Will private equity master accounting?

When TowerBrook Capital Partners invested in the Top 20 firm EisnerAmper last August, many say that move finally put PE on the accounting industry map and more big moves could follow.

My good friend Allan Koltin, a frequent guest on my podcast who has served as an advisor and broker on many large merger-and-acquisition deals in the accounting industry, believes as many as four of the top 20 CPA firms could be owned by private equity by year-end 2022.

People ask me all the time what PE sees in the accounting space. I tell them there’s excitement about the non-attest services such as technology consulting and professional service offerings that they see as being more scalable — i.e., requiring fewer humans and more machines — than traditional tax and audit. That mindset tends to be good for the bottom line, for the PE investors and for the CPA partners who are being bought out. It’s not so good for rank-and-file staff (and clients) who have always enjoyed strong personal relationships between each other.

Despite all the changes to our industry, I still think we’re a people business. More on that in a minute.

PE, the rocket fuel behind CPA firm acquisitions

Firms are merging fast and furiously to expand geographically and to expand their products and services at a time when boomer partners are retiring at a record clip. Here are some of the more noteworthy developments:

• BDO USA, a Top 10 tax and accounting firm, acquired Morrison, Brown, Argiz & Farra, a Top 50 firm in Miami. 
• Springfield, Mass.-based accounting firm BKD merged with Charlotte-based accounting firm Dixon Hughes Goodman. The combined firm, yet to be named, will become a Top 10 firm with 5,400 employees and $1.4 billion in total revenue.
• CliftonLarsonAllen, the eighth largest firm in the country, acquired Blum, Shapiro & Co., the largest firm in New England. 
• Chicago-based Baker Tilly, the 12th largest U.S. firm in 2020, acquired Top 40 firm Squar Milner, one of California’s largest firms.
• Top 50 firm Whitley Penn acquired Johnson, Miller & Co.
• Wipfli, a Top 20 firm headquartered in Milwaukee, is merging with St. Louis-based Mueller Prost.

Beyond acquisition financing, why else would CPA firms agree to take PE money?

As Koltin explained on my podcast recently, a “perfect storm” of factors is brewing. In addition to firms’ strong need for capital and a tidal wave of boomer partners retiring, there’s a “major transformation of the platform of public accounting, just called simply compliance to consulting,” observed Koltin. Within that compliance, Koltin said there is going to be an “evaporation of compliance” due to the bots, machine learning and blockchain. The marketplace is saying, “I’m only going to pay so much for compliance work, but I will pay a lot of money for value added type services,” Koltin added.

Cash grab or strategy? 

From my vantage point, it seems partners are getting their buyouts today and they’re still getting an investment in the new firm. And then when that new entity turns over in five years, they’re going to get their buyout again. Is it really just a cash grab?

Older partners don’t have to worry about who is buying them out, assuming the buyer has enough money to do so. Younger partners get to participate in two or three separate flips of the firm. Their total buyout is going to be a significant multiple of what they originally got.

From what I’ve seen, private equity typically holds the ownership stake in the acquired company for four to seven years and then sells it to a larger PE group. What’s nice for the CPA firm partners — despite often taking lower salaries — is they get ownership shares in the new entity, which they hope will appreciate in value during the time they own it. By not buying the entire business, the PE folks leave a lot of equity and upside on the table for younger and maybe, to a lesser degree, older partners to take advantage of.

As Koltin told my podcast listeners, when PE takes majority control of an accounting firm, it generally doesn’t own more than 70 percent. That way they can give a disproportionate amount of the shares to the younger partners. They tell the younger partners that the older partners are retiring soon and going to the beach. “We’re going to build a business [together]. You’re going to get a check on day one, you’re going to get a second bite of the apple, maybe three, four years out, if we can hit certain benchmarks. And in years four to seven, we’ll probably sell this to a bigger fund, a bigger PE group – and don’t worry, we’re not going to sell without your permission. You’re our partner,” Koltin related.

Why are PE firms suddenly interested in CPA firms? 

It’s no secret that PE firms have a ton of investor money that needs to be put to work. They are certainly looking for new areas in which to invest. They’re also discovering that CPA firms are more scalable than they previously thought. That change in thinking is based on the upside they see in CPA firms’ technology-based services as opposed to tax, audit and other employee-based services.

As with so many industries, it’s been increasingly difficult for CPA firms to find skilled employees. If they can replace employees with technology — and it takes PE money to do that — that can help a firm’s bottom line in terms of growth and scalability. I had another guest on my podcast recently who argued that technology will not reduce the number of humans you have at accounting firms. What he meant was that technology will free up human workers from doing routine grunt work so they can focus on higher-level, higher-margin work, which also contributes to the bottom line. Who wouldn’t be in favor of that?

What makes CPA firms attractive to PE?

• Compared to other industries, CPA firms are low-risk and recession-proof. Many accounting firms had one of their best years in 2021, and 2022 is shaping up to be equally strong.
• Valuations are relatively low, considering the profitability of the firms and consistency of revenue.
• Balance sheets have little debt. 
• Cash flow is usually strong. More than 50% of the revenue (in some firms up to 80%) is annuity work, whether it’s an audit, a tax return or a maintenance agreement on the technology side. It’s a predictable revenue stream without much volatility.
• Clients are predominantly annuity-based.
• Accountants are trustworthy. They’ve got ethics and high integrity. And private equity looks at all those things.

What size firm is ideal for PE investment?

According to Koltin, PE firms are looking for Top 50 firms that generate between $100 million and $700 million in revenue. From there, they can look for niche firms with specialized expertise to add to their fold, generally firms with $15 million to $100 million in revenue. Kolter said PE firms are also looking for very profitable firms whose average partner compensation is at least $500,000. They know there’s excess cash in those firms — the partners can take a cut in pay and still make a very comfortable living.

Accounting firms with high partner pay tend to be more scalable because they usually have higher-paying clients and have more assets in play to increase additional services. One thing’s for sure, when PE comes in, partner comp will go down, because the partners already received a portion of their buyout.

Skeptics point to Great Hill Partners’ $60 million PE investment in SMART Business Advisory and Consulting LLC in 2007, which ended four years later in bankruptcy. But PE backing of CBIZ and UHY, among others, have been arguably very, very successful.

What could make PE investments in CPA firms more successful?

As I’ve long argued, PE must understand that accounting is a relationship business. Slowly but surely, PE folks are realizing that both employees and clients are very, very important to an accounting firm’s future success. If you start doing things that strain those relationships, you’ll ultimately hurt the firm’s bottom line and adversely impact the PE investment. PE folks must ensure that anything they try to do to scale the business won’t hurt the firm’s underlying relationships. That’s an area in which smaller firms can compete successfully against private equity because they have more of a human touch with respect to the services they’re providing.

It’s no secret that PE is not all that employee friendly. Private equity and public accounting seem to have completely different values and priorities. In general, CPA firms are built for the long term. The focus has always been on building and maintaining client relationships and employee relationships. By contrast, PE is all about generating a short-term bump in the bottom line and then getting out. You can’t build long-term client relationships with that mindset.

When I see long-established firms getting flipped every four to seven years, I have to wonder what the end game is. It’s been said the key assets of a CPA firm “walk out the door every night” and hopefully return the next day. As the stakes get higher, fortunately there are a few PE firms — and PE firm advisors — that get it. They’re starting to understand that so much of the value and goodwill they’re trying to unlock in a professional service firm comes from its longstanding employee and client relationships. Technology and automation are not going to change that.