Why mid-tier Indian IT services companies are becoming takeover targets

Two transactions over the past 20 days put mid-sized Indian information technology services companies under the limelight. On March 18, engineering giant Larsen & Toubro Ltd launched a hostile bid to take over Mindtree Ltd for as much as $1.56 billion. And on Sunday, buyout firm Baring Private Equity Asian unveiled its plan to buy a majority stake in NIIT Technologies Ltd for $709 million.

In some ways, the two transactions couldn’t be more different. Mindtree’s founders have strongly opposed L&T’s bid saying it would destroy their company’s culture while the parent of NIIT Technologies welcomed Baring’s involvement and believes it will help take the company to the next level of growth.

The different reactions aside, the twin deals undoubtedly reflect continued interest from PE firms as well as strategic buyers in mid-tier IT companies in India where market conditions have been evolving over the last five years reducing the relative disadvantage in growth.

Why IT companies are attractive bets

According to a report from Kotak Institutional Securities, the interest in IT companies could be many—the easy entry of digital services, attracting the right kind of managerial talent and PE firms seeing these IT companies as high, free-cash generating machines with steady growth prospects in the near term.

“The slowdown in the growth rate of tier-1 IT companies has constrained career growth and ESOP-led wealth creation for managerial talent. Many senior management professionals from tier-1 IT organisations are happy to move to mid-tier firms for a better profile, higher compensation (especially ESOPs) and a greater say in the business,” Kawaljeet Saluja and Sathishkumar S, analysts from Kotak Institutional Securities, explained as part of the report.

This, the analysts believe, gives mid-tier companies an edge as senior professionals from such large organisations not only bring in clients but also best practices. L&T Infotech, Mphasis and Hexaware are beneficiaries of such talent acquisition, they said.

Shrinking deal sizes and improved ability to participate in large transactions are other reasons PE players are attracted to IT firms.

“Mid-tier companies have augmented delivery capabilities over time. In addition, they have stepped up engagement with external consultants, sourcing advisories and industry analysts to sharpen their request for proposal skills for large deal leads and for right positioning,” Saluja and Sathishkumar explained.

They added that since average deal sizes are shrinking, multi-year mega deals (over $500 million) are fewer, thus bringing to the fore smaller cheques—for example, $50 million—and tenure-based deals, which fall in the sweet spot for most mid-tier firms.

Interestingly, the analysts also believe that digital transformation has altered the sourcing mindset of organisations (clients and customers).

“Clients are willing to experiment and engage with new vendors. They look for vendors with next-generation capabilities and the nimbleness to work with ecosystem partners. A few mid-tier companies have successfully competed against large players in their focus segments,” the analysts said.

They added that smaller projects should mostly augur well for mid-tier IT firms, and if they successfully implement such projects or pilots, they may become beneficiaries to large customer accounts.

In fact, the analysts said that mid-tier companies have outperformed their larger peers in the last couple of years on revenue growth and are likely to do so again in the financial year 2020.

Long-standing interest

India’s IT industry, dominated at the top by TCS, Infosys, Wipro and HCL, has attracted investments from mid-tier PE firms over the past few years.

According to data from research platform VCCEdge, the Indian IT/ITes and BPO industry has seen a total of 138 PE deals in the last 20 years with a deal median value of $16.50 million. While 2009 saw the maximum number of deals being processed, 2018 saw the highest deal activity in terms of value.

In 2018, Swiss PE firm Partners Group acquired 48% stake in GlobalLogic from Apax Partners for $960 million.

In 2016, US-based PE firm Blackstone bought a majority stake in Mphasis from HP for $1 billion.

Earlier in 2015, Baring Asia had bought CMS Info Systems Ltd from Blackstone and CMS Computers Ltd for $300 million.

In the same year, Blackstone India had acquired business process outsourcing firm Intelenet for $385 million from UK-based Serco Group. The PE firm had sold Intelenet to Serco in 2007. French company Teleperformance bought Intelenet from Blackstone for an enterprise value of $1 billion in June last year.

In 2014, Bain Capital had picked up a 25.5% stake in business process management and technology services company Genpact for $850 million.

A new and different deal

Baring’s buyout of NIIT marks the first transaction in recent times that was carried out with a forward multiple of more than 15X for an Indian-listed IT services company by a PE player, Saluja and Satishkumar said.

While Hexaware was acquired at a 10X multiple, Mphasis was offered 13X on forward earnings.

Also, according to the analysts, most PE players follow a template when looking to invest in IT firms but NIIT Technologies seems to be an aberration.

“The template that seemed to emerge from the two deals viz. Hexaware and Mphasis was to acquire companies at inexpensive valuations. The PE players improved capital allocation (increased payout ratio), put in place a good management team with aligned incentive structures and offered access to portfolio companies for business (more in the case of Blackstone),” they said.

However, NIIT Technologies seems to be reasonably well run with an accelerating growth rate and improving margins, they explained.

Speculation has emerged that Baring may merge NIIT Technologies with Hexaware. While Hexaware’s management has shown no interest in a merger, a report from investment firm Motilal Oswal claims that the merger will see the formation of a $1.2-billion IT services company with over 40% of revenue being generated from BFSI and approximately 17% of revenue coming from the transportation sector.