PE investments into accounting firms: Is history repeating itself?
Posted On July 28, 2022
In recent months, we have seen much written about the growing involvement of private equity firms in the accounting industry. In this past year alone, three major PE deals have made headlines: TowerBrook Capital Partners’ investment into EisnerAmper, New Mountain Capital’s investment in Citrin Cooperman, and Lightyear Capital’s investment into Schellman & Co.
It appears that there is growing momentum toward the concept of PE firms investing in the accounting profession. I personally know many partners at CPA firms who have been approached by PE firms and are in the process of having initial conversations.
If you lead an accounting firm, it’s natural to be curious about what a PE investment into your firm could mean. Equally, for PE firms looking for opportunities to allocate their funds, accounting firms present an intriguing opportunity. Accounting firms are stable, low-risk businesses with stable cash flows that tend to hold up well in a recession.
While the initial investment thesis is attractive, success in their world demands rapid growth and the path to this remains unclear. History tells us that accounting firms acquired by outside investors tend to face a difficult journey and so far, there’s little to suggest things will be different this time around.
Going back in time
In many ways, the questions currently facing accounting firms are reminiscent of those they faced in the mid-1990s. If, like me, you were around back then, you may recall a similar trend in acquisitions of leading accounting firms.
American Express bought up CPA firms from all over the country and HR Block acquired hundreds of small firms. Neither corporation’s efforts were successful, and both eventually sold off all their newly acquired assets. Another firm, UHY, tried to go public by rolling up a series of smaller firms, but ultimately was unable to.
The one company that saw success with its strategy was CBIZ — and the firm is still in business today. The companies acquired by CBIZ in the 1990s were predominantly CPA firms, but if you look at their business today, you’ll see it is primarily an advisory practice. CPAs are very much the minority in their business. PE investors and today’s accounting firms can learn a lot from this advisory approach.
In an era where many failed, the success of CBIZ holds several strategic lessons that accounting firms, and PE investors who acquire controlling stakes in them, ought to bear in mind in the years to come.
When a PE firm acquires a stake in any company, it’s all about the return on investment. What CBIZ quickly realized is that it’s difficult to squeeze incremental profits out of a CPA practice. In a CPA business, your assets are your people, and they expect to be compensated well for the work they do. If you don’t pay them what they’re worth, they’ll simply walk out the door and find somewhere that will.
CPA firms traditionally don’t offer investors a high return on investment. The vast majority of profits are distributed among the partners, save for some small amount set aside to pay for future growth and projects. It’s a structure that simply doesn’t lend itself to generating the returns that investors expect to achieve.
Instead of focusing on their CPA business, CBIZ prioritized the advisory side. This area offers much more capacity to generate the incremental profits that investors demand. Trust me, I’d know: my firm, SS&G Inc., added a wealth management company and a payroll company to our core CPA practice. Both these advisory businesses were extraordinarily profitable.
It’s an approach that worked very successfully for CBIZ. Since they went public in 1995, their stock is up nearly 2,700%. For comparison, in the same time period, the S&P 500 is up 668%.
But here’s the issue: Many of today’s Top 100 Firms simply don’t have a significant presence in the types of advisory businesses that generate outsized returns for investors. Instead, they’re primarily focused on tax and audit, practice areas that are hard to generate additional profits from. And that’s far from the only roadblock holding back successful PE investments into CPA firms.
No clear exit
PE firms operate on a fixed time horizon: usually around five to seven years. That’s not a lot of time to build and scale successful advisory businesses, or to solve the challenge of how to generate incremental profits from an accounting practice. Accounting firms are highly complex businesses, and delivering the required amount of growth is a challenge that few, if any, PE firms have solved.
Additionally, there’s an open question when it comes to the exit strategy. There are not many options: selling to a larger PE firm, going public, or even selling to a larger accounting firm. But we’re still in the early innings and it’s unclear exactly what the endgame looks like for a PE firm investing in an accounting firm.
Even if growth milestones are achieved in the desired timeline, the successful sale of the firm is far from a certainty. A lot of this is driven by macroeconomic trends. A few months ago, anything was possible, but in today’s market, it’s a struggle to make deals happen.
Navigating culture & aligning incentives
In recent years, I’ve spent a lot of time working with PE firms. I’ve had them as clients, negotiated deals with them, and worked on acquisitions. In all of these cases, one thing has become very clear: The only goal PE firms have is to make money.
Look, obviously making money is important, but running an accounting firm is complicated. You might want to invest in building the capabilities that pave the way for future growth 10 years down the line. Perhaps your firm is a good corporate citizen that’s actively involved in philanthropic efforts in your local community. Or maybe you’ve built a reputation as a family-friendly firm that’s an award-winning “great place to work.”
When you cede control of your firm to a PE firm, a lot of the autonomy you enjoyed is taken away. In your initial discussions, when figures of tens or hundreds of millions of dollars are being floated, everything seems rosy, but there’s always a catch.
The decision to accept a PE investment is particularly impactful for junior partners. Senior partners have probably done very well for themselves financially, but what about the next generation of leaders?
Instead of a path to partnership, in this model you’re granting stock options and equity to younger partners. That only works if you achieve the incremental growth the PE firm requires. And let’s be clear: Talented junior partners are central to the future of your firm. There’s no guarantee they’ll want to roll the dice on future growth, and they wouldn’t be short of other opportunities should they choose to look elsewhere.
Proceed with caution
These are all big questions that firm leaders have to consider going forward. What we’re seeing today isn’t a new phenomenon, but it’s not clear that today’s PE investors have learned from the lessons of 25 years ago.
For large firms with well-developed advisory capabilities, a major PE investment represents an attractive exit strategy. But the reality is very different for small and midsized firms. A lot of smart minds are working very hard on these challenges, and it’ll be interesting to see how this trend evolves. So far there’s little to suggest things are going to play out any differently than they have in the past.