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Midsized to large CPA firms may be considering a private equity transaction as growth and wealth creation vehicle, but there is much to be considered beforehand.
In a
Due diligence
Going through private equity due diligence, you should be prepared for a deep dive. With some variety by size of deal, generally, the process will focus on these areas:
- Information systems: Private equity firms are numbers-driven. They will mine data that will identify where cash flow is coming from and where it is going. This “professionalization” of information systems is viewed as a key tool, providing insights that will help enhance the value of your firm when the investment is “flipped” in three to five years.
- Cash flow: CPA firms are traditionally rich in cash flow, but an evaluation will be made on how good the quality of that cash flow is and what can be relied upon on an annual basis. Although net income is important, private equity firms are fixated on cash flow. They value businesses on EBITDA. Increasing EBITDA is what is going to allow them to eventually cash out for more than they paid.
- Expense control: Private equity firms will dig into all current partner expense accounts, asking questions about firm policies, controls, expense spikes, etc. Partner expense accounts could well be scrutinized and cut back.
- Liquidity: Private equity firms use leverage to make investments. They will require weekly, monthly and quarterly receipts tracking to make sure you are not in jeopardy of any covenants you may have, and that their portfolio stays liquid. They will take swift action if covenants are not being met.
- Services and cost of delivery: With the objective of determining and improving margins, private equity firms will delve into all services being provided and the cost of service delivery of each. CPA firms often lose track of where they are really making profits and gross margins, and a private equity firm will analyze contracts to ensure services are not being provided just to increase revenue while not actually increasing profitability. Also expect a focus on how new and recurring work is bid, with a particular emphasis on avoiding contracts that increase revenue but are not all that profitable.
What could your new structure look like?
“Structure” is the "plumbing" of a private equity transaction. Typically the investment creates an “alternative practice structure,” resulting in two entities: an attest CPA firm that is 100% owned by the CPA firm partners and is the vehicle for the firm to be able to continue to do attest work. The second entity will become a non-attest consulting company that is jointly owned by the CPA firm partners and private equity investor. The non-attest consulting company essentially leases employees to the accounting firm to conduct the attest work and perhaps the tax compliance work. It also would not be unusual for there to be an affiliate or subsidiaries to the non-attest consulting firm.
Since the attest CPA firm only retains the audit and tax compliance work, the retirement plan (deferred compensation) that it had in the past may well be reduced as part of the transaction since the accounting firm is not as valuable as it once was with the consulting revenues. It also would not be uncommon to see a slight reduction in draws and partner compensation. Sometimes in the initial transaction, a portion of the proceeds goes directly to the CPA partners in the form of a dividend and in firms where the partnership agreement and compensation plan require it, the retired partners may also share in that dividend.
The new attest firm must satisfy AICPA 101-14 requirements and state laws: Each director must be a licensed CPA and attest CPA firm partner. All owners of the attest CPA firm will also be employees of the non-attest consulting company. The board of the attest CPA firm should include attest CPA firm employees. The attest CPA firm board is distinct from the non-attest consulting company board, so there will be two boards, and the private equity firm will have no representation on the attest CPA firm board. Non-attest consulting company employees on the attest CPA firm board are not directors, executive officers or senior management of the non-attest consulting company.
The attest CPA firm is independently managed, with some oversight by the private equity firm: The managing partner of the attest CPA firm reports to the attest CPA firm board. Promotion to or removal of an attest CPA firm partner is the decision of the attest CPA firm. There is a services agreement that provides that the non-attest consulting company does not control the governance, structure or operations of the attest CPA firm, but does provide services such as personal (including licensed CPAs), IT and back-office support. It will also include a statement that services rendered on behalf of the attest CPA firm by CPAs will be under the direction, control and supervision of the attest CPA firm and will be rendered in accordance with its personnel manual and other policies and procedures.
Prepare yourself when it comes to cashing out. History has shown it is not easy to “flip” a professional services firm. When it’s done, it’s often not done successfully. But when it’s time to flip, there have been a number of public company exits, IPOs and perhaps some SPACs, but there is little known about these transactions because they are private.
So if your partnership can accept the aspects of the structural and governance changes, is a private equity infusion an effective vehicle to create partner wealth? We believe so, but with the caveat that if a CPA firm has a strategic plan that it revises to reflect how strategies and tactics will be enhanced as a result of a private equity infusion, and that the alternative practice structure effectively delivers on that plan, private equity could be beneficial for the partners.
But the question remains: Is the gain worth the pain? With bank borrowing rates being very inexpensive these days and many firms under capitalization with partner cash capital accounts, these vehicles could be considered alternative vehicles for growth as well as a private equity infusion, but without all the bells and whistles that private equity demands.
Only time will tell if these transactions gain traction and are more successful than in the past.
