In the dynamic landscape of finance and accounting, the relationship between private equity and CPA firms has transformed unlocking opportunities for wealth creation for partners of CPA firms. This article explores why private equity is attracted to CPA advisory firms and how strategic investment can greatly benefit the firms and their partners.
By way of background, we are private wealth advisors at a fully independent registered investment advisor. Previously, we were partners of a Top 10 public accounting firm and co-led their wholly owned RIA. We've completed hundreds of financial plans for partners across tax, assurance, and consulting.
Our takeaway: The whole industry is ripe for change.
At the heart of many CPA firms lie the pervasive challenges of talent acquisition, deferred compensation, and slowing organic growth.
Talent acquisition
It's no secret that the ability to attract talented young people to the profession is struggling. On July 31, 2024, the National Pipeline Advisory Group, an independent advisory group convened by the AICPA's Governing Council, released its
1. Address the cost and time of education;
2. Make the academic experience more engaging;
3. Enhance the employee experience, particularly in the first five years of employment;
4. Prioritize strategies to expand access to the profession for the underrepresented at every stage;
5. Provide better support to CPA Exam candidates; and lastly,
6. Tell a better story to young adults thinking about which career to pursue on the impact accounting has on businesses, communities and economies.
It's clear the intense, demanding nature of "busy season" that can occur several times throughout the year depending on where you sit within the organization, combined with staff turnover and increased pressure from management teams to drive organic growth