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.
