Read time: 3-4 minutes

“When everyone is looking for gold, it’s a good time to be in the pick and shovel business.” (Mark Twain)

Introduction

Metaphorically speaking, a company is said to be in the picks and shovels business if they are providing derivative goods and services in support of entities engaged in some primary activity.  Using the gold mining analogy, the idea is that while perhaps less glamorous, it may be a similarly lucrative yet less painful existence to simply hand out the tools than to be the ones tasked with using them.  I contend that we are amidst a golden age (or will be very soon) for service providers to the PE community, and we’re starting to see transaction activity (i.e. funds investing in their own service providers) that supports this claim.

In the U.S., private equity firms have an estimated $900 billion of unspent capital that needs to find a home.  The mandate to invest this money wisely and in a timely fashion is what drove funds to lace back up in the second half of 2020 and get creative about how to get deals done when the world seemed like it was ending.  And, as long as returns in the broader PE space remain attractive relative to other alternatives, capital will continue to flow into the system, fueling an ongoing gold rush dynamic.  The chart below illustrates the generally increasing fundraising trend for U.S.-based PE firms which has been the primary driver of elevated competition (2020 omitted for obvious reasons).

In response to increasingly crowded auction processes and rising valuations, PE firms started pulling out all the stops.  This resulted in the rise of the business development professional, CRM implementation, sector specialization, growing marketing budgets and a host of other behaviors that made PE firms start to look like real businesses.  As a peer in the PE industry lamented to me not long ago, “This is starting to feel like work.”  Therein emerged the opportunity for service providers to ride to the rescue with solutions that made workstreams more accurate, efficient, automated, and generally palliative to the plight of the investment professional.  And, to the delight of those offering their wares to the private equity community, they discovered a clientele that was fragmented, seeking tech-enablement, amenable to recurring revenue-denominated relationships and not especially price sensitive. This dynamic creates a fertile backdrop for the PE industry to begin foraging for picks and shovels businesses as investment candidates within its own ecosystem.

Read on for some examples of such businesses that I think will be primed for sustainable growth and, thus, investment by PE firms.  But first, let’s learn about the OG¹ pick and shovel magnate, Levi Strauss.

The Levi Strauss Story

Levi Strauss

In 1848, Levi Strauss immigrated from Buttenheim, Bavaria to the United States where he joined his brothers Jonas and Louis who had begun a wholesale dry goods business in New York City called J. Strauss Brother & Co.  Levi learned the trading business from his brothers, and, upon hearing of the California Gold Rush, he ventured to San Francisco to seek his fortune and arrived there in 1853.  Levi set up a wholesale dry goods business of his own and served as the West Coast representative of his family’s New York firm providing clothing, bedding, combs, purses and handkerchiefs.  Levi’s company was eventually renamed Levi Strauss & Co.

Around 1872, Levi received a letter from one of his customers, Jacob Davis, a Nevada tailor who had developed a technique for making denim pants using rivets at points of strain to make them last longer.  Davis sought to patent his idea but needed a business partner to commercialize his products.  Understanding the appeal of more durable workwear to support gold mining, Levi partnered with Davis, and a patent was issued to Jacob Davis and Li & Company on May 20, 1873.  Consequently, blue jeans as we know them today were born.

What Levi Strauss didn’t do as an entrepreneur is almost as important as what he did do.  In other words, he participated in the boom of the Gold Rush but without panning for gold like everyone else.  Of course, panning for gold held the potential of a big payoff, but a more likely outcome for prospectors was coming home empty handed after expending a lot of time and energy.  In contrast, a picks and shovels (or blue jeans) business model ensures that you get paid every time as opposed to shooting for the moon and hoping to win big.  However, without the patent on the use of rivets, Levi Strauss may never have made the impact on the apparel industry that he did.  Therefore, I conclude that it’s not enough to just be a pick and shovel-style business supporting a growing industry, you also need to develop and commercialize your version of “rivets” that make your offering both special and defensible.

In 2020, Levi Strauss & Co. generated approximately $4.5 billion in revenue with around 75% of that revenue generated from pants.  The company’s brand remains one of the most recognizable in consumer products globally.  Can you even imagine jeans without rivets on them now?

“Pick and Shovel” Sectors to Watch

The private equity industry has long relied upon service providers to support the pursuit and execution of deals.  You might say, for instance, that M&A attorneys or accountants represent classic pick and shovel disciplines, which would be true.  However, my focus here is on the emerging class of, primarily, tech-enabled service providers cropping up to make PE firms better, faster, and stronger across their various workstreams.  Note that for each sector example profiled below I’ve included an idea about what a potential “rivet” could be – in other words, what could or should these entities be providing PE firm clients that would lock them in as essential partners.

