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Why PE is hot on consultancies

Traditionally, consultancy business models have not lent themselves to the interests of private investors. They have typically relied on highly-qualified employees undertaking project-based work – a scenario which tends to generate ‘lumpy’ cash flow profiles: not ideal for investors looking for regular income streams. Some strategic acquirers also have concerns around the challenges of integrating people-based businesses and of ‘cashing-out’ major shareholders and fee-generators.

However, these perceptions are rapidly changing, and valuations and deal activity in the sector has begun to flourish. Where previously uncertainty in the market hindered investor confidence, now the allure of high-quality specialist consultancy assets across the sector, and a recognition and understanding of the impressive returns that many consultancies generate, has acted as a catalyst for growth in M&A activity.

By: Alex John

Obviously, the consultancy market covers a wide spectrum of business models, serving a diverse range of end markets and thus demonstrating differing values to investors. Of the key subsectors, IT consultancies are currently the highest rated. These companies boast a strong market sentiment, with gross margins consistently above 30% and are seen to have intrinsic value, enhanced by ‘hot’ areas of interest, such as digitization, cyber-security and managed services. Similarly, professional services consistently trade at high EBITDA multiples, reflecting the high levels of expertise and intellectual property associated with their service delivery.

That being said, technical consultancies have shown strong revenue growth in recent years, off the back of robust automotive and infrastructure markets and a recent recovering oil and gas market. While they have demonstrated strong growth in recent years, human capital resourcing commonly attracts the lowest valuation multiples, reflecting lower margins and ‘value-add’ in their business models.

What are the key value drivers?

There are several characteristics that have heightened investor appetite in the sector. Firstly, consultancies offer a high quality of earnings. Despite the project-based nature of many consultancies, private equity (PE) investors have identified that a clear track record of repeat work with loyal clients can prove attractive as an earnings stream. On top of that, longer-term projects have helped provide better earnings visibility, a fact valued by investors.

Then there is the matter of scale and diversity that consultancies can offer. Greater scale implies less reliance on key clients, and as well, larger consultancies often have evolved talent management and proven business development processes that reduces reliance on key individuals. This diversification of a consultancy’s client base and staff helps mitigate perceived risk in the eyes of investors.

High-quality consultancies that boast well-developed knowhow, and solutions that can be easily implemented across multiple clients and enhance margins can also drive considerable value. Where these capabilities are underpinned by custom software and technology platforms, it will attract a meaningful premium.

In addition, strategic investors and acquirers will be keen to know what they are buying into in terms of key ‘assets’ in the business. Fundamentally, consultancies are people businesses, so a strong base of directly employed consultants will benefit a firm’s worth, whereas an excessive reliance on a self-employed base of ‘associate’ consultants can have the opposite effect.

Finally, any scope for international expansion has become an increasingly attractive proposition, as it reduces vulnerability to localized economic cycles and allows opportunities for companies to service larger international clients.

What trends are apparent in deal activity?

Recent high-profile deals illustrate the scale of interest that the consultancy sector is generating in terms of international investment. Trends show that the financial services consulting sector attracts the most private sector attention and there is a particular focus on the pursuit of opportunities that allow for a buy-and-build type strategy. A recent notable example is Permira’s investment in Duff & Phelps for $1.75 billion in late-2017 who in turn acquired risk consultancy Kroll in March this year.

Numerous sector experts have taken the stance that they are better off under private equity ownership, as illustrated by Clayton, Dubilier & Rice’s $474mm investment in financial services specialist Capco in May 2017, acquiring majority control from technology firm FIS. Looking at the wider consulting sector, private equity investment at the mid-market level is significant, generating substantial returns. Example deals include, Graphite Capital’s acquisition of leadership consultancy YSC, generating a 2.4x return for Livingbridge and HgCapital’s investment in Citation.

What’s becoming evident is that previous assumptions about the consultancy industry’s unsuitability for private equity investment have been clearly proven wrong. The reality is that the sector has enjoyed a huge surge in deal activity, demonstrating an increasing appetite for investment as well as opportunities for future growth. Fundamentally, this is down to investors acknowledging the high quality of consultancy businesses, as well as understanding the key drivers of value: the prevalence of expert knowledge, loyal client bases, strong HR infrastructures and opportunities for international expansion. This increased interest will invigorate the sector, stimulating deal activity and powering future development.

Alex John is a Partner in the London office of Livingstone, with a focus on the business services and industrial sectors. He has advised on and led over 40 completed transactions since joining the mid-market M&A firm a decade ago.