In the past, mid-market private equity has tended to turn its collective nose up at consultancies, be they specialist IT consultancies, professional practices, or marketing specialists.
It hasn’t been that difficult to explain the reticence; consultancies tend to make money by selling the time of deep specialists. Those specialists tend to be highly paid, difficult to replicate and the key individuals often own the business (frequently through partnerships rather than limited companies).
The risks to an investor are clearly that the embedded specialists might exit the business or lose their drive. Replacing them or adding new specialists to drive growth is a recruitment nightmare and client relationships are forever dependent on individual delivery.
As business models go, it isn’t the most straightforward to back. In addition, once EBITDA is normalised for partner earnings then there is frequently a disconnect between the value aspirations of the vendors and the returns requirement of the investor.
None of those fundamental characteristics of a consultancy has changed, and yet the last few years have seen a shift in the attitude of private equity investors to investing in consultancies. A recent study by law firm, Mayer Brown, shows a 179% increase in private equity investments in the business and professional services sector in 2021. We have also witnessed this trend fist hand at HMT Corporate Finance, having worked recently with consultancies such as Aker Systems, VueAlta, and The Marketing Practice to secure them transformational private equity investments.
So what has changed?
One thing that has driven private equity into the arms of consultancies is the sheer volume of investment cash private equity investment funds have to deploy. With wafer thin interest rates and stable markets, PE firms have been raising bigger and bigger funds and moving inexorably up market. In estate agency parlance it is a seller’s market and for businesses with substance and scale there will be competition to invest, almost regardless of business structure.
Another factor which now makes consultancies more attractive to private equity is the use of technology to both drive efficiency and to productise those elements of the business which are capable of replication and standardisation. There is less investment risk in a business where 20% of the revenue is derived from the individually very clever, than one where 60% of it is.
Even where processes cannot be delivered or even partly delivered by technology, the embedding of intellectual property in standard toolkits and blueprints will make an investor more comfortable that the revenue engine will remain in the business and not walk out of the door. Similarly a structure which sees key client relationships spread throughout the organisation and not focussed on a few key consultants will be reassuring.
The larger and more established a consultancy is, the more likely it is to have already addressed the challenge of growth and scalability, to have created an effective recruitment machine and to have put in place recruitment, induction, training and retention programmes to ensure that there is a steady supply of the “cleverness” at the heart of the consultancy. When a consultancy business is sufficiently well established to have already demonstrated generational succession then it is considerably de-risked for an investor.
One interesting dilemma for a consultancy considering an exit, be it to Private Equity or a trade acquirer, is the balance between employed consultants and associates. On the one hand a model which is heavily dependent on associates reduces the fixed cost base and makes the business easier to flex in line with demand. On the other, unless the associate programme is very well managed and proven, there is a risk that any transaction unnerves the associate network and leaves the business significantly under-resourced post deal. IR35 risk also plays a part here and there has been a clear move in the direction of wanting most consultants on payroll. This makes it even more important that a consultancy can demonstrate strong and consistent demand for its services over time.
Private equity is driven by returns, returns are driven by market demand and market demand is influenced by shifts in societal and consumer behaviour. The flip to online working, the overnight move to single channel retail (ecommerce!) in Spring 2020 and the “work anywhere” culture which has emerged because of lockdowns, have all been favourable to the consultancy business model. Not only are key services such as digital transformation, cloud migration, social media marketing and networking often delivered through consultancies, but those consultancies are also now spending less on travel, office space, entertaining and pitching, making the model more profitable than ever.