PE “Pick and Shovel” Sector Investment Ideas
Category	What They Do	Potential “Rivets”
Deal Sourcing Support	Subscription services that assist with intermediary identification & management as well as proprietary deal sourcing.	Customized information or deal flow that every other subscriber is not also receiving.  Example: One-off introduction to a business owner with a pre-established “buy it now” price.
Digital Marketing	M&A-focused agencies that help PE firms develop brand & content strategies and support the dissemination of marketing pieces across relevant channels	Ability to independently produce high quality content marketing pieces in the voice of the PE industry without relying on the PE fund client to write them.
CRMs	Purpose built, cloud-based platforms for managing interactions with targets & referral sources	Dashboard automation that optimizes BD professionals’ time and travel-management strategy and eliminates unnecessary (i.e. time wasting) activities.  Example: automated report that highlights to which cities BD professionals should travel based on deal flow data2.
Workflow Management	Tech-based solutions that automate & quality control drudgerous and/or human-error prone activities associated with deal execution and portfolio company management	Anything that streamlines tasks that are most frequently delegated to Analysts or Associates.  Examples: NDA mark-up, scheduling, soliciting preliminary leverage reads, teaser evaluation, etc.
Expert / Talent Identification & Management	Includes expert networks, executive search and HR strategy services tailored for PE investors and their portfolio companies	Just-in-time provision of premier caliber human resources on a customized basis.  Another “rivet” might be branded, high-accuracy predictive behavioral / cognitive assessments.
IT Services / Compliance	Specialized technology service providers that manage cloud-based, on-premise and other IT assets on behalf of investment managers	Intimate understanding of the PE industry’s specific needs pertaining to cybersecurity, compliance, technology adoption, etc. → all with rapid response times

Conclusion

The PE industry itself remains a fabulous place to make a career and a living.  It’s also true, though, that the amount of capital being managed, and the number of participants, has spawned an excellent opportunity for an array of service providers to serve a demanding yet high quality PE clientele.  An opportunity so compelling, that PE firms themselves may increasingly recognize that investment opportunities in high margin, recurring revenue generating, high retention, strong organic growth potential, low customer concentration, tech-enabled services businesses have been hiding in plain sight.

As always, please get in touch if this piece inspired any reactions, and I encourage you to share, like and comment on LinkedIn.

_______

¹Original gangster.  This is hip hop parlance for someone credited with being the primary or founding influence on a given profession or discipline.
²Anything that eliminates the indiscriminate participation in M&A conferences would be a big win and an undeniable “rivet”.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Read time: 3-4 minutes

“Every act of creation is first an act of destruction.” (Pablo Picasso)

Introduction

The pandemic is stress testing everything, and COVID-19 may finally kill several BD strategies already in decline.  This isn’t great news because finding good deals at reasonable prices is still challenging, and the menu of remaining strategies to stay ahead of the competition has become pretty limited.  Just ask anyone who has submitted an indication of interest in a traditional auction process recently.  It is not pretty.  

As it pertains to deal sourcing, investors that want to survive will essentially have two options.  First, they can go back to the well of the old reliable origination channels (i.e. intermediaries, executives, independent sponsors, direct sourcing, etc.) and commit to becoming truly excellent at the strategy or strategies where they think they have a shot at doing so.  That’s one option.  The other would be to invest in and treat deal sourcing like an innovation hub.  A laboratory, if you will, to crack the code on the next wave of technology- and marketing-driven strategies that will entice the fish to jump in the boat, so to speak.  I believe that the best originators in the lower middle market will start to approach the private equity game through the lens of a lead generator with the content and lead capture techniques to match.  More on this later – first, we have to pay our respects to the deceased. 

RIP Old BD Strategies

Not everyone is going to like or agree with what I’m about to say here, but it’s high time that we pour one out¹ for a few strategies that just don’t move the needle anymore. For starters, the game of staffing up one or more business development professionals to focus their energies on literally the exact same strategy every other private equity fund is employing is simply dead. The famous investor Sir John Templeton once said, “It is impossible to produce superior performance unless you do something different.” This is sage advice as we usher in business development 3.0 and say farewell to the following activities that are sort of like rocking chairs – they give you something to do but don’t really get you anywhere.

