How private equity is transforming accounting for the better

Drawing on his 20 years of sector knowledge, Koltin says, “By the time this is over, I think there's going to have been a complete transformation, much like private equity has done in other industries.” 

Through new types of deals and evolving management structures, private equity houses can provide additional capital to firms to aid M&A growth, talent retention and technological investment. Stuart Ferguson, managing partner of strategic consulting firm Pointe Advisory, who has worked with Koltin Consulting to investigate the attractiveness of accountancy firms to private equity firms, describes the disruption of private equity as offering “a path towards reimagining the entire direction of the industry”. 

Initially, as Ferguson notes, there was scepticism in allowing private equity investment. However, as partnerships between private equity and accounting firms proved successful, once adamant opposition softened across the industry. 

Since the deal with TowerBrook a little over two years ago, EisnerAmper has more than doubled its revenues, making clear the value of the private equity partnership. Deals elsewhere have had similarly transformative impacts.

While part of the reason accountancy firms are so attractive to private equity is the recession-proof nature of the industry alongside high rates of client retention, the challenges facing the accounting industry alongside the traditional partnership structure mean that firms are looking for external capital. 

The persisting talent shortage in the industry means that firms must adapt to attract talent back from other industries, such as investment banking and wealth management. Alongside this, firms are looking to expand service offerings developing new services to respond to client needs outside the realms of compliance. There is also a need to invest in technologies that can accelerate and improve the rate and quality of work. 

Accountancy's core challenges of the talent shortage and the need for technological investment go hand in hand. Once capital is obtained to fund technological innovations, menial compliance tasks can be completed by AI and other automotive processes, making the profession more attractive to potential employees. 

As the fourth industrial revolution continues to unfold, Koltin notes that accounting firms need to be building out technologies like AI, machine learning and blockchain in order to reduce time spent on compliance tasks. 

He notes, though: “It takes real capital and where does real capital come from in an accounting firm? It comes out of partner earnings and, as partners reach the end of their careers, they are reluctant to invest back into the business, despite the clear need.” 

This represents the opportunity for private equity firms – to provide this capital injection while also shaking up the traditional partnership structure to make the profession more attractive by offering ‘rollover equity’. This refers to the stake that those invested continue to hold after a new ownership or partnership structure has been enacted, meaning they can both benefit financially from a deal and remain invested as owners of the business.

Accountancy’s position as a stable, recession-proof, low risk industry with high rates of client retention makes it attractive to private equity firms. However, now the initial buzz is over, the interest from such firms has evolved in the last couple of years. 

“Private equity firms are no longer just willing to take any bite at any apple that emerges,” says Ferguson. “Auctions are incredibly well attended, so we're seeing sponsors be thoughtful about ultimately who it is they pursue in terms of exposures by different service areas, geographies, industries and client sizes. This reframing is indicative of a more educated class of sponsor.” 

Despite the evident symbiotic relationship between private equity firms and accountancy’s need for capital, it is not every accounting firm that can attract such investment. 

Private equity approaches accounting firms in two ways, according to Koltin – either as a foundation and sponsor or as a ‘tuck-in,’ joining an already existing sponsor firm. 

To be eligible to be a foundation firm that would use private equity capital to acquire other smaller firms, accounting firms need to demonstrate a track record of successful M&A and integration of acquired firms. 

In addition to this, investors look for firms that: have a track record of scaling the business; have shown profitability and organic growth alongside great leadership; are viewed as a destination for young talent; are respected within the profession; and invest heavily in consulting, advisory and outsourcing.

As a tuck-in, firms can merge into a CPA-owned private equity group, but this still requires high levels of profitability for the same reasons as for a foundation firm.

Koltin explains that, while firms of any size can be eligible for private equity funding, firms need to be in the upper half of profitability within their peer groups to be considered. Despite, pretty much all firms wanting such capital to bolster M&A growth and invest in new talent, Koltin says that the harsh reality is more than half of accounting firms in the US do not qualify for a private equity loan.  

He explains: “It's a simple algebraic equation. The profit that you give to private equity, multiplied by a value based on how valuable your firm is, equals enterprise value. So, if you can't turn over a lot of profit, any multiple of that small number is going to produce a small enterprise value.”

For firms currently below the benchmark, Koltin advises: “My advice to you is to focus on becoming a more profitable business and then let’s talk in a couple of years”. 

