The M&A imperative for tech services

The Covid-19 crisis has impacted all industries globally, including the tech services sector. Global companies’ spend on tech services—which includes IT, BPO, and engineering R&D—has shifted to digital. Organisations are increasingly prioritising service providers with deep capabilities in delivering next-gen technologies. Consequently, the competitive landscape is changing rapidly. There is a new breed of service providers—digital specialists—who are rapidly gaining a share in this market.

While established tech services companies are investing heavily in building their digital capabilities, some of them are struggling to do this organically. Such players are now leveraging the mergers and acquisitions (M&A) route to acquire these digital capabilities and drive growth.

Tech services companies with M&A success have performed better than peers, driving 100‒300 basis points of incremental top-line growth (analysis based on Capital IQ data). Over the past three to five years, the strategic rationale for M&A has also shifted towards capability-driven acquisitions—a majority of these deals are in key growth hot-spots such as front-end digitisation (mobile, UI/UX), cloud services, analytics and cyber security.

As tech services companies increasingly think about M&A as a part of their post-COVID-19 growth recovery strategy, some imperatives could be considered to ensure success.

When M&A moves could hurt

M&A transactions in tech services sometimes fail to deliver desired return on investment (ROI) and top-line growth. This could be due to two factors. First, given that most digital specialists are niche and sub-scale, an accurate, comprehensive, and fair valuation of such targets may be difficult. As a result, multiple acquirers chasing these few seemingly attractive assets are increasingly paying higher premiums, raising the bar on ROI expectations. This is further complicated by the fact that there is limited proof of the target’s business model working at scale.

Second, M&As could be unsuccessful because tech services companies fail to get desired revenue synergies—according to the 2020 McKinsey cross-sell survey, less than 20% of tech services companies are able to do this. Companies may fail if key design choices—full integration or keeping the target at arm’s length, go-to-market strategy for driving cross-sell and scale-up, offering integration, and retaining talent and culture of the acquisition—made during integration are not right.

What could make an M&A successful

In the post-Covid-19 world, the CXOs of tech services companies could continue building on the M&A trend for inorganic growth by focussing on four critical imperatives.

First, put purpose before process. Tech services companies successful at M&A focus on ensuring that their M&A plan is in sync with their corporate strategy and focus areas. For example, since 2018, an Indian tier 1 IT services provider has acquired four Salesforce-focussed consulting and implementation companies in line with its strategic priority to scale up its Salesforce service line.

Typically, tech services companies have a good M&A track record when they proactively generate exclusive deal flows. As companies define and prioritise M&A themes, they could now factor in the impact of Covid-19 to identify resilient industry trends (such as omni-channel sales in retail, cybersecurity, digital workplace, or cloud transformation).

Second, place value protection ahead of value creation. According to experts, in over one-third of M&A transactions, target companies experience a dip in revenue trajectory post deal closures due to increased customer churn and talent attrition in the year following the acquisition.

Tech services companies with successful M&A moves typically focus heavily on building a “100-day value protection plan”. They identify key risks associated with stakeholders (clients, partners, employees) and use a combination of pro-active actions and contingent response plans for any potential unfavourable situations.

Third, tailor value creation plans to purpose. Tapping into digital capabilities is not a quarterly game—it may take a few years to get the right business model for the target and the acquiring company. Successful acquirers do their assessment beforehand—they evaluate cultural diversity, integration benefits and trade-offs, and potential risks to the balance sheet and brand—and are clear on what elements they want to integrate.

Tech services companies successful at M&As overemphasise culture and change management. Right from the diligence phase, they assess fit and lay down guidelines for integration teams to preserve the underlying culture of the target company.

Fourth, view M&A as a capability versus M&A as a process. The success of the best tech services companies which develop M&A capabilities can be emulated by having a dedicated team, supported by nominated functional SPOCs to help with integrations on a full-time basis. Private equity-like diligence processes can then be run with a pre-defined cadence and strict approval criteria for projected IRR, revenue growth, and margins.

These four imperatives could help the CXOs of tech services companies with an active M&A pipeline to develop an “M&A muscle” for successful transactions.

Views are personal. Kadyan is a partner in the Delhi office of McKinsey & Company. Sharma is an associate partner in the Delhi office of McKinsey & Company. The authors would like to thank Pallav Garg for his contribution to this article.