• Conference circuit.  With apologies to the ACG, it’s sort of an open secret that these events are generally not a great use of time for tenured business development professionals. And, conferences will have ever diminishing value as investment banks increasingly adopt CRMs and automatically include buyers that have expressed an interest in seeing their deal flow. Yes, there are exceptions to every rule, but the primary remaining benefits to conference attendance from my perspective are (i) allowing new business development professionals to get critically important in-person time with intermediaries that they have not yet met, and (ii) giving tenured business development professionals an opportunity to be seen and market themselves to the industry for whatever career opportunities that may produce. Outside of that, I would advise staying home, spending more time with your family and focusing on strategies that produce deal sourcing alpha.

• High volume / low value city visits. Another travel-based strategy with diminishing value is the approach of picking a city with a critical mass of intermediaries and setting up as many meetings as possible to remind investment bankers that you have a fund and want to do deals. While investment banks may be more inclined to take the meeting since you are going to be in town, the net result of most of these meetings is the same. In most cases, buyers leave with information that could have been gleaned from a phone call and investment bankers go back to doing something more productive with their time. The key here is quality over quantity and activities that produce real relationship development. Go see people in person, but be intentional about it, and go long form when you can, particularly if you can do so somewhere outside of the conference room.

• Book collecting. Many (of course, not all) business development professionals are tasked with hunting down as many CIMs as possible. Their firms judge the success of their BD efforts by the percentage of the addressable market of teasers / books that they capture. While an understandable initial approach, as firms evolve their deal sourcing capabilities, they ultimately realize that a robust top of the funnel is worthless if you can’t advance those leads through the later stages of the funnel. This is where leveled up² BD professionals earn their paycheck. Good business development pros will analyze every deal that comes in the door through what I’ll call an “angle matrix” and elevate those deals with relatively higher probabilities of closing. In other words, before any deal is analyzed on the basis of its investment merits, a firm needs to first determine if they have an angle that will allow them to prevail. As a reminder, eligible angles include process dynamics (e.g. more intimate auction), executive resources to bring to the table, prior experience / investments in a related space, a previously developed investment thesis and geographic proximity. In the end, a thousand opportunities are simply academic if the firm cannot close on one of them.

Celebrating the Birth of New Strategies

All is not lost. Like a phoenix, or odyssey³ of phoenixes, the following strategies are emerging from the ashes of deal sourcing strategies past. Some have been around for a while with varying adoption, but with necessity being the mother of invention, get ready to welcome the following approaches to the world in a much bigger way.

• Specialization.  This one goes out to all the generalists. Enough is enough. Pick a small handful of sectors on which to focus and become excellent at them. When a firm focuses, the brand becomes synonymous with the industries you care about and relevant deal flow will start to find you. The classic rebuttal to specialization is that a secular decline in one or more of the industries on which you’ve decided to focus could blow up your strategy if the timing doesn’t work in your favor. Solution: pick sectors that are specific enough to be memorable, but that are broad enough to offer room for pivots if need be.

• Thesis development. Investors that put in the work to get off of their heels and proactively call their shots by developing investment theses have advantages over more reactive investors. I’m always amazed by how much incremental deal flow arrives when I market very specific sectors of interest to intermediaries and other deal referral sources. What’s also amazing is how long people remember that you’ve stated interest in a specific sector. I’ve had people call me years after I’ve ceased a search for deals in a given industry to ask if we are still looking. Thesis development also offers a sort of synthetic specialization to generalist investors to create advantages in sourcing and closing deals. The missing piece for a lot of firms, though, is knowing how to market their theses effectively.

• Digital marketing for lead generation. If I could hold up one new deal sourcing strategy like a newborn Simba in the Lion King, it would be this one. The vast majority of private equity professionals could not articulate their firm’s digital marketing strategy despite an insistence that their portfolio companies have one. This creates a real opportunity for early movers to differentiate themselves with high quality content written for business owners that facilitates engagement. Despite an improving philosophy around PE website design that offers a more welcoming feel to business owners, funds still have a long way to go to make contacting them easier and less daunting. Hint #1: make it easier, not harder, for business owners to contact you. You don’t gain anything by being elusive. Post your e-mail address and telephone number on your website. My personal goal is to close a deal based on a lead that came in through a website form submission⁴. Hint #2: If you’re looking for a nudge in the right direction, look at management consulting websites for inspiration around content and website design – they are lightyears ahead of most private equity funds.

