Service providers are emerging as an important asset class for investors, particularly for corporate investors and private equity (PE). Take IT services, for example: a significant part of its appeal is its lack of cyclicality. The need for IT services is consistent because the services are often mission critical for customers navigating increasingly complex new technologies, especially if customers lack their own IT talent.
In many ways, the story of the global IT services industry is one of resilience and fragmentation. This combination creates opportunities to create value through M&A. In the private markets, PE firms can use roll-up strategies—acquiring multiple companies in a sector to consolidate market share—to achieve economies of scale and bargaining power and to be able to pursue larger clients. On the other side of a transaction, some IT services providers use M&A to exit legacy businesses and to improve the balance between legacy and growth in their portfolios.
To support stakeholders while they look for value creation opportunities through M&A, we have distilled some of our insights into a brief overview of important trends in IT services M&A and outline how investors can use M&A to create significant value.
A fragmented market
The IT services market is fragmented and diverse (Exhibit 1).
As of April 2023, the top 15 providers held only about 40 percent of the market.1 Our analysis suggests that the industry will likely see some consolidation because niche players may struggle to scale and large providers may seek ways to broaden and strengthen their capabilities.
Digital IT will power the next phase of growth
Over the next five years, we project that a disproportionate part of the industry’s growth will be driven by digital IT, which uses digital technologies and practices such as the cloud, machine learning, and DevOps (software development and IT operations) (Exhibit 2).2
Our analysis found more than 100 fast-growing subareas within digital IT. We call them “digital hot spots.” Each hot spot, which is projected to attract at least $1 billion of annual spending, has its own commercial and technological dynamics, including growth rate. Because of the number and variety of hot spots, many IT services providers find it challenging to build their own capabilities. This presents an opportunity for new entrants to capture a share of the growing market.
M&A is a winning strategy for creating value
M&A is a proven way to create value and build capabilities in emerging digital hot spots (Exhibit 3).3 But the kind of M&A matters. As measured by TSR from 2013 to 2022, companies that chose programmatic M&A outperformed their counterparts that emphasized large deals or did not conduct M&A.4
Because programmatic M&A helps companies manage overall risk and create significant revenue and cost synergies, IT services providers that rapidly build or scale their capabilities through M&A can break away from the pack and deliver top-quartile shareholder returns.5 McKinsey analysis suggests that when done well, M&A can not only help add one to three percentage points to inorganic growth but also lift organic growth and shareholder returns by five to ten percentage points.
Three approaches to programmatic M&A
When we examine the most successful programmatic M&A programs in IT services, we see three archetypes.
Digital specialists are digital natives that have built differentiated capabilities across multiple digital hot spots. These acquirers use M&A to acquire specialist digital capabilities that are difficult to build organically, and they use M&A to strengthen front-end consulting and design capabilities that are often found in smaller, niche companies.
Vertical specialists are tech services providers with deep domain expertise in one or two verticals. Their motivation for M&A is to strengthen vertical-domain expertise in existing and adjacent segments and to build end-to-end value propositions in those verticals.
Synergistic M&A seekers may be midsize IT services companies with strong performance and fast-growing digital portfolios. They could use M&A to broaden their offerings to present themselves as one-stop shops for IT services for midsize clients and to access new clients and geographies.
Five elements to create value
An M&A playbook executed by an experienced team is critical to closing deals and creating significant value. Five elements are particularly important.
Proprietary deal origination. In our experience, top-performing companies originate about two-thirds of their own deal flow. They may have an in-house team of researchers to generate leads, which require rigorous screening and prediligence. A short list—about 5 percent of the full list of original leads—is then passed along for detailed due diligence.
Rigorous, standardized diligence and investment governance. Strategic investors could borrow practices from PE firms. Elements of an effective governance structure include an internal investment committee (IC) that reviews investment opportunities in two or three stages; a standardized IC memo, the structure of which helps the committee assess deals’ attractiveness; and strict approval criteria, such as thresholds for internal rates of return.
Extensive focus on cultural diligence. The assessment of culture fit would ideally be thorough, so much so that it might feel excessive to participants who are not used to it. Clear choices and expectations related to the design of post-M&A integration, particularly when it comes to merging cultures, can ensure that the elements that made the target company and the acquiring company individually successful are preserved.6
Dedicated integration team and rigorous integration progress tracking. A cross-functional team should be focused on integrating the two companies. Rigorous tracking is a significant part of this team’s work—that is, tracking the integration progress, financial performance (such as revenue growth and margins), and operational metrics (such as attrition and costs per full-time equivalent).
An experienced team of leaders. A dedicated corporate development team at the relevant levels can make success more likely at every stage of M&A. Specific individuals could also be assigned as full-time points of contact to support integration.
The right playbook can help investors produce significant value from IT services. The key is to learn from the most effective approaches to M&A and spring to action.