1. Rising interest rates are slowing deals and could lower valuation multiples.

On July 26^th the Federal reserve increased rates a quarter point into the 5.25% – 5.5% range. The outlook for continued rate increases in September and November is an open question but could potentially place rates into the 5.5% – 5.75% range.

Multiplied impact due to nonbank lender interest rates: A 1% increase in Federal interest rates generally leads to an approximate 2.5% increase in interest rates for non-bank acquisition financing. Potential acquirers often make nonbank loans for transactions due to higher flexibility in payment terms, higher loan limits, and decreased stipulations among other factors. These nonbank lenders offset increased risk with a higher interest rate than standard bank lenders.

What this means for valuation multiples: As strategic and financial acquirers look for targets in the BPO industry, a higher federal interest rate can impact valuation multiples. A potential buyer in the industry that uses financing to complete a transaction requires a certain rate of return to justify the purchase. As acquisition financing rates increase causing cash buyer return requirements to go even higher, the valuation multiples for middle market companies could decrease to 5.5X – 7.5X EBITDA from the current market average of 6.5x – 8.5x EBITDA. We have seen buyers holding to these ranges and sellers holding above causing deals to fall apart. It is worthwhile to note that in 2022 companies were transacting in the 8x – 10x EBITDA range. In some sub-segments of the market, such as USA domestic delivery BPOs with 8%-10% EBITDA margin, we have seen transactions come to something close to a standstill.  Our survey indicates only one transaction for a US Delivery only BPO in the first half of 2023.

2. Potential upcoming recession could decrease client volumes reducing company EBITDA.

6 out of 8 public BPO companies that Yellowstone Capital Advisors surveyed have reported decreased volumes from their clients in their most recent earnings calls. All eight companies commented on the macroeconomic headwinds that could potentially decrease volumes in the near-term future, however 6 out of 8 are reporting overall growth in revenue just at a slower pace.

Yellowstone Capital Advisors has met with 60+ private market BPO companies since January 1^st of 2023. In these calls surveyed by Yellowstone Capital Advisors, most mid-market private companies have reported reduced volumes or expected reduction of volumes from current client projects. However, the majority also expressed optimism in their ability to grow with new projects with current clients and new logos. Mid-market owners remain optimistic as new projects can create significant growth relative to their overall company size.

3. A decreasing Enterprise Value/EBITDA of public BPO companies could further slow the M&A landscape.

As public BPO companies’ Enterprise Value/EBITDA multiples and stock prices have been decreasing, we can potentially expect a downstream effect on private companies eyeing IPOs or wanting to transact in M&A as buyers or sellers. The larger private companies are often active as acquirers in the BPO middle market. As these strategic acquirers see potential diminishing returns from the public markets, these private companies are slowing M&A activity or wanting to transact at lower valuations to recalibrate required financial returns.

4. Generative Artificial Intelligence has caused many financial investors to slow or pause until it’s BPO industry impact is better understood while creating optimism among operators and BPO executives.

Our recent calls and surveys with financial investors that invest in BPO has resulted in a resounding hesitance to invest new dollars in new investments until the impact of Generative AI is better understood.  An exception to this has been investors who have already invested in a BPO company, those investors are being selective about follow-on investments.

Our survey of most operators in the industry yields a remarkably different view. The general feeling among operators is that the new work created by Generative AI will expand the industry and using Generative AI to deliver service will improve margins.  When and how will financial investors and operators converge on their views?  This remains to be seen.  Regardless, the impact of this cautioness by financial investors pressures mid-market deals by lowering public company valuations and limiting the initiation of new deals.

5. The convergence of non-bank interest rates and EBITDA margins is stalling M&A activity in converged markets

In this report, we already discussed the impact of the Fed on non-bank acquisition financing interest rates.  As those rates converge with EBITDA margin percentages, we can possible see an immediate slow down or stalling of M&A activity for impacted companies.  For example, with the current cost of non-bank financing in the 10 – 12% range, it is exceptionally difficult for acquiring firms to underwrite a check for a USA domestic delivery BPO company producing below 12% EBITDA margins. US Delivery EBITDA margins has historically been in the 8%-10% range.  If the Fed continues to raise interest rates, which are the next susceptible markets?  Below is a chart with historical EBITDA margin performance by delivery geography.

6. Buyers have strong free cashflow and Sellers may need improved financials to achieve the same valuation in 2024 vs 2023

Despite slower growth and longer sales cycles, strategic buyers are reporting strong free cash flow. This free cash flow keeps M&A deal activity opportunity open as buyers have cash to spend on potential acquisitions. If the outlook on volumes remains pessimistic and free cash flow remains high, buyers could become more interested in pursuing growth via an acquisition.

However, many of these buyers are transitioning service delivery into higher margin markets such as the Philippines, Nearshore (especially Colombia and the Carribean), and Africa (especially sub-Saharan Africa as a nearshore location for European clients). Heading into 2024, as strategic acquirers complete plans to increase EBITDA margin by operating in these higher margin markets, it’s possible sellers will need to deliver improved EBITDA and revenue growth performance to achieve the same valuation multiples as transactions that occurred early in 2023 and in 2022.

If you’d like to learn more about the current state of the BPO market, please send an email to Trevor Allen at tallen@yellowstonecapitaladvisors.com

Sources:

Stock price and Enterprise Value/EBITDA information:

This information has been sourced using publicly available SEC financial information for the following public companies identified using below stock ticker symbols.

TaskUS – TASK

IBEX – IBEX

TTEC – TTEC

Concentrix – CNXC

Telus – TIXT

Wipro – WIPRP

Genpact – G

Yellowstone Capital Advisors calls:

Yellowstone Capital Advisors has held video calls and meetings with 60+ companies and investors in the BPO industry. During these meetings our team has collected information for our proprietary database such as but not limited to Services, Delivery Geography, Industries Served, Revenue, and EBITDA Margins.

Earnings Calls Transcripts:

Retrieved using Seeking Alpha as a source. https://seekingalpha.com/article/4620165-teleperformance-se-tlpff-q2-2023-earnings-call-transcript.

Miscellaneous sources:

https://www.reuters.com/markets/rates-bonds/fed-seen-raising-rates-this-month-traders-less-sure-further-hike-2023-07-07/