Private equity's buying and building for profit ‘not that straightforward’

In April, Foster Denovo became one of the latest advice businesses to receive funding, with an investment of up to £100mn from Crestline Investors, a Texas-based institutional investment management company.

The increased appetite from US private equity has led to increased competition for assets in the UK, says Howard Garland, a partner at Pollen Street Capital, which invested in Kingswood in 2019.

“US private equity… currently sees UK wealth management as better value than US equivalents, which have traded at premium valuations to the UK peer set,” adds Garland. 

An industry prime for private equity

Analysis by Dyer Baade & Company, a corporate finance boutique, counts 31 active private-equity-backed consolidators at the end of last year, 16 of which received investment in 2021.

“Advice firms have a very high percentage of recurring revenues,” says Daniel Baade, chief executive and co-founder of Dyer Baade & Company. “Typically, 70 to 80 per cent of an IFA’s revenue is recurring. This makes the revenue and cash flow very predictable, which is very valuable for a private equity firm.

“The industry is also incredibly fragmented, with about 5,000 FCA-registered firms. Most of these firms are small, they operate sub-scale and it makes sense to consolidate them.

“There’s also a market where you have a lot of willing sellers, so it’s not hard to find targets, which also makes it quite attractive.”

Three in five owners of financial planning companies are looking to exit the industry in the next three years, according to a survey by business broker Gunner & Co, with private equity companies pursuing ‘buy and build’ strategies in the financial advice industry not uncommon.

“Buying a few smaller businesses, putting them together into one larger business, and then having a value premium is a strategy that quite a few firms have done over the past few years,” says Baade. “It works, but with more private equity firms being in the sector, prices have also gone up for smaller businesses.”

Indeed, businesses are regularly selling for more than four times recurring income, up from an average of 3.4 times in 2021, according to Gunner & Co.

Private equity firms have looked increasingly towards businesses less exposed to the uncertain economy and with strong recurring revenues.Andy Strickland, Palatine

A traditionally loyal client base is another factor that has driven private equity interest in the financial advice industry, says Andy Strickland, senior investment director at Palatine, a private equity company that sold Wren Sterling in December.

“It’s a sector that requires considerable understanding however, given a complex and frequently changing regulatory environment.”

Strickland, who cites robust and thorough regulatory knowledge as absolutely paramount for any investor in the financial services sector, adds that the regulatory environment has created a lot of opportunities for consolidation, with many smaller businesses looking to join larger organisations that have better resources and better-invested compliance operations.

“It’s fair to say that historically, financial services has been something of a Marmite proposition for some houses, principally because they’ve been put off by the regulatory risk.

“However, the recent success and strong financial returns by firms that have invested in the sector has revived interest in it from those firms who have previously struggled to see the opportunity.

“This has been accelerated in the past couple of years since Covid, as private equity firms have looked increasingly towards businesses less exposed to the uncertain economy and with strong recurring revenues. As a result they’ve been willing to pay higher multiples for financial services firms.”

The importance of integration

Garland at Pollen Street Capital describes a 'good' consolidator as one that acquires and integrates smaller businesses to create a “scaled, best in class, operationally capable business that continues to offer excellent client experience”.

A specialist private equity investor will also have a deep knowledge and extensive experience of the sector and regulator, Garland says, and can add value across the different players in the financial advice industry.

Freddie Athill, investment director at Cabot Square Capital, likewise says that as a financial services specialist, the business believes that specific expertise is required. “We have technical, consulting, financing, analytical and regulatory backgrounds, which means we can give tangible help.”

Cabot Square counts MKC Wealth and SPF Private Clients as part of its current and realised portfolio of investments, the majority of which consists of companies in the financial services industry.

The business's collective experience is why business owners and executive teams decide to partner with Cabot Square, says Athill, who describes a profitable divestment after buying and building as “not that straightforward”.

The key challenge for investors is regulation and the high risk of businesses falling foul of it.Andy Strickland, Palatine

Richard Thompson, a partner at CBPE Capital who led the investment in Perspective Financial Group, concurs. “The buy and build strategy is a clear opportunity to achieve synergies and multiple arbitrage through consolidation. However, achieving the greatest returns is not straightforward and requires an efficient M&A and integration process.

“Integration is key to realising synergies, ensuring consistency of the advice proposition and good advice across the client base. The more seamless consolidation can be, the more valuable the platform [company] is.”

Although buy and build is undoubtedly a significant opportunity for private equity companies to scale a financial services business and enhance value, Strickland at Palatine agrees that it is “never straightforward”.

“Having a track record in successfully executing buy and build is essential. Being able to integrate acquisitions smoothly and generate synergies is a big part of this dynamic. A further factor to think about is creating the right pipeline of acquisitions, which does require a degree of market knowledge and understanding, which is again easier said than done.”

Financial advice firms are people-businesses, and not every financial investor understands the particulars around that.Daniel Baade, Dyer Baade & Company

Besides horizontal consolidation, another buy and build strategy available to private equity companies is vertical integration.

While companies typically do not involve themselves in the day-to-day operations of a business they have invested in, Baade highlights a private equity company's role in the investee business's strategy, citing a bolt-on acquisition of an asset manager as an example of vertical integration.

“If you think about what private equity firms actually buy in financial services, they’re buying people businesses. They don’t buy big machinery or factories. They buy an office of people who come in the morning, leave in the evening, and they hope that the same staff come back the next morning. These staff have clients, so you’re buying people’s relationships.

“Some of the [private equity] firms that are strong in the industrial sectors tend to forget the people aspect, both with the staff members and the clients.

“One of the things [that private equity firms] try to do is vertically integrate firms, so they sometimes try to buy a few financial advice businesses and then try to buy an asset management business.

“Then they hope the clients will also use the asset management function, but that doesn't always work. Some of the clients and staff don’t like it because they’re independent, and they want whole-of-market work.

“Although the private equity firms don’t get involved in the day-to-day operations of the business, they’re still very important for the strategy of the firm. Therefore it’s important for them to understand the specific characteristics of financial advice firms. They are people-businesses, and not every financial investor understands the particulars around that.”

The beginning of the end?

The increase in new private-equity-backed consolidators, deal activity and therefore valuations will make it harder for buyers to create value through simple consolidation, notes Baade, who adds that without buy and build opportunities, financial services companies do not alternatively grow by a huge amount organically.

Consolidators are also facing competition from small and regional businesses. When asked about the type of buyer they would consider selling to, Gunner & Co’s survey found that regional buyers were more popular among business owners (63 per cent) compared to consolidators (51 per cent). A small local buyer was also preferred over a consolidator start-up (37 per cent versus 30 per cent).

But in addition to the fragmentation of the advice market, Garland at Pollen Street Capital says the ability to create scaled, vertically integrated businesses will remain for a while, and should continue to provide attractive investment opportunities for private equity investors.

Strickland at Palatine likewise says the dynamics that have made financial services an attractive investment opportunity will remain for the foreseeable future, partly as a result of the constant need for financial advice.

“The key challenge for investors is regulation and the high risk of businesses falling foul of it,” he adds. “But if you have the knowledge and understanding of the landscape, it shouldn’t be a deterrent. [We] remain very positive about the prospects for the industry as an investable proposition.”

Thompson at CBPE also predicts that the financial advice industry will continue to be attractive to mid-market private equity companies, in part due to continuing levels of fragmentation.

“While the market is likely to stay fragmented for many years, the next stage of growth will likely also involve some consolidation of consolidators – an opportunity for larger private equity funds.”

Chloe Cheung is a senior features writer at FTAdviser