This week, rather than focusing on short-term movements in asset markets, we look instead at the growing trend of investment in financial services companies by the private equity (“PE”) sector, particularly in the UK. For the uninitiated, private equity funds are usually set up for institutional and ultra-wealthy investors and generally target outsized 10-15% p.a. returns (larger before the financial crisis) by acquiring private or de-listed companies using significant levels of leverage and debt. Through a variety of means, they then look to improve the financial performance and prospects of those companies with a view to re-selling them, often via an IPO, with a 5-7 year exit strategy. Among the many examples of companies that have, at some point, been through this process include household names such as RJR Nabisco, Toys “R” US, Hertz, Alliance Boots, Debenhams and Hilton Hotels
Why then are the attentions of the private equity industry now aimed at financial services companies, particularly in the UK? The answer is down to the significant industry changes resulting from the Retail Distribution Review (RDR) and recent pension reforms. PE firms have clearly recognized that the market for financial advice, trusteeship and wealth management is set for significant growth, particularly in the baby boomer 55-65 age segment, and are keen to cash in.
At the same time, we have an industry that is composed of many fragmented small players and ripe for consolidation, as the thousands of independent financial advisers or trustees who are being forced to look at other options, due to the unwelcome combination of increased compliance costs and the demise of commission-based revenue models.
Is the PE equity opportunity to shake up this dynamic, drive innovation and take advantage of consolidation? Some could argue that the younger generation will look for financial advice online and therefore investment in technology is the reason for their interest. Whilst PE generally looks for strong management teams and little operational involvement, they will all be interested in a term known as “vertical integration” in the financial services industry. The ability to acquire various parts of the advice chain and profit from these synergies, is undoubtedly a rationale for their investment interest and something that can be extracted within the exit time frame.
These are not your typical PE targets, however. Typically, these tend to be in innovative sectors proliferated with venture capital start-ups, asset-heavy industries that are ripe for cost cutting and divesting of non-core operations, or underperforming businesses in need of a turnaround. Financial services, by contrast are capital-light, service-oriented businesses in which the principals, relationship managers and clients are the primary assets and cash flows are paramount. Moreover, whereas private equity operates on that aforementioned 5–7 year timescale, financial advice and wealth management is generally a long-term relationship game, quite often inter-generational in nature.
This is a different proposition for the PE managers to understand, therefore, and one that investors in their funds and the sellers of business in the industry, must also comprehend. Clients, meanwhile, must also recognize that their advisors’ new owners will undoubtedly “crack the whip”, so to speak and any “sweating of assets” might likely result in lower levels of service due to reduced headcounts, increased fees, or even both. For whilst PE investors may not be that passionate about the advice or wealth management industry, they are very interested in its returns.
Private Equity Investment in Financial Services