Transformative partnerships: capitalising on digital and regulatory change
Digital transformation and regulatory change offer fresh opportunities for investors and professional services firms to work together. Strategy expert Richard Punt spoke to Inflexion’s portfolio over dinner about his expectations as the two intersect, drawing on experience from his career spanning senior roles at Deloitte, Allen & Overy and most recently Thomson Reuters.
How has demand for professional services been impacted during the pandemic and what are the prospects for the market moving forward?
It’s been a mixed bag. Some professional services are a necessity, and some more are discretionary. If areas were deemed the latter, they tended to be put off, especially in the first half of the pandemic.
Business change driven by the pandemic and the current wave of M&A mean that firms serving the larger end of the market have been doing very well. They’ve also seen cost reductions as travel has been curbed, boosting profitability. Looking ahead, there may be a bit of late pandemic bounce for firms serving smaller clients as they return to the projects they put off in 2020.
The prospects for professional services growth going forward look strong. The pace of change in the economy – whether digital, regulatory, ESG, hybrid working, global trade – will continue to drive demand for professional skills and expertise.
Digital transformation of their clients has been a key source of growth for professional firms. How is technology driving change in their own businesses?
Despite their digital work for clients, many professional firms are coming late to their own digital transformation – with the pace of change held up by their dependence on a time-based paradigm and limited capacity for investment.
We are now seeing an accelerated introduction of tech to improve efficiency but also quality, particularly in larger firms in legal, tax and accounting. But digital also offers the opportunity for new business models including subscription and managed services.
New kinds of businesses are offering a tech-enabled solution from the start and I think you’ll start to see more of this as clients look to move from one-off projects to ongoing support from their professional firms.
Regulation of professions has been an area of significant focus over the last decade. How do you see it developing from here?
The fallout from the financial crisis catalysed regulatory change in the audit market, with the UK now requiring that area to be ringfenced from other lines of business. What that means, especially for the Big 4, is they’re having to revisit aspects of their multidisciplinary model because they experience high levels of conflicts in some parts of their business. It’s a boon to firms who are are more focused and is also driving divestments – with two of the Big 4 recently exiting their restructuring businesses. It creates significant opportunity in the market – either for M&A or for other firms to emerge and be successful.
We are seeing change in the legal space too, with the impact of more liberal ownership rules having growing impact. External investment is growing through both private equity and IPO routes. It is an important next stage for the legal market given its high fragmentation and early stage in tech adoption.
Outside capital is playing a greater role in professional services. Why do professional firms seek outside capital?
When I talk to firms considering private equity investment, it’s often as much about enabling change in the governance model as it is the access to capital. Managing partners can find seeking consensus from a large partner base onerous, whereas an external investor typically brings a fresh dynamic to decision making.
A further attraction of private equity to professional services firms is to increase the pace of their own digital transformation, something many firms struggle with. An external funder can bring capital, experience and intent to drive change in what are often conservative environments.
As the benefits of scale become ever more clear in professional services, many firms in the mid-tier realise they want to be part of the consolidation rather than get left behind, so they may look to private equity to realise that goal.
What are some of the challenges for investors investing in professional services firms?
The challenges for investors revolve around people and projects. Professional services are all about their people – and some see people businesses as more difficult to manage and control, especially when the talent market is as hot as it is today. While a transaction enables partners at the time of acquisition to achieve a capital gain through selling shares, the next generation may feel disincentivised as they’re sharing the profits with external investors. It may therefore make talent retention tricky.
The other sticking point for private equity is the lack of recurring revenues which comes with project work. Professional services firms tend to have a short work pipeline. Investors can get their heads around this if they can see the customer base and capability sets are both broad. If the brand and relationships are stable, then the exposure isn’t as material as it may initially seem. On the other hand firms with a small number of clients may be less attractive to private equity. Others may look to move from a project-based area to a recurring revenue set-up.
The pace of digital and regulatory change brings opportunity, so if hesitancies on both sides can be overcome, private equity partnerships could help bring professional services firms along their transformation journey.
Professional services organisations serving active and energised end-markets is fertile ground for private equity. We are keen to continue our investment activity in the space, with our track record giving us conviction we can bring value to the businesses we partner with