The increasing trend of private equity investment in advice firms

It was about five years ago I first became fully aware the trend of external investment in advice firms was ramping up.

Investors seeking out a very specific type of practice principal – $500 million funds under management and a desire to quadruple that in a short period of time – seemed to be the profile.

The motivation behind it was understandable.

Advice firms have always been strong on the numbers in ways other business models often aren’t. That private equity was looking at ways to leverage this into something bigger made sense, given the other options on the table at the time.

As we sit here years later, that quest for super firms may potentially create ticking time bombs that, in the worst-case scenario, could explode in everyone’s faces.

The difficult challenge of complexity

Netflix’s freedom and responsibility principles that underpin their culture is an interesting read. It’s freely available via a quick Google Search if you want to dive into it.

It states that one of the problems large organisations suffer when left unchecked is they are doomed to evolve into complex systems.

Just as John Gall amusingly outlined in his book Systemantics: How systems work and especially how they fail, complex systems usually exist in a state of imminent failure. The more complex the system, the greater the demand it places on the individuals within the system to stave off collapse.

Eventually, one of two things happens.

The business becomes dependent on extremely capable people to keep it running – this is something I call the Bismarck Effect, after the famous German chancellor whose web of treaties ultimately turned the initial sparks of conflict into World War I – or the system exceeds the capability of the individuals to manage it, and chaos ensues.

In response to growing complexity, most organisations implement bureaucracy to control the chaos.

The problem with bureaucracy is it curtails high-performing team members, who often leave. Top-tier performers don’t usually enjoy being micromanaged or submitting to inefficiency to account for those who are less capable.

In Netflix’s case, the answer to this growth quandary is to give their team members freedom from micromanagement and instead rely on control via self-accountability through willingness to be measured and commit to deadlines to create a more optimal balance.

It’s one way to deal with it, but there are others.

The solution is simple

The best response to growing complexity, particularly for large businesses, is a focus on simplification.

All systems gravitate towards complexity. The hedge in your garden will always try and grow out of control. Your taxation affairs will become more complicated if left unmanaged.

One of Steve Jobs’s first acts upon returning to Apple was to replace the countless product lines and versions of the Macintosh with just four products, which he announced by drawing two columns labelled "Consumer” and “Pro" and two rows labelled “Desktop” and “Portable”.

Their job, he told his team, was to focus on four “great” products, one for each quadrant, and cancel everything else.

That simplification decision was the spark that began the renaissance of Apple as we know it today.

As Gall expressed, large, complex systems can only be controlled when broken into smaller systems that will behave like simpler ones.

Anyone who has implemented workflow software will concur. Small “chunky” threads work better than long ones.

This brings us back to that ticking time bomb.

Growth is not a straight line

The mandate for many of these external investors has been to drive consistent levels of growth year on year on year. The reality is practice growth isn’t usually linear.

As Hiroshi Mikitani’s rule of three and ten teaches, businesses go through growth patterns that are more like stairs than straight lines.

Just as you reach a certain size, a whole bunch of new problems appear that render your previous operating model ineffective.

You solve those problems and go through another growth spurt, at which point everything changes again, and you have a bunch of new problems to solve before the next growth spurt.

It doesn’t get easier; you just get better.

This is the nature of the journey.

Two problems to solve

Of course, one way to smooth the stairs is through constant acquisition, which provides constant growth.

The issue with acquisitive growth is that it has two components: the acquisition itself, and integration.

Integration is often harder to get right of the two, as anyone subject to a corporate merger or takeover will tell you. The failure rate is high.

The systems for delivering advice have become mostly more complex as time has gone on, both through regulation and the painful fact that, despite many years of evolution of advice technology, the pure efficiency gains promised mostly haven’t occurred quite the way that we wanted them to.

In most cases, advisers are more swamped, overwhelmed and under pressure to deliver advice than ever before.

So, when you’ve got a business on an acquisition path, gobbling up smaller businesses and occasionally melding with businesses of a similar size, you’re mashing together multiple systems, most of them complex.

When you’re doing that, there’s work required in the background.

Operational alignment, standardisation of processes, usage of singular systems and, often the most challenging of all, the efforts required to ensure adoption, change management if you will, or training if you prefer.

Ultimately, you’re trying to get a bunch of different people, often doing very different things, to do similar things in order to create greater efficiency, get the most out of your tools, and, importantly, ensure adequate risk management.

The missing piece

Herein lies the concern.

In most cases, this acquisition path isn’t accompanied close behind by adequate operational integration.

Many businesses are likely operating as multiple kitchens.

Instead of having multiple systems operating as simple ones, we are more likely to have multiple systems operating in states of extreme variance and complexity.

You can see where this may be going.

It’s easy for operational control of these systems to very quickly outpace the capability of those within it to manage. This often manifests first as elevated levels of stress among team members, and cascades from there.

A duke gets shot in Sarajevo, and in no time, the world is at war.

When you add to that the resourcing hole when it comes to people in financial services, with the best and brightest being more likely to be attracted to the tech world than the money markets, we have all the ingredients for a bushfire.

The singularity

Where’s it going to end?

Hopefully, nowhere. The likelihood is that through necessity, those businesses realise that expedited growth rates are only sustainable when the operational model can match the pace, so they slow down, do the work, maybe tech gets better and things get easier with AI playing a leading role.

The dark alternative is we end up with several large super firms in the industry falling in a heap in a way that makes Dixon Advisory look like a teaser trailer.

The industry has needed scale for a while, and the promise of the super firm is part of that.

That’s not to say there isn’t a place for small boutique firms that focus very clearly on certain niches or become very efficient by doing what they do over and over again better than anyone else.

The concern that others and I are beginning to speak about with greater frequency is the drivers behind this year-on-year rapid growth mandate – presumably to create an asset that becomes very appealing to sell sooner rather than later – doesn’t end up creating sustainable advice models at all, but rather Frankenstein monsters with more holes than the Swiss cheese industry.

Then suddenly, we’re in a position where the good name of advice is, once again, on the line.

Stewart Bell, business coach and founder, Audere Coaching & Consulting