• Own your local market.  Yes, Virginia, private equity funds can still do proprietary deals. The way to do so is by leveraging geographic proximity to your firm, particularly in the era of COVID. All else equal, doing a deal with a local entity feels inherently more friendly, safer. Whether or not this is true is certainly debatable, but it does create an opportunity to avoid an auction process. In all likelihood, the buyer will not get a screaming bargain, because the valuation has to be sufficiently high to forestall an auction. However, the certainty of close improves dramatically. The hardest part about this approach is figuring out how to allocate the time / resources to best market yourself locally. Here are some ideas for consideration: membership in YPO or Vistage, providing regular content / interviews for the local business journal, sending personalized invitations to business owners to luncheons / events⁵, and partnering with law / accounting firms to deliver value-added in-person content (they have marketing departments after all).

Conclusion

Think like Gretzky: skate to where the puck is going to be. Indeed, there will be deals that get done through the old ways of doing things, but it doesn’t mean that this will last forever. If this stimulates any ideas or feedback, please call, email or comment on LinkedIn. Stay healthy my friends.

_______

¹The act of pouring an alcoholic beverage on the ground as a sign of reverence for friends or relatives that have passed away.

²”Leveled up” is video game speak for having attained sufficient strength and abilities with your character to take on more formidable adversaries.

³While I had initially used the word “flock” here, it turns out that the collective noun for multiple phoenixes is “odyssey”. As an aside, my personal favorite collective noun for a group of birds is a murder of crows. But what, you ask, shall we call a group of private equity business development professionals? How about a blazer of BDs (nod to Brendan Burke at Capstone Headwaters for this one)?

⁴For anyone who scoffs at this aspiration, remember the words of Arthur Schopenhauer, who said, “All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.”

⁵One last tip, if you are nearby a racetrack that offers an exotic car driving experience, your conversion rate on invitations for such an event will be exceptionally high.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Read time: 3-4 minutes

“Information technology and business are becoming inextricably woven.  I don’t think anybody can talk meaningfully about one without talking about the other.” (Bill Gates)

Introduction

Something is up in the world of IT services.  Investors are flocking to MSPs like the salmon of Capistrano¹.  By my last count there are now approximately two dozen PE-backed MSP platforms in the U.S., and the majority of this deal activity has transpired within the last three or so years.  So, why now has a sector like IT Services, historically less of a focus for private equity investors, stimulated so many transactions?  Well, come along with me on a journey into the history of IT Services to find out where MSPs came from, where they are now, and the specific attributes that have compelled investors to place big bets on the sector.  To start, let’s define what an MSP is.

• An MSP, or Managed Services Provider, is a business that, on an outsourced basis, provides the following primary services to businesses of all sizes and across industries:
  • Subscription-based management of cloud-based, on-premise & other IT assets;
  • Onsite project-based services (e.g. network design, deployment & repair); and
  • Hardware / software re-selling & implementation

In short, MSPs are delivering the same services your in-house IT guy² used to offer onsite but now on an outsourced basis, and often remotely.  However, this wasn’t always the case.  In fact, MSPs weren’t even always referred to as MSPs.  The following section will explain how IT services companies have evolved into their current form.

A Brief History of the IT Services Industry

The need for IT support emerged alongside widespread adoption of technology, which in the earliest years simply meant a transition away from legacy communication and productivity methods to the use of computers.  And, with more computers came more opportunity for things to break.  Thus, the IT Services companies of the 80’s that initially focused primarily on hardware re-selling to participate in the rapid growth of business computing inevitably found their way to break/fix services when issues emerged that customers weren’t capable of or inclined to solve on their own.  So, if you’ve ever heard the term “VAR”, or value-added re-seller, this simply referred to an entity that provided hardware and/or software but also the ancillary services to assist with technology implementation, maintenance and repair.  What’s really interesting is that everyone saw the growth of IT Services coming.  In an article in the Washington Post from December of 1981, it was written, “Computer service technicians – the people who install, test and maintain the equipment – will experience the fastest job growth in the industry.”⁴   It just took a while for VARs to become MSPs.

The transition from VAR to MSP began in the 90’s, though this was well before any widespread awareness of what managed services was or would become.  This evolution was facilitated, in part, by the emergence of application service providers (ASPs) which allowed for the remote monitoring and management of IT infrastructure.  Initially, remote monitoring and support was focused on servers and networks, though the scope of service ultimately expanded to include mobile device management, managed security, remote firewall administration, security-as-a-service, and managed print services.

