The rain will come back
There is a saying that “the seeds of destruction are sown in good times”. And these were some good times for the consulting industry.
In 2021, the average company grew its assets under management by 22%, according to a survey by Ensemble Practice. In the last six years, a typical company has doubled in size (between early 2016 and late 2021). Average homeowner income has grown by 46% over the same period.
Because our entire industry has been so successful, we’ve started making some dangerous assumptions — and it’s important to remember that these are just assumptions. This often happens in my hometown of Seattle. In summer it’s easy to forget that it rains for 10 months (which requires anti-depressants and oversized gutters). The sky is so blue and the clouds such a distant memory. Still, as those of us who have been here a while can tell you, it would be a mistake to take good weather for granted.
As we still shine in those halcyon days, perhaps it’s a good time to review our business models, scrutinize our assumptions and examine some of the clouds gathering on the horizon.
Low interest rates and high credit availability
Low interest rates have a profound impact on our society and have benefited consulting firms enormously. I’ll leave the macroeconomic implications to more qualified individuals and instead focus on some of the overlooked industry implications.
Low interest rates allow advisor buyers to borrow more, pay less, and use the extra capital to buy more property. The same effect that’s driving up real estate prices across the country is also driving up valuations of consulting firms. Both internal and external buyers have been able to borrow heavily to buy equity and the result has been valuations at all-time highs. Low interest rates are a bit like beer glasses: after a certain level of intoxication, everything looks attractive.
Unfortunately, the effect can be reversed. When interest rates rise, existing borrowers can find it difficult to service their loans and some may default. New buyers may be discouraged from buying or may buy less. Demand can suddenly contract, and as we know from Adam Smith, this tends to result in lower prices.
The biggest beneficiaries of low interest rates weren’t the internal advisory buyers, who bought 5% or 6% of their businesses, nor the small buyers, who bought a book or two. No, the biggest winners are the private equity companies. The vast majority of reported transactions and most of the upward pressure on valuations are from private equity-backed companies. And if you look under the hood of the acquirers who are very actively consolidating our industry, you’ll find that 90 cents of every dollar invested in company acquisitions has been borrowed.
Here lies the greatest danger for the valuation. A rise in interest rates could severely limit private equity’s appetite for purchases, while also putting pressure on those already purchased to generate the cash flow needed to service existing loans.
Additionally, rising interest rates usually cause the market to correct or even get worse. The cost of capital for public companies is rising and the attractiveness of bonds and other fixed income instruments is increasing. Imagine for a moment that if interest rates rise and loan payments rise as a result, stock markets would fall 15%. The relationship between acquirers and their portfolio companies could change dramatically, as we witnessed in 2008.
To make matters worse, many very large institutional investors have seemingly increased their private equity allocations over the years because fixed income instruments don’t generate as much income. This was certainly the case in the years prior to 2008, when banks bought risky mortgage-backed securities, partly because they couldn’t get the old 5% from government bonds. As interest rates rise, we may see a decrease in the funds allocated to private equity and consequently less capital available to acquire consultancies.