In addition to high profitability, Koltin emphasises that the most important thing to ensure a successful combination is the alignment of strategic goals of both what the foundation firms and PE firms are looking to build and what the necessary investment will be once they are partnered.

Underpinning this trend has been a new deal type and management structure entitled Alternative Practice Structure (APS). Due to concern from the US government of PE firms influencing audit, an APS separates the business into an audit and assurance entity and a tax and consulting entity which is owned by the PE firm. In this new structure, most partners are members of the advisory company, and a small number of auditors belong to the audit company. When an audit is undertaken, employees are leased from the PE-owned advisory arm of the business which sends an invoice for the work carried out by its employees on the audit once it is completed.

By separating attestation from advisory, private equity firms can invest capital into the advisory arms of firms whilst allowing them to retain their CPA majority ownership.  

Koltin notes that it is not just private equity firms taking an interest in CPA firms' family offices, sovereign wealth funds, wealth management firms and even teacher’s pension funds are also looking – especially within the US market, with a view to investing in the US top 400 CPA firms. 

Once funding is secured, capital can be used in a variety of ways to grow a firm, with private equity firms providing strategic oversight that can help to scale a business.  

Koltin explains: “You take a great accounting firm that has a vision of what it wants to build, and all they need is capital and a strategic partner, and you partner with the right firm that sees their greatness and doesn't get in their way. In other words, doesn't micromanage and take over the business. Let the accounting firm lead just like they were leading the day before. And they agree together on how the capital will be deployed going forward.” 

A key approach highlighted by Koltin in which private equity firms can assist accounting firms is by offering strategic decision-making.  

While firms attracting investment are already running successful businesses and adept at day-to-day operational decision-making, private equity firms can offer the strategic oversight that can scale a business from $100m to $250m or from $300-400m to $1bn. Private equity firms can advise how to manage service diversification, sector expansion, region capture and increase of client sizes in order to bolster revenue effectively. 

Koltin has heard first-hand how accountancy firms tend to suffer from lower self-esteem and thus undervalue their firms, mostly as they do not have the next generation of talent to take over the business. Private equity firms view this as an opportunity, being able to replace the partnership structure with a more corporate structure in place, speeding up decision-making processes, enabling more timely decisions and resulting in higher performance. 

One key change brought in by private equity investment which affects the partnership structure is rollover equity, in which the partners roll a portion of their ownership stake into the new equity capital structure instead of receiving cash. Whilst accountants are still a bit sceptical of what rollover equity can become, other professional and financial services firms show it can at least quadruple the original rollover value and provide the opportunity of payouts through the career alongside the offer of favourable tax treatments. 

The bulk of capital obtained by such deals flows towards fuelling M&A growth, building out the product lineup of consulting, advisory and outsourcing as well as attracting lateral talent from other firms.  

Via these avenues, firms can diversify their offerings in line with the needs of clients. Ferguson explains that the current diversification shift toward advisory is centred around responding to what customers require instead of merely buying the most interesting advisor area.  

Overall, he says private equity firms can expand the capabilities of accounting firms by increasing the calibre of talent, better aligning incentives, and enabling access to new technologies resulting in better services and solutions for clients.

The accounting industry has largely remained static for much of its history, being able to grow while offering just financial statements and tax returns. Now, Koltin explains that, with the disruptive nature of technology taking over more and more compliance work, coupled with the talent shortage, there is an imminent need for firms to be future-proofing.  

He worries, though, that some firms cannot see this, and emphasises that firms must concentrate on providing ‘type two’ value-adding services to help clients grow their businesses rather than just ‘type one’ compliance-based offerings.

“Right now, the status quo is pretty good, so I think a lot of firms are just blinded,” Koltin explains. “They're just looking at what they're making. And they're saying, “There’s no need to invest, no need to transform. Let's just keep going like we're going I guess until we can't”, and those are the ones that are going to really suffer.”

On the wider implications across the industry, Ferguson describes the trend of private equity in accounting as the “first domino to topple”. He explains that this disruption will have ripple effects all across professional services and specifically in the office of the CFO. 

Koltin also foresees the creation of truly global accounting firms through the involvement of private equity. While the Big Four “have the aura of being one firm on a global basis”, in reality, the firms operate and make decisions in their respective countries and thus the profit stays there too. Koltin describes that currently they are insulated in terms of liability, the sharing of profit and the consequences of decisions only impact the specific country they are made in. Through private equity investment and oversight, Koltin suggests firms will be able to truly share profits, decision-making and risk across the globe.

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