In 2005, the modern MSP business model began to take shape, and three individuals – Karl Palachuk, Amy Luby and Erick Simpson – are credited with having pioneered the new recurring revenue model.  In fact, both Paluchuk and Simpson published books on the topic of managed services in 2006, and the MSP model began to take hold with adoption led by enterprise-level clients.  Consequently, savvier VARs migrated their businesses to higher margin, recurring revenue models and tailored service offerings to the needs of the small-and-medium sized business (SMB) community.  Since then, SMBs have responded favorably to the MSP model.  The key drivers for outsourcing IT support in the current environment include a need for:

• A more proactive and strategic approach to IT given that management of IT resources is non-core to most businesses
• Maximizing “uptime” to mitigate the risk of disruption from technology malfunction
• Enhanced risk management / compliance support in light of regulatory requirements that can put an outsized burden on SMBs
• Cost savings / better forecasting – MSPs often provide for cheaper and more predictable costs (via fixed monthly fees) relative to in-house resources
• Access to newer technologies to keep pace with change and cybersecurity needs

Today, the global managed services market is estimated to reach over $250 billion by 2022 with an expected growth rate in excess of 10%.

Why Private Equity Funds Like MSPs

PE funds are smitten with MSPs. One need only look at the large and growing volume of transaction activity in the industry to draw this conclusion.  The following graphic and supporting commentary will explain why.

1. Investing behind technology growth.  Worldwide IT spending is expected to increase 4% annually through 2022, and a great way to invest alongside this growth without taking direct technology risk is to invest in MSPs.  This is because MSPs are not necessarily beholden to any specific technology and can nimbly adapt, and help their clients adapt, to inevitable technology change when it occurs.  Although the backdrop within the MSP industry is technology, the B2B nature of the service offering is comfortable for non-tech investors and will likely be a gateway for firms with less tech experience to get closer to technology plays.

2. High fragmentation.  The most credible figure I’ve seen is that there are an estimated 3,700 MSPs in the U.S., the vast majority of which are owned / operated by individuals (i.e. rather than by VC or PE funds).  And, in most cases, the basis of competition is largely local or regional with no clear national leader serving SMBs.  Therefore, the sheer number of remaining independent MSPs bodes well for the ability to build regional leadership through a focused acquisition strategy.

3. Meaningful “white space” remains.  Believe it or not, an estimated 30% or so of SMBs have not yet outsourced the management of their IT needs which suggests strong organic growth potential via new client acquisition.  Further, MSPs continue to offer a compelling value proposition for SMBs to outsource this service, so it’s likely that any slow adopters of the MSP model will ultimately see the light.

4. Contracted, recurring revenue.  Contracts are customary in the MSP industry which provides good revenue visibility to investors and management teams alike.  Most MSPs will have some mix of recurring managed services revenue, project-based work and re-selling income, but the best MSPs will derive 50% or more of total revenue from MRR.

5. Tangible benefits of scale.  Investors want to know that there are real benefits to scaling their MSP platforms aside from simply generating more profitability.  With MSPs, growth means the ability to better leverage fixed costs (e.g. Network Operations Centers (NOCs), internal software expense), achieve better pricing & mindshare from key product / software vendors, and access more resources to support customer acquisition which can be expensive when targeting SMBs (e.g. Sales force, digital marketing).

6. Consolidating, but still early enough to grow via M&A.  To borrow a baseball analogy, we’re likely in the 3^rd inning of the MSP industry’s consolidation.  Despite the fact that there are two dozen or so private equity-backed MSP platforms, many markets have little-to-no representation by consolidators.  In other words, secondary or tertiary markets continue to present opportunity for investors.

What a “Good” MSP Looks Like to a Private Equity Investor

With nearly 4,000 MSPs in the U.S. there are going to be good MSPs and not-so-good MSPs.  Fortunately, many MSP owners have readily embraced best practices and KPI benchmarking to maximize the valuation of their business.  Here are some general guidelines for what a private equity investor is going to look for in an MSP.

