cluttered and everything. And for every dollar that you pay an expert in doing that you probably reap $25 to $30 in return.
Colin: I think that’s very fair. I think that’s very fair. And if you use that same analogy, you probably aren’t going to, accept the first offer that comes in off the street, unsolicited. You’re going to want to run an auction. And I think that’s again, a value add that folks like Livingstone, folks like my team and I can provide, which is we make sure that that not only is your house in order, but that it’s being presented correctly, in order to maximize value and help guide you through that process in that transaction.
Patrick: One other thing I was thinking about, and this is because we’re based here in California, and I’m a Silicon Valley, and you’re down in Southern California. But the M&A community, particularly in tech, is not that huge. And so I think another value you probably add is not only do you know the market out there, but you know buyers, and which buyers are serious and which buyers are kind of grinders and wheel spinners. And that can be particularly helpful.
Colin: Correct. So we maintain… Livingstone has been around for more than 20 years. And all of us have been at prior firms prior to Livingstone. And so, we’ve got a very good sense as to who’s serious versus who’s just tire kickers. We know how people behave in the course of a process. And, I think that goes a long way to lending value, when you’re in the throes of a deal and you’re trying to compare different types of bids. You know which one has more teeth to it, has more meat to it. And you have a sense as to how people are going to behave during the course of the process. I think that’s that’s your point, right? That’s the value of having a more seasoned team behind you guiding you through the process.
Patrick: Well, what’s what’s the ideal profile for an ideal client for you, and for Livingstone in general, but for you and your practice in California? I know you’re not limited just to stay in the Golden State, but give us a quick profile.
Colin: Yeah, so Livingstone has offices across the US, Chicago and LA. And then we have offices throughout Europe. And so, a fair amount of our deals are in fact cross-border. I spend most most of my time working on sell side transactions. So, typically business owners that are looking to exit their business or bring in capital, whether it be private equity, or whether it be debt financing. And so, generally they’re they’re located in North America, I tend to look at businesses that have EBITDA between call it $5 and $25 million. That typically translates to enterprise value. We have a strong restructuring practice out of our Chicago office for companies that maybe need a little bit more help, have a little bit more of a story to them. Those businesses are probably in the $20 to $25 million enterprise range. And then, once we get healthier sell-side, you know, we’re typically looking at businesses that are $50 million upwards to $500 million in enterprise value.
From a sector standpoint, I’ll add, I think where I spend most of my time, is, as I said, the IT consulting and services business. And so, that tends to be anything in the IOT space, managed services providers or MSP space, anything that is cloud-related, those tend to be where I spent a lot of time thinking about, talking to buyers, talking to sellers, and tend to have a pretty good grasp of what’s going on in the day-to-day. We’ve got a number of transactions that we’ve completed here recently that have been in that space, that have gone a long way to helping inform, I think what it says in the article, but just again, our sort of industrial knowledge of of the space.
Patrick: I also think just your initial background, being in wealth management and estate planning, you definitely convey a perspective of looking for the welfare of the owner/founder or investor in this transaction and helping them transition either to short term or long term. So, I think you have an experience of beginning with the end in mind, which is very helpful. Colin, how can our listeners find you?
Colin: Yeah, Patrick, so you can email me at Campbell, spelled like the soup, @LivingstonePartners.com, or you can reach me in my office 424-282-3709.
Patrick: Thanks very much. This has been a great insightful look into the possible outcome with a slowing tech space, but just how diverse it is. And, there are ups and downs throughout. And the best way to do this is navigate with a professional who cares about your outcome. Colin, thank you very much for joining us today and we’ll talk again
Colin: Thank you, Patrick.