The Wild West of Knowledge Economy M&A
The push toward digital transformation ignited by the coronavirus pandemic is remaking the M&A landscape with unusually high valuations, quickened auction processes and unprecedented deal activity.
Since the pandemic first walloped the world 18 months ago, the resulting economic impacts have been far from universal. In advising businesses in what we call the “Knowledge Economy,” Clearsight’s focus area, we recognize the confluence of macroeconomic factors at work in creating today’s unprecedented M&A market. The Knowledge Economy includes IT services, management consulting, digital transformation, life sciences and strategic consulting, cloud and data analytics, compliance and cybersecurity.
Following a brief period of uncertainty, Knowledge Economy businesses are on an epic roll. Extraordinary demand from clients is fueling incredible growth, robust valuations and a very atypical M&A market. We explore what’s creating this “Wild West” moment in M&A, from the competitive dynamics to the evolving strategies for both private equity firms and corporate acquirers.
The M&A Landscape
The Knowledge Economy experienced tremendous growth throughout the pandemic for a multitude of reasons. For one, Knowledge Economy businesses were able to pivot to remote work quickly and effectively given their own digital expertise. As with other industries, employees were more productive as they worked longer hours at home, uninterrupted by commutes or travel. IT services and digital transformation businesses also experienced a surge in demand for their solutions. In helping other companies pivot to digital and shore up their internal IT offerings, Knowledge Economy businesses scaled dramatically, and strategic acquirers and PE investors noticed.
While PE firms took a clear but brief pause in 2020, partially to allow debt capital markets to return, they refined their investment strategies and came back with a vengeance this year. Now, record levels of dry powder and newly minted funds are massively increasing competition for the highest quality assets. As competition increases, PE firms are getting more creative about the assets they invest in. This is especially evident in the dramatic increase in the number of PE firms excited about investing in the Knowledge Economy. How sponsors structure deals—and even how they pursue targets—is changing as well. Say goodbye to the old process and hello to pre-emptive offers (more on that later!).
Competition for Quality, Golden Assets
Creative investing can take many forms, but the organic growth of the Knowledge Economy put dollar signs in investors’ eyes. IT services and digital transformation became top of mind for virtually every C-suite, and leapfrogged other items on their agenda, out of necessity for their business to survive. The pandemic accelerated digital infrastructure and transformation overnight, as opposed to five or 10 years down the line, priming Knowledge Economy companies for growth as they helped other companies and industries navigate their sudden pivot to digital.
Clearsight Advisors was founded a decade ago on the premise of the burgeoning Knowledge Economy. In those 10 years, the industry continues to evolve in new and interesting ways, catalyzed of late by the pandemic. Digital transformation, one of the fastest growing subsectors within the Knowledge Economy, enjoyed active M&A pre-pandemic and has since exploded with investment activity. In 2018, PE drove 22% of the digital transformation deal volume. By comparison, this figure has increased to 29% as of Q2 2021, according to Pitchbook. Overall, the amplified interest and investment in the Knowledge Economy from both new and existing players creates increased competition for assets experiencing strong organic growth.
Strategic acquirers can pivot their investment strategies quickly to capitalize on this growth in the Knowledge Economy. Through the shift to digital, companies increasingly relied on their IT services providers, who took that as a sign to bulk up their offerings. IT consulting firms are now looking to move up market by acquiring strategy consulting firms and simultaneously looking down market at staffing firms. Not to be outdone, accounting firms are also showing interest in digital transformation assets as they seek to bolster their capabilities and reputations as thought leaders. In expanding their services, we have seen some interesting strategic combinations, including Cognizant’s acquisition of IT staffing firm Hunter Technical Resources. The transaction supports Cognizant’s path toward a one-stop shop of management consulting, IT services and outsourcing for their clients.
In helping other companies pivot to digital and shore up their internal IT offerings, Knowledge Economy businesses scaled dramatically and acquirers and PE investors noticed.
As the M&A strategies at a growing number of corporate acquirers mature, the PE community takes note of the creation of a growing number of exit options for their target investments. Additionally, PE firms look to the incredible public market valuations for many of the highest-flying Knowledge Economy subsectors with the thought of a future public offering as the right liquidity event. Some public market success stories such as Epam (NYSE: EPAM), Endava (NYSE: DAVA) and Globant (NYSE: GLOB) averaged a 39.5x EBITDA multiple through Q2 2021. Indeed, GlobalLogic’s former PE backers, Canada Pension Plan Investment Board and Partners Group, generated a solid exit in selling to Hitachi for $9.6 billion, at 37x EBITDA. More importantly, these success stories and exit valuations go a long way in convincing PE investment committees of a profitable, viable platform in a subsector. While a growing number of new funds’ investment theses focus on the Knowledge Economy, existing funds are being deployed tangentially to capitalize on industry tailwinds. In applying principles from previous investments (e.g., staffing businesses) and getting a foothold in the Knowledge Economy, PE investors can translate their experience to a system integrator or custom software engineering business. With readily available money and overflowing interest, how this competition plays out in the M&A process also defies norms.
Tradition Thrown to the Wind in the Deal Process
On the demand side, acquirers and investors are now trying to differentiate themselves by altering the traditional deal process. We increasingly see buyers attempt to pre-empt processes, hoping to knock out the competition and lock up the deal quickly. Additionally, while breakup fees—binding agreements of money- owed if a deal falls through—are not uncommon in public deals, we are now seeing PE firms introduce breakup fees into our processes, often as early as in their Indications of Interest stage. Buyers are also more prepared than ever to move quickly through diligence on an asset, especially priority assets. But as teams only have so much bandwidth to evaluate the dramatic increase in new opportunities, buyers continue to refine their M&A strategies out of necessity. If a buyer wants a deal, they go hard and fast, but if there’s any hesitation, they will bow out early.
Turning to the supply side, management teams are calculating how to take advantage of the tailwinds in their industry. While some are simply riding the wave of the active market, others are capitalizing on their PPP loans and weighing potential capital gains tax changes in 2022. More private companies are becoming comfortable investing in sell-side market studies and quality of earnings to ensure a more seamless marketing process. This pre-market due diligence in turn helps buyers move quickly on an asset, continuing to fuel the competitive M&A market.
When the pandemic first gripped the world 18 months ago, we were unsure how it would affect businesses. Today we find ourselves in a surprisingly active M&A market with record valuations for Knowledge Economy businesses, spurred by an accelerated demand for anything digital at the enterprise and consumer level. Competition is at an all-time high among investors and strategic acquirers looking to snatch up companies with these valuable capabilities, resulting in a changed M&A process. As these trends show no signs of abating, differentiation and creative business strategies will be key for both acquirers and private companies looking to successfully transact. A trusted advisor like Clearsight can help Knowledge Economy businesses navigate these and other uncertainties to forge ahead in this Wild West of M&A.