	Explanation
1. Higher Value-Added Service Offering	There’s no faster way to determine how commoditized (or not) an MSP’s service offering is than to look at their Gross Profit Margins.  Ideally, you will want to see Gross Profit margins in excess of 30%.  Higher margin services include managed services and cybersecurity whereas less value-added services include things like hardware re-selling and routine project-based work.
2. Strong Recurring Revenue Profile	Across all industries, companies are doggedly chasing MRR in the interest of maximizing the value of their companies.  MSPs are no exception – in fact, the most tangible benefit of IT services companies evolving from VARs to MSPs has been their ability to capture more recurring revenue.  So, investors are generally going to want to see 40-50% or more of an MSP’s revenue tied to recurring maintenance and monitoring services.
3. High Client Retention	One of the benefits of the MSP space is a tendency for service providers to retain clients.  I would argue that MSPs doing a satisfactory job or better should not be losing accounts with the exception of those clients that go out of business or get acquired.  Therefore, annual client retention should be in excess of 90% for a good MSP.  Below that level, and MSPs will need to have a pretty good explanation as to why.
4. Longer Contract Terms are Better	For the same reason that investors like recurring revenue, they also like contracts – increased certainty of future revenue and profits.  Contracts are customary in the MSP space, so suitors will typically want to see a minimum of 1-year contracts (particularly for any larger accounts) to provide more comfort around stability of an MSP’s clients.
5. History of (Successful) Acquisitions	Insofar as M&A growth is a compelling way to rapidly grow the scale of an MSP, an investor will take comfort in the fact that an MSP has lived through at least one acquisition and integration exercise.  Anybody can talk about doing add-on acquisitions, but until you’ve done them, you won’t have the benefit of knowing the pitfalls to watch out for.  Interestingly, investors may even like to see that one or more prior deals didn’t go well such that you won’t make the same mistakes again.
6. Sophisticated Client Acquisition Engine	The double-edged sword of high client retention is that it can be hard to unseat the incumbent service provider of a prospective client.  Therefore, a material portion of organic growth for an MSP will be the acquisition of clients that may have not previously had a relationship with an MSP.  This means that MSPs seeking to ramp up organic growth will have to invest in things like sales personnel, SEO and digital marketing with the attendant processes behind them to produce good outcomes.  An MSP with organic growth of less than 5% may not yet have cracked the code on client acquisition.
7. Client and End Market Diversity	Most private equity professionals learn in Investing 101 that customer concentration is bad.  And, as a general rule, investors will pause if any customer accounts for 20% or more of total Revenue.  The beauty of the MSP space is that many MSPs are serving the SMB community which often translates into a very appealing diversity of accounts with limited dependence on any one or more clients.  Similarly, end market exposure can create risks if, say, an MSP is serving a preponderance of clients in a cyclical space that may put a swath of those clients out of business every time a recession hits.  So, investors will want to see a healthy mix of industries served and may hesitate around a focus on clients within sectors like Energy or Construction, for example.
8. History of Adaptation to Technology and Industry Change	One thing is for sure, there will be technological change to which MSPs will have to adapt in the future.  A good present example is the migration to the cloud and the implications that’s having on on-premise maintenance and hardware sales.  So, a good MSP will have proven able to nimbly react to prior periods of technological disruption and help their clients respond accordingly.  After all, the beauty of the MSP industry is that most MSPs are not beholden to any one technology and should be able to successfully adapt during times of change.  A negative sign would be if an MSP holds firm to declining service offerings in spite of clear signs that the world is changing.

In the Land of the MSP, the MSSP is King

Wait, what is that extra “S” doing in there?  If you’re like me, it actually took me a while to admit that I wasn’t quite sure how an MSP differed from an MSSP.  To eliminate any doubt, an MSSP is essentially an MSP that specializes in providing security-as-a-service offerings for their customers.  In other words, MSP + strong cybersecurity capabilities = MSSP, and the acronym stands for Managed Security Service Provider.  While MSPs have been around for nearly 20 years, MSSPs have only recently started to emerge as a more sophisticated variant on the traditional MSP model.  This is important because there will likely be an ongoing and increasing need for companies to embrace best practices in thwarting the cybervillain community lest they be subjected to ransomware or some other crippling attack on their business.  So, the mission critical and esoteric nature of cybersecurity is likely to create a high growth, high margin opportunity for MSSPs for the foreseeable future, and investors will react accordingly by demonstrating strong interest in both acquiring MSSPs and helping their existing MSPs get their extra “S”.  The challenge is going to be when MSPs simply start referring to themselves as MSSPs in an effort to elevate their valuations.  Investors will need to respond in kind by asking more granular questions about service offerings, creating an interesting cat and mouse game while it unfolds.

Conclusion

We hope this sheds some light on why private equity funds like investing in MSPs and what they’re looking for in an MSP.  As always, we’re here to help, so give us a call to start a conversation.

_______

¹Yes, I realize that the proper saying would have been, “…swallows of Capistrano,” but I couldn’t help myself³.

