Written by Guy Barnes and Oliver Staple
As private equity firms continue to look for interesting areas to invest in, Professional Services has increasingly come to prominence, in particular consulting, law, accounting, and technology services firms.
What makes this an attractive market? One asset in particular stands out: human capital.
Professional services firms are filled with experts in various niches, offering expertise and specialized knowledge on demand. Combine this with the sector's potential for growth, its highly fragmented nature, diverse range of services, and the ability to secure steady streams of work, and you have the underpinnings for compelling value creation opportunities.
The value
Human capital is the most important investment we can make.McKinsey
Human capital
Human capital and intellectual capital are the true strengths of professional services firms. PE firms recognize the potential to capitalize on these knowledgeable workforces and cutting-edge intellectual assets, and do so to drive innovation and enrich client servicing.
The only way to grow a professional services firm is by hiring and developing people, either organically or inorganically. This isn't straightforward or a magic bullet; there needs to be a rigorous focus on talent, attraction, and development right from the outset.
Growth
Every investor knows growth is the most important value creation driver, and the professional services landscape offers several organic growth and M&A opportunities. The potential for geographic expansion, service diversification, scaling operations, and strategic acquisitions all present significant growth potential.
Stability
Professional services firms often have a recurring revenue model as they tend to operate on longstanding contracts. This stability, in turn, reduces risks associated with investments and enhances potential for reliable financial performance. For more conservative PE firms seeking consistent returns, this financial predictability can be particularly attractive.
"It depends on the type of revenue model, but these businesses typically have reasonably long-term clients and contracts," said Tim Freeman, a managing director and head of financial sponsor coverage at Goldman Sachs.
Profitability
Access to specialized expertise comes at a cost. Add to that low capital expenditures, and this equals high margins and an attractive return profile for PE investors.
Private equity is attracted to consultancies because of their consistent revenue streams from government agencies and financial institutions. Additionally, investment firms acquiring professional services firms do not need to invest heavily in producing physical products or constructing costly infrastructure.
The deal wave sweeping the profession means that one in three of the top 30 [accounting] firms has taken, or is close to taking, private equity investment.Financial Times
Consolidation
Frequently fragmented, there are ample opportunities for consolidation in these markets. By weaving together smaller competitors into a compelling force, benefits are gained through economies of scale, market influence, cross-selling opportunities, increased profitability, and so on.
Resilience
Professional services firms have shown remarkable adaptability and resilience admist market volatility. As many as 64 percent of clients said that how their professional services firms dealt with the pandemic increased their trust in their services.
Many companies in this space provide essential services, which are appealing for their inherently more stable and somewhat recession-resistant nature. PE firms see these parts of the sector as "safe havens" during market volatility, owing to their enduring client relationships, can't-go-without-services, and metronomic revenue streams.
Conversely, some areas are less "safe," namely the biggest sector in management consulting, financial services, which is often so dependent on the state of the banking industry.
During challenging periods, clients will be more discerning with their spending, leading to a preference for high-quality services. Brand, reputation, and service will become increasingly critical. The focus will be on how the industry can adapt to and capitalize on existing demand, particularly during times of crisis.
Topic du jour
One of the joys of professional services is the continuous evolution of businesses. By embracing emerging industry trends and staying agile in response to rapid changes, firms are able to adapt and stay relevant. This adaptability aligns well with the private equity investment strategy, which values dynamic and evolving companies.
Currently, digital transformation has been reshaping professional services firms for some time now and - enter the explosive proliferation of AI tools - the market is shifting even more rapidly. Firms have now pivoted from experimentation to at-scale deployment, which is attractive from a PE perspective.
"AI will be sure to reshape the consulting and accountancy sector, transforming the way consultants operate and provide value for their clients, as well as opening new avenues for growth and efficiency. Digital transformation is starting to disrupt the traditional pyramid consulting model, enabling firms to streamline processes, automate simpler tasks, and increase productivity," according to Oliver Vaughan, managing director in investment bank Houlihan Lokey's Business Services Group.
BCG CEO Christoph Schweizer adds to this, noting that he expects AI consulting to generate 20 percent of the $12B firm's revenues in 2024 and 40 percent by 2026. The bulk of this work will be helping corporations integrate artifical intelligence into their businesses.
The risks
Like every sector, investments in professional services come with a handful of inherent challenges and risks that demand consideration and due diligence.
Talent
Private equity's primary concern when conducting diligence on a professional services firm is talent, quality, and retention. This is the be all and end all since attracting and embedding the best talent in the space is the only growth plan. Robust talent strategies must be devised to keep top performers engaged, which includes competitive compensation packages, scaled management incentives, career development opportunities, and a positive work environment.
Talent is the lifeblood of professional services firms, and PE firms must prioritize human capital management to ensure long-term success in their portfolio companies.
Culture
Introducing a variable like a private equity owner with a professional services firm's partnership model may create conflict around shared goals and values. PE owners need to thoughtfully manage the tension between pursuing immediate profits and backing the firm's long-term goals.
Competition
As more money flows into professional services, there will likely be interesting shifts in market dynamics. Smaller, specialized firms that gain private equity support may grow swiftly, challenging the supremacy of larger, traditional competitors.
Final thoughts
PE firms seeking their next investment may find professional services to be a prime hunting ground. Characterized by predictable revenue, high profitability, growth potential, and consolidation opportunities, there is a lot of value to be created for the smart investor with capital, expertise, and strategic direction at their disposal. As partnerships between private equity and professional services firms become more commonplace, we expect exciting shifts in how professional services firms operate, deliver, and grow.
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