IFASep 22 2021

Private equity could be a force for good

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While the activity of private equity companies in financial services is by no means a recent phenomenon, the level of activity has increased markedly of late.

The question is: is this good for the advice sector? Or would we prefer that these third parties restricted their activities to buying producers and platforms?

As advisers, we are perhaps less sensitive to changes in the product part of the sector than we are to the current increase in activity in the advice part of the sector.

It’s no secret that well-established product distribution businesses are more profitable on a pound-for-pound basis than manufacturers

But it should not surprise us that the 'smart money' behind private equity companies has started to follow the same path as peers in other sectors. It’s no secret that well-established product distribution businesses are more profitable on a pound-for-pound basis than manufacturers.

The wisdom of buying shares in Ford dealerships as opposed to in Ford Motors itself as source of future returns is almost a cliché.

While we don’t like to describe ourselves as distributors, those who own and control the client relationships do look like distributors. And they seem to have the potential for resisting the inexorable pressure to reduce costs and margins experienced by all manufacturers, whether of pens or pensions – hence the increased private equity involvement in buying into the client contact end of our sector.

Of course, all this has always been true, but I believe that there are two other factors at play. Firstly, poor returns on capital elsewhere means that our sector is able to attract capital in search of an attractive return, and, secondly, the widespread practice of charging fees based on assets makes consolidating assets attractive from an economies of scale viewpoint.

For too many years the capital value of advisers was minute compared to that of providers, despite the fact that IFAs dominate the advice market, so it's good to see the balance change.

Positive consequences

New additional capital and the process of consolidation adding scale to advice businesses, together with potential falls in the costs of technology may mean that the long-held aspiration of advisers to own the platforms they place clients on may be becoming reality. There are a few regulatory issue to manage, but it seems to me they are issues, not barriers.

So far, so good. And I would add another, perhaps unintended, positive consequence. This additional capital injection seems to be addressing the problem of funding the exit and subsequent succession of the old guard – people of my cohort, who, with the greatest respect, are not likely to be at the cutting edge of technology and business development in the next 20 years, as many of them have been in the past 20 years. So, funding the injection of fresh blood and increasing diversity – what’s not to love about that?

But – and there is always a but – I’m not totally sure that some aspects have been fully thought through.

While advisers ‘own’ the client relationship, history tells us that non-shareholding advisers are often not engaged with the new owners of a business. Such advisers are easily able to set up shop elsewhere – either directly or as an appointed representative. If you then couple this with the fact that clients' barriers to migration are, and will remain, low, then there is a very real risk that an outside buyer deploys capital, and then sees the future value of the business dissipate.

I also wonder about the next phase. While some private equity is patient capital, some of it, understandably, has finite timescales. And we’ve all been pitched propositions predicated on another capital event in five or 10 years' time.

Who will fund this exit? I think we are still waiting on consistent proof of concept here.

And where the underlying commercial reason behind the consolidation is based on moving assets to a particular fund house or houses, then the ‘stickiness’ of passive funds on a platform may have been underestimated.

I do not wish to present those advisers and our clients who have bought into this investment philosophy as cult-like in any way, but it is a fact that once experienced, the metrics tell us that turnover away from this model is very low.

Ironically, and I hate to say it, the market for these often very profitable businesses may be narrower than for those businesses where switching between active fund groups is part of the normal client activity.

In summary, it seems clear that the rewards are high for those that get it right and keep advisers and clients on board for 10 years. 

They capture a sustainable income stream, the ability to build succession plans and they get to own business models that have proved surprisingly robust through years and years of market and regulatory disruption. Most of us have seen manufacturers and regulators come and go, but we are still here.

So, in my opinion, we are seeing a positive change – if the process is well managed and sensitive to the peculiarities of the 'herd of cats' that constitutes the current IFA sector.

Phil Billingham is a chartered financial planner at Perceptive Planning