The professional services industry is built on the exchange of ideas and the provision of guidance. Though not immune to the pitfalls that can impact any industry, such as lack of resources or staffing shortages, the professional services industry adapted to pandemic-related challenges more nimbly than other industries, especially those that rely on foot traffic or in-person experiences. This was due to the nature of the work done by professional services firms, which enables them to collaborate with clients and conduct meetings remotely — without compromising performance or deliverables.
Additionally, the characteristics of the professional services industry provided subsectors like advertising, architecture and legal a unique opportunity to grow during the pandemic. Catalyzed by private equity’s (PE’s) recent interest in the professional services market, companies are increasingly seeking or pursuing an acquisition as part of their growth strategies. For businesses providing professional services within cutting-edge, quickly growing technology ecosystems, the demand for their expertise has never been higher, which has the added benefit of positioning professional services firms as attractive investment targets.
Though professional services encompass a spectrum of subsectors — including engineering, consulting, IT services and more — this piece examines the drivers — and impacts — of increased M&A activity and the unique factors that make advertising, architecture and legal firms such attractive targets.
What’s driving the surge in professional services M&A?
PitchBook data shows that investment in the professional services industry has grown steadily over the past decade. 2019 saw 3,677 deals at a median value of $26 million, a significant jump from 2012’s 2,398 deals and median value of $18.02 million. The COVID-19 pandemic temporarily paused M&A activity for part of 2020, but there were still 3,499 professional services deals at a median value of $28.13 million. In 2021, M&A volume increased again to 5,075 deals and a $45 million median value.
Much has changed over the past decade, including investor profiles and priorities. Investors have developed an appetite for companies that allocate resources to digital transformation and those that emphasize environmental, social and governance (ESG) values. However, the three latest drivers of M&A activity in the professional services industry are PE’s newfound role as a key investor, supportive market conditions and the shifting labor market.
Private equity’s foray into professional services
A few years ago, private equity’s interest in professional services was a rare occurrence. Project-based work can be sporadic, which has historically been a deterrent for investors seeking steady income streams. Also, since the professional services industry is people-based, investors feared that integral personnel would leave and take intangible assets with them. However, these longstanding barriers to entry are beginning to erode as more PE firms recognize the value of professional services. PE firms are increasingly drawn to specialist knowledge, loyal client bases, established HR protocols and potential for international expansion.
PE firms are also eager to take advantage of economic growth and low interest rates while the macroeconomic climate allows. They are looking to quickly deploy capital so that they can raise additional funds and are employing innovative competitive strategies during this seller’s market period. We are seeing an increase in sophistication and aggressiveness regarding the inorganic growth strategies at many of the largest diversified professional services firms. Firms that had no active M&A function less than 10 years ago are now routinely completing many transactions per year. Crunchbase identified 313 companies with PE funding in consulting alone. A surge in high-profile PE investments in professional services firms is likely to continue inspiring similar dynamics in the middle market.
Motivated sellers meet eager buyers
The possibility of tax increases was a significant motivating factor for sellers during 2021. Even with changes to tax laws and capital gains currently on hold, some professional services companies may have already started preparing for a sale during a busy time for M&A. With high valuations, it is still a seller’s market — but deal activity could subside somewhat with anticipated inflation-driven interest rate increases as well as midterm elections on the horizon. Companies that hope to sell may have a limited window to take advantage of the seller’s market, as high multiples and the current appetite for deals could shift.
Owner-operators of small to mid-size professional services firms are also well-suited to take advantage of strategic buyers’ interest in add-ons. Speed is a key component of success in such highly competitive markets. From a buyer’s perspective, it may be preferable to acquire or merge with a company to gain desired capabilities quickly rather than to grow them internally. Furthermore, buyers know that professional services firms typically have a strong operational outlook, which helps them assess a target’s potential for ongoing value creation.
