Business services targets can be a less predictable source of portfolio growth than the sector’s history of steady income would suggest, warns Evolved, LLC's Matthew John McNally, a member of ACG New York.
Citrin Cooperman made waves in January when it announced that Blackstone had arranged “a definitive agreement for a significant investment” in the top 20 accounting and advisory firm. Blackstone acquired its stake from New Mountain Capital, which had previously been Citrin Cooperman’s majority private equity investor. Blackstone’s acquisition of New Mountain Capital’s stake came only two years after New Mountain Capital itself took the majority investor position.
This transaction, which did not surprise due diligence specialists, is worth monitoring for observers assessing potential pitfalls in future mega-deals in the business services arena.
M&As that include two conditions seen in this transaction—the target’s fungibally defined growth and the purchaser’s excessive dry powder—may serve as indicators that business services acquisitions are a less predictable source of portfolio growth than the sector’s history of steady income would suggest.
In the case of Blackstone’s acquisition of New Mountain Capital’s stake in Citrin Cooperman, the details are revealing. Citrin Cooperman achieved rapid growth over the past two years by acquiring multiple smaller accounting and consulting firms; only a small percentage of revenue was achieved through organic growth and streamlined operations.
"M&As that include two conditions seen in this transaction—the target’s fungibally defined growth and the purchaser’s excessive dry powder—may serve as indicators that business services acquisitions are a less predictable source of portfolio growth than the sector’s history of steady income would suggest." - Matthew McNally, member of ACG New York and managing partner at Evolved, LLC.
Still, Blackstone paid 15x EBITDA to acquire New Mountain Capital’s position, presumably with the expectation to make good on that investment in the typical three- to five-year window. Further concerning is Blackstone’s substantial cash reserves. The company reported dry powder valued at $40 billion in Q3 2024. An article last year by Penn Mutual laid out several challenges of having excess dry powder in the market, including pressure to deploy and artificially inflated valuations among others.
Between Blackstone’s possibly unrealistic expectations of recouping its initial investment in a standard time frame and its lush dry powder volume, some investors are asking why Blackstone would acquire a stake in Citrin Cooperman at all. A look at why business services are a tricky acquisition sheds more light on such skepticism.
Serial M&A activity has worked well for private equity in other industries, so long as they involve streamlining operations through cost-cutting, layoffs and replacement of top-tier management.
Acquiring a business services company is different. Business services models rely on people serving people, and these relationships build institutional knowledge earned through years of client interactions. The streamlining tactics used in a conventional M&A may actually undercut the productivity of the target company, thereby leading to reduced growth potential of the target.
The financial incentives for equity partners and ESOP participants in a privately owned business services company are straightforward: work hard, increase valuation and realize gains. By making leadership and employees part owners of the company, all employees work toward a common goal that maximizes shareholder value—and because the employees are shareholders, they understand the payoff of their labor.
After a business services company sells to private equity, the incentives to work toward a common corporate goal—that is, to work toward maximizing the valuation of the company in which employees share equity—vanish or decrease considerably. Employees with entrepreneurial instincts often leave to start their own enterprises where they can build on their business relationships, set the terms for their employment, and grow a company in a straightforward manner that offers clear financial incentives. And because these entrepreneurial employees are often a business services company’s rainmakers, their departure threatens to slow growth.
Thus, when PE acquires a business services company, growth must often be realized via consolidation. Given the finite stock of viable business services firms available for acquisition, each M&A deal comes with increased costs (e.g., due diligence, regulatory scrutiny and tax and debt obligations) and risk (e.g., team turnover and client attrition).
If purchasers acquire a business services company that itself was once the purchaser in an M&A, they may find that loose ends from the previous M&A deal lead to lingering contractual, financial or operational risks. Some of these risks include:
Concerns about post-M&A cultural misalignment, failures to integrate synergies and flagging brand loyalty—all of which affect the profits, debts and market share that made a target attractive in the first place—should also be weighed. Regardless of the industry, M&As will result in some level of cultural erosion, attrition and deterioration of client services. And when private equity directors outline strict growth targets in the context of these changing dynamics, they risk exacerbating these problems.
There are, of course, winners in every M&A deal. Top layer, PE-backed owners receive windfalls and padded exits from their initial PE investment, and original equity partners in the target company stand to yield significant return on their investment. Some private equity firms seeking growth via acquisition of business services companies will find success in purchasing business services firms, but many will realize frustrating losses or underwhelming returns. Only the largest firms can afford to weather such conditions.
As dealmakers add business services companies to diversify their portfolios, they must ensure that the employees responsible for growth in the target company continue to engage clients, and they must execute proper due diligence to uncover short-term and long-term risks. Their growth strategies must rely on more than consolidation if actual growth is to be realized.
Strategic due diligence, revised operational strategies and leadership incentives may positively change the dynamic for growth in PE-backed business services firms. Time will tell.