 ²I must admit that one of the things I miss most about having an in-house IT guy at a prior firm were the colorful stories about niches of daily life not often frequented by members of the non-tech community.  My all-time favorite involved a lengthy diatribe about the alleged dangers of using ammonia to clean out a ferret cage given the potential to lose consciousness – an unfortunate experience endured by our IT guy on more than one occasion.

 ³If you somehow don’t know that this is an homage to Dumb and Dumber, then you are likely terribly confused by the reference and should watch the movie immediately to enhance your awareness of an essential film in the canon of American comedy.

⁴The same article from 1981 also addresses the notion of technology-driven job displacement when one economist is quoted as saying, “What we’ll see is a large displacement of many people as more computers and computerized robots are brought into the workplace.”  If this sentiment sounds familiar, it’s because the idea of AI’s potential to eliminate jobs is presently top of mind for workers across most, if not all, sectors.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Read time: 3-4 minutes

“The child is both a hope and a promise for mankind.” (Maria Montessori)

Introduction

The basic definition of a “do well by doing good” industry is one where you can achieve financial success as a result of owning or operating a business that benefits society. Perhaps the most readily acknowledged sector that embodies this concept is education. For decades now, investors have flocked to for-profit educational products and services, and in many cases strong returns have ensued alongside the enrichment of students of all ages.

Presently, a growing recognition of the benefits of early childhood education (ECE) is stimulating entrepreneurship and investment alike in facilities focused on serving children up to around eight years of age. To start, children who attend preschool are more likely to have eventually attended and completed college. Further, preschool educated children are less likely to be arrested, more likely to graduate high school and less likely to struggle with substance abuse as adults. For these reasons and others, the evidence overwhelmingly points to the conclusion that preschool is a good idea, and parents are voting with their dollars. Another powerful driver of the industry’s growth has been the increased labor force participation rate of women which now sits at around 58% of the female population. This trend has elevated both the need for childcare as well as disposable incomes. Today, the U.S. ECE industry is around $28 billion and growing at a rate of 5% annually.

The Different Types of Private Preschools

In this context, preschool generally refers to childcare centers with an educational focus. Preschools are typically more expensive than traditional daycare and charge tuition that is paid directly by families (i.e. not subsidized). When referring to the different types of preschools, more often than not, you’ll identify them by their pedagogy. If you weren’t previously familiar with the term pedagogy, it stems from Greek word paidagōgia which essentially means “to lead a child”, and the dictionary¹ defines pedagogy as follows:

• Pedagogy (pe-dә-gō-jē): The art or science of teaching; education, instructional methods.

The preeminent pedagogies include Montessori, Reggio Emilia, Waldorf and other / unaffiliated. In terms of the number of schools, Montessori has emerged as the leading branded pedagogy by a fairly wide margin. The following section provides a brief history of how Montessori schools came about followed by a high-level comparison to Reggio Emilia and Waldorf in the accompanying chart.

The Montessori educational philosophy was developed by Dr. Maria Montessori, an Italian physician and educator. The first Montessori center was opened in 1907 in an apartment building in Rome and enrolled 50 or so children of low-income working parents between the ages of two and seven. Through observation, Dr. Montessori took note of incidence of deep concentration, repetition of activity and a sensitivity to the order of the environment. It was in this first classroom that Dr. Montessori discovered that when given autonomous choice of activity, the children demonstrated more interest in practical activities and educational materials than in the toys provided for them. She concluded that a self-directed environment would allow the students to develop better self-sufficiency and reach higher levels of understanding. Indeed, four- and five-year olds educated through her methods quickly gained a proficiency in writing and reading far beyond what was expected for their age. These early observations led to the formalization and implementation of practices that became the cornerstones of the Montessori pedagogy. By 1911, the first Montessori schools were opened in the U.S., and by 1916 there were more than 100 schools in operation. The Montessori method later experienced some setbacks in the 1920’s based on criticism from William Heard Kilpatrick, a highly regarded educational figure, with nearly every school shuttering as a result. However, the Montessori pedagogy experienced a resurgence in the 1950’s, and today there approximately 5,000 Montessori schools operating in the U.S.

The Thesis for Investing in Private Preschools

When strong industry growth, fragmentation and elevated profit margins collide, it tends to create a fertile environment for private equity investing activity. The following graphic and supporting commentary will provide some more color on why private preschools present a compelling investment thesis.