Engaging in an M&A transaction may also enable professional services firms to benefit from the research and development (R&D) tax credit – by using R&D credits to offset any tax attributable to the gain resulting from the sale of assets in an M&A transaction, or by providing a valuable attribute to the buyer of the stock of a company that has performed R&D that resulted in a carryforward. Companies that are working to make products or processes better, faster, leaner or greener may qualify. According to PitchBook, professional and technical services companies are the third most common beneficiaries of the R&D tax credit, enjoying federal tax reductions of up to 20% of qualified spending and other perks. A consulting firm that partners with a technology company, for example, might be able to better serve clients through innovative practices and increase the likelihood of qualifying for the R&D tax credit.
Shifts in the labor market and remote working
Industries that were deeply impacted by the COVID-19 pandemic, such as hospitality, continue to struggle through the current labor shortage, making those industries less suitable candidates for growth in 2022. Though the labor shortage poses a threat to all industries, remote capabilities helped the professional services industry fare better than others and offer employees the flexibility they desire.
Remote capabilities, while attracting investor interest and talent, also provide more options when performing due diligence prior to closing a deal. The rise of teleconference meetings has led to decreased travel costs and compressed deal timelines. Negotiating smaller deals may remain a largely virtual process even as pandemic challenges subside.
M&A trends in the advertising, architecture and legal subsectors
Snapshots of M&A activity from the advertising, architecture and legal subsectors are pieces of the larger professional services M&A puzzle.
The pandemic prompted numerous shifts in consumer behavior to which advertising quickly adapted. Lockdowns and work-from-home initiatives gave people more time to stream television. Viewers turned away from traditional cable subscriptions (2020 saw six million U.S. households cancel cable) to streaming platforms for entertainment — and advertiser dollars followed.
Customers’ inability to enter brick-and-mortar stores, or their discomfort with doing so, led to an uptick in online shopping, and advertisers met them in the e-commerce space. Clothing, cosmetics and furniture retailers began offering customers “virtual try-on” options. Social commerce also took off, with almost 80 million consumers buying items they saw directly through apps like Instagram, Facebook and Pinterest in 2020, a 25% increase from the previous year.
Advertising firms expect that many consumer habits solidified during the pandemic are here to stay. Those that realize this and adapt to behavioral shifts are attractive prospects for investment or partnership.
Free from the restrictions of a commute, remote workers moved to less expensive suburbs. So-called ”Zoom Towns” sprang up across the American South and West. Architects were called upon to design private homes and develop communities. Meanwhile, companies that retained their physical locations devised plans for drawing employees back to the office. They reconfigured existing offices and built new ones for pandemic-related concerns, such as social distancing, ventilation, and outdoor access.
Architects saw a substantial rate of M&A activity in 2021. Firms using cloud computing and 3D modeling technology gained attention as viable investment targets due to their commitment to digital transformation and focus on long-term operations.
Architects are also shifting their focus to sustainability, creating new eco-friendly materials and finding green ways to accomplish goals. With the U.S. green building market projected to reach $99.8 billion in 2023, sustainability is quickly becoming an avenue to value creation. Sustainable investing is on the rise, with 85% of U.S. investors interested in seeing a company’s ESG disclosures, and architecture firms are poised to play a key role in this ongoing trend.
Law firms have joined architectural firms in embracing AI and the cloud. They increasingly rely on workflow automation to complete administrative and repetitive tasks. The volume of M&A activity in the legal sector might also be attributed to a growing number of firms positioning themselves as specialists rather than multipurpose firms. In the past, a firm might provide services pertaining to a wide array of legal matters to attract as many clients as possible. Practices that provide counsel on a niche aspect of the law can merge to dominate a specialty market.
M&A trends persist in 2022
Professional services M&A activity is at fever pitch due to a confluence of the above factors. The current seller’s market won’t last forever, and many firms are positioned to take advantage of it.
Before proceeding with a deal, it benefits sellers to assess all their options for attracting investment or making a potential exit. And for buyers, especially considering high valuations, it’s wise to conduct thorough due diligence, have a clear plan for integration and strategize around how to maximize deal value for the medium and long terms.
PE interest, favorable market conditions and workforce shifts will continue to heavily influence professional services M&A activity levels in 2022. The potency of these recent trends points to a continuing rise of M&A in professional services.