Private equity 'revolution' brings risks to wealth and accounting

Private equity capital is driving a "revolution" in the wealth management and accounting industries, but its ties to credit from non-bank lenders could pose risks, a new study found.

The fields of wealth management and certified public accounting, as well as consulting, represent professional services that "provided cause to be optimistic relative to an otherwise dim M&A landscape" in 2023 due to "aggressive add-on campaigns" by private equity firms finding "consolidation opportunities within fragmented segments," according to an annual report on leveraged buyout deals by accounting firm Cherry Bekaert. The add-on deals — tuck-ins by private equity-owned firms of additional outside companies — have kept transactions flowing at a much healthier pace in the wealth and tax fields than in others amid higher interest rates.

Those elevated rates are pushing up the cost of capital, which is leaving traditional lenders like banks "stuck with about $40 billion in loans that are now worth less than when they were advanced only a few years ago, when that debt cost virtually nothing," the report said. Direct lending, co-investments and other forms of private credit are filling the void, to the tune of $1.5 trillion in nontraditional loans globally on their way to $2.3 trillion by 2027, according to alternative investment data firm Preqin. Private equity firms "have been and will continue to be the primary drivers of private credit consumption," Cherry Bekaert's report said. The concerns about that financing largely haven't come to fruition. For now, at least in select professional services fields like accounting and wealth management, deal volumes remain strong.

"Private equity's entrance into the professional services sector, specifically in the areas of wealth management, CPA and consulting organizations, is quickly changing the dynamics of the industry," Scott Moss, a Cherry Bekaert partner and the leader of the firm's private equity services industry practice, said in an email interview. "For 135 years, the CPA industry, for example, has remained relatively unchanged in terms of its business model, with steady but not necessarily transformational growth. However, what we have seen over the last two to three years can only be described as revolutionary."

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An old investing adage, violated

Insights from Moss and the company's report provide wealth and accounting professionals with a wider lens on the appeal of their fields to private equity investors and how that capital could buffet ongoing shifts in their industries. As they accelerate the consolidation in accounting and wealth management with massive deals touching either or both fields, the private equity investors are changing how they view those industries as well. In the process, private equity firms are violating an idea once revered as an adage in their business strategy, even as they alter the way that their portfolio firms do business.

"Private equity has emerged as a powerful catalyst for driving transformation, process improvement and growth acceleration for professional services firms," the Cherry Bekaert report said. "Investments in this sector buck the previously unwritten rule against investing in sectors whose primary asset goes down the elevator at the end of the day (i.e., people). However, as investments have begun to take shape and private equity demonstrates its ability to drive transformational growth and improve financial performance in people-heavy businesses, the hesitation has become less concerning. In particular, CPA, consulting and wealth management firms appear to be in the midst of a private equity-backed revolution."

Examples of the kinds of major deals cited in the report include private equity investments in accounting firms EisnerAmper, Citrin Cooperman and Cherry Bekaert itself, as well as wealth management companies like Captrust, Prime Capital Investment Advisors and Choreo. 

For many CPAs and financial advisors, though, the most important question about these private equity deals looms around when the investors will turn their firm over, i.e., when will their parent company sell to a different incoming owner. Private equity firms refer to that kind of transaction as an "exit" from their investment. Those types of deals fell into a slump last year "because investors chose to hold on to their investments rather than take them to market, hoping that a future recovery of valuation multiples would allow them to exit at better prices," Moss said. The question of whether there's a bounceback in store for exit transactions this year revolves around interest rates, inflation, valuations, initial public offering activity and other factors.

"The pressure is building on PE firms to deal with a backlog of maturing investments and the need to monetize investments to return capital to investors. This is creating optimism that exit activity will rebound in 2024," Moss said. "Given the level of add-on investments these organizations have undertaken in the last 24 months and the level of deal flow expected to take place in 2024 and 2025, a key component of value realization will focus on how successful buyers are at integrating acquired firms and practices that support the overall value creation thesis. Investments would need to continue to 'season' to realize ultimate value. Based on some of the earliest investments, we are likely several years from experiencing a flurry of second-turn transactions in this sector." 

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The private credit factor

The boom in private credit adds another layer to the way that these investors are buffeting fields like wealth management and accounting. Non-bank lenders like the private equity firms and other alternative asset managers use private credit funds for loans to small and midsize businesses that "are usually highly leveraged and cannot borrow in corporate bond markets," according to Moss. 

"For borrowers, it is an alternative to traditional bank loans," he said. "Although private credit is a small slice of overall business financing, it has been growing very fast, raising concerns among some market participants and regulators about risks to investors and threat to the overall financial sector."

Problems with this rapidly expanding form of financing could come to the surface if there is an economic downturn that further reduces capital flows or interest-rate cuts hurt institutional investors who invested in private credit instruments, Moss noted. The lenders also display less transparency than traditional banks, which must disclose more to regulators and the public, and the lenders simply have shorter track records. New regulations for private credit "may be on the horizon as regulators seek more transparency and safeguards against potential contagion," and those new rules could raise expenses and modify "the lender/buyer dynamic in ways that are difficult to predict," he said.  

"Some market participants worry that investors in private credit — many of whom are new to the business of lending to small and mid-size firms — may refuse to roll over loans in an economic downturn, leaving highly leveraged, higher-risk firms that have borrowed from private credit funds vulnerable and unable to refinance their debt," Moss said. "Affected businesses may reduce investment and employment and, in some circumstances, may default on their debt, creating direct losses to lenders and other financial market participants. If these losses are significant, this could cause an excessive tightening in risk appetite, disrupting the functioning of some markets and tightening credit conditions in the overall economy."