1. Compelling reason for existence. As one of the classic “do well by doing good sectors”, early childhood education benefits from both strong social and commercial tailwinds. Further, numerous studies point to lasting benefits of preschool that extend into adulthood. Early childhood education is just one of those sectors that’s hard to argue about – it seems to only offer positives.
2. Large & highly fragmented industry with strong growth. As mentioned previously, the U.S. early childhood education industry is around $28 billion and growing around 5% annually. The industry is comprised of over 20,000 preschools with the largest direct competitor having an approximate 2% market share. So, given the fairly extreme fragmentation without the presence of nationally dominant competition, there exists an exciting opportunity to build strong local / regional / superregional preschool footprints.
3. Private pay model. The variety of preschools contemplated here are private pay models that do not rely on government subsidy. This means that tuition is paid directly by families, and preschool operators will thus not be exposed to any political forces that could adversely affect revenue generated through government programs. Think of it this way, as an investor or owner of a private preschool, it would make for a less stressful existence not having to worry about uncertainties created during election years, and your school’s valuation will be better than one that has exposure to subsidies.
4. Attractive unit economics. Generally speaking, a well-managed mature school can generate $2-3MM of annual revenue with 20-30% EBITDA margins. If you assume a build-out cost of $500k-1MM, then there is good rationale to grow via a greenfield, or de novo, strategy.
5. Franchising potential. If you investigate some of the larger private preschool operators in the U.S., you will come to find that many of them have sold franchises to independent business owners. Franchising can be an excellent way to rapidly scale a school’s footprint by allowing entrepreneurs to invest the capital to own and operate their own schools. In our case, we’ve invested extensively in franchising, so this dynamic creates a merging of two arenas on which we are presently focused – private preschools and franchisors.

What Investors Want to See in a Private Preschool

With over 20,000 preschools across the U.S. there’s a wide spectrum of operating models and resulting performance. From an investor’s perspective, the following KPIs and benchmarks are generally indicative of a well-managed preschool.

	Explanation
1. Sufficient Child Capacity to Support Critical Mass	There are exceptions to every rule, but we generally look for capacity of around 150+ students. Using basic assumptions around tuition, this allows for a critical mass of revenue and profitability on a per school basis.
2. Utilization Indicative of Parent / Community Satisfaction	High utilization is generally indicative of parent satisfaction with a school, but you don’t always need to see that a school is 100% utilized. While full utilization is encouraging, it doesn’t provide for the best student experience or organic growth outside of tuition increases, so investors will generally look for utilization of around 85%+.
3. Reasonable Operating Tenure	There’s something to be said for longevity. If a school has made it past the 3-year mark, it’s generally operating under a viable model. Investors may have some hesitation around schools that have not yet withstood the test of time.
4. Relevant Accreditation	NAEYC accreditation is a great stamp of approval for a private preschool operator. It shows that they not only took the initiative to make sure their school met important threshold performance and curriculum standards, but that they also passed. Investors may also take comfort with certain pedagogy-specific accreditations (e.g. American Montessori Society, Association of Waldorf Schools).
5. Strong Reputation; Proven Results	Schools with positive online reputations show that they both are paying attention to how their brand is regarded and that they have been validated by parents. Good sites for preschool ratings include GreatSchools.org and Yelp. Assuming a sufficient number of reviews to be statistically significant, it’s hard to see how an investor would get excited about a school with below a 4-star rating.
6. EBITDA Margins in Excess of 20% for Mature Schools	Tuition for private preschool has reached a level that should create for healthy profit margins for school operators. Many families are now paying upwards of $10,000 / year (or more) per child to attend preschool. Investors will generally want to see 20-30% EBITDA margins for well-managed schools.
7. Multi-Site Presence	For a private preschool operator to be considered a “platform” for an investor, they will need to have proven their ability to replicate results across a portfolio of schools. Using general estimates about profitability on a school-level basis, many investors will want to see around 5 or so schools to provide for both a sufficient base of profitability and conviction that the management team has the capability to expand the company’s footprint by opening and/or acquiring new schools. Given the fragmentation of this industry, and the propensity for owners to operate 1-2 locations, larger operators can be harder to come by.
8. No Headline Issues	There is nothing scarier to a parent than the threat of something bad happening to their children. So, prior incidents at a school are going to make investors extremely cautious. Depending on the severity of the issue, an incident at a school could have an extremely damaging effect on a school’s ability to survive and thrive in a local community.

Conclusion

We hope this illustrates why investors are taking interest in private preschools and some of the attributes they will look for in a school operator. As always, we’re here to help, so give us a call to start a conversation.
_______

¹Per dictionary.com

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.