Professional Services and Private Equity - Some Important Considerations

Key Article Takeaways:

1. The outlook for professional services growth is good: The professional services sector has historically thrived on innovation and continues to grow - current softness notwithstanding.  AI is emerging as both a significant market opportunity and a transformative element of engagement delivery. Based on this and other factors, overall demand should recover from the sluggishness of 2023-24 – although some areas, such as sustainability, will continue to be faced with headwinds.

2. There are a number of market dynamics to watch closely: There are certain dynamics (having both positive and negative influence) that will determine how successful the next few years will be.  Key among these dynamics are: AI’s growing ubiquity, the existence of persistent talent shortages (e.g., accounting), the policies and plans of the incoming US Administration (for services providers to US Federal agencies, and State and Local governments), and a growing market embrace of managed services. These dynamics will influence each firm differently depending on the markets and clients that they serve.

3. Operations Due Diligence will need to be rigorous: Talent management, offerings portfolio management, pricing strategy, and market management are key operational factors to evaluate – along with the traditional financial and sales metrics.

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Introduction

The professional services sector has experienced explosive growth over the past 50 years, driven, largely, by technological advancement and business management innovation. Despite recent challenges, this sector continues to present attractive investment opportunities, particularly as the sector evolves to address emerging market dynamics – however there are operational areas where deeper due diligence will become increasingly important. This article will explore the critical operational areas that potential investors should be focused on when making investment decisions regarding professional services firms. The opinions in this article are not presented as investment advice, nor should they be construed as a recommendation of any kind.

 An Historical Perspective on Professional Services Demand

Over the past few decades, the professional services sector has seen remarkable growth fueled by external trends and internal innovation. The key drivers of the demand have included:

Management Theory: Significant demand was created and driven by the writings and teachings of management luminaries such as Peter Drucker, Michael Hammer,  Rosabeth Kanter, and Thomas Davenport – to name a few.   Entire practices and disciplines were created to operationalize those theories for almost every corner of the public- and private-sector market.

Technological Advancements: From enterprise software to digital to the Internet-of-Things and now AI, tech has been a cornerstone of the professional services sector’s evolution. Sector growth has gone hand-in-hand with technology innovation.

Regulatory Changes: Shifts in public policy and compliance needs have created waves of demand in both accounting and advisory services. More recently, regulatory requirements associated with reducing greenhouse gases and their impact on the earth’s climate has been a significant catalyst for growth.

Industry-Specific Shifts: Industries like pharma, financial services, and media – among others - have leaned heavily on professional services during periods of transformation with waves of acquisitions, mergers, and divestments driving significant transaction advisory growth.

There is no indication that these drivers will cease to positively influence demand in the coming years. Technology-based transformation, powered by AI, will continue to be a strong driving force of demand.  Regulatory-based demand will continue, even in the face of shifts toward deregulation, as clients will look for guidance on how to best adapt to the changes. Deregulation may also bring a new wave of mergers, acquisitions, and divestments.  And while the introduction of broad, new, management theories may have slowed a bit, there is still a fair amount of innovative thinking being put forth. Disciplines such as human-centric transformation and organizational agility are still heavily present – and will continue to drive professional services demand.

While the sector has shown its resilience and ability to adapt to emerging marketplace needs, and while it appears that the historical demand-drivers will remain, the sector has also faced some recent challenges. Post-pandemic overcapacity has led to workforce reductions while demand for previously hot areas - such as certain areas of sustainability, and equity and inclusion consulting - has significantly slowed. On balance, however, the demand outlook is expected to be positive.

Market Dynamics to Watch

While a positive outlook exists, there are a number of market dynamics that could significantly impact the professional services sector – collectively delivering a combination of tailwinds and headwinds. The most significant of these include:

AI as a Game Changer: AI is not only reshaping client demand, it is also impacting how services are delivered. Continuous innovation in AI, and the steady march towards AGI (Artificial General Intelligence), will drive a continuous need for clients to adapt and incorporate new capabilities – a need that is expected to grow for the foreseeable future. Firms are also investing heavily in AI to enhance internal productivity, reduce costs, and enable value-based pricing models (something that the “Big Strategy” firms, and other boutiques, have relied on for decades).

The Reality of Talent Shortages: Persistent sector talent shortages – particularly in regulated areas such as public accounting – will remain a challenge to professional services firms – at least in the near future. These shortages also cannot be quickly resolved with technological advancements (at least not today). The counterweight to this is that there are existing and emerging skills shortages on the client side – especially in areas of emerging technology. Clients in both the private and public sector are recognizing that staff augmentation, out-tasking, and out-sourcing may be the best way to quickly meet constantly shifting skills and resource needs within their operations.

Managed Services Growth: In response to skills shortages, and the need to increase provider accountability and reduce risks, clients are escalating their embrace of Managed Services.  These long-term, and often technology-enabled, contracts offer a promising avenue for firms to drive sustained revenue. They also add a new level of risk that is different from what is found in “typical” professional services engagements.

The US Government (for services providers to US Federal agencies, and State and Local governments, only): As the biggest “wild card” of the four dynamics, we will go into some depth here.

While it is still “early days”, all indications point to significant shifts, being driven by the incoming Administration, in how agencies are organized and operate.  Most practitioners providing professional services to the US Federal government will agree that there continues to be numerous opportunities to improve the efficiency and effectiveness of government services and support operations - even though significant transformation, and progress, has been made.  Additionally, the need for the vast majority of critical services, provided by these agencies, will be ever-present.

The Administration has telegraphed that significant changes are coming in how agencies are organized, the services that they provide, and how they provide those services. If the campaign commitments are realized, there could be significant opportunities for professional services firms who can deliver high-quality support at a lower cost (versus the agency’s current operating cost).  This assumes that most of the critical services currently being provided, by the government, will continue.  A caveat… We should expect that any increased opportunity will come with greater pricing pressure, and greater performance accountability.

There is also the possibility that changes across the Federal landscape could drive demand for additional professional services support from the State and Local government market as some of the services responsibility is shifted to the States.  For example, the incoming Administration has promised to shift some responsibilities of the Department of Education to the States.

The bottom line… Commitments made by the incoming Administration, if brought to fruition, could drive growth opportunities for those firms focused on the US Federal, and US State and Local, markets.

Obviously, every professional services firm will be influenced to different degrees by these dynamics; and they may, or may not, have an opportunity to turn the dynamics into competitive advantages.  Those looking at the Sector for investment purposes should evaluate the impact of these dynamics on a case-by-case basis.

The Four Pillars of Operational Due Diligence

With so much to consider, where does one start to perform due diligence relating to the operations of a potential investment?  When evaluating professional services firms as investment opportunities, one should consider these four critical areas of internal execution:

1. Talent Management:

Best-in-class firms anticipate market shifts, quickly adapt hiring strategies, and reskill/upskill their workforce.  The ability to balance contraction (in traditional areas) with expansion (in emerging fields like AI) is essential for long-term success. It’s also critical for firms facing talent shortages – such as in accounting – to have plans in place to address this via a combination of non-traditional hiring and technology-driven efficiencies.

Additionally, potential talent challenges exist regarding AI-enabled delivery, forcing a disruption to the age-old staff “pyramid”. As AI is called upon to perform more-and-more tasks typically relegated to junior consultants and accountants, what will be the impact on how these staff are sourced and trained, and how they advance? Will the pyramid now compress with AI serving as the foundation and only senior practitioners being needed to engage with the client? Firms rushing to incorporate AI into their delivery models should also be looking at how the talent model will be impacted.

2. Pricing Strategy:

As we saw above, AI looks to offer unparalleled opportunities to enhance service delivery and efficiency.  Beyond the talent implications of AI-enabled delivery, a challenge is bound to surface in integrating AI into a firm’s pricing approach (while ensuring profitability). What will be the impact of AI on the traditional leverage-based pricing model? Will clients be willing to pay for AI-based “work” the same as they would for work delivered by a junior staffer? Value-based pricing could be an alternative, but this will require a fundamental shift from the traditional pricing practices, and rate card models, of many firms.

3. Offering Portfolio Management:

Best-in-class firms have robust processes to identify emerging demand for new offerings, refresh existing offerings (and solutions), and retire those that are underperforming. These firms dedicate resources to managing a dynamic offerings portfolio - ensuring firmwide agility in responding to client needs and market trends. As new technologies are introduced, and as global market pressures increase, those firms that can quickly sense-and-respond will fare the best.

4. Market Management:

Market Management refers to the strategy, plans, and processes dealing with selling and business development. This includes effective account management as well as capture management (Capture management includes opportunity-based risk management, win strategy, pricing, and quality assurance).  Best-in-class firms have well-defined processes and tools that support each element and sub-element of Market Management, ensuring that the firm can deliver on opportunities while mitigating financial and reputational risks.

Summary

Financial performance, competitive positioning, and pipeline health will remain the most critical areas to assess when evaluating a firm’s attractiveness; however significant due diligence should also be focused on a firm’s performance across each of the four operational pillars described above.

 In summary, those looking at the professional services sector should:

• Assess how well a firm anticipates and adapts to market changes relative to its offering portfolio.

• Evaluate the maturity and scalability of its internal AI strategy, and the associated plans for transforming pricing.

• Analyze the completeness and effectiveness of both its talent and market management practices.

These factors not only influence profitability but also signal a firm’s ability to sustain growth and adapt to the rapidly changing landscape.

The professional services sector continues to hold significant potential for private equity investment. As we look to 2025, firms that excel in these operational areas will likely outperform their peers, presenting compelling opportunities for investors to capitalize on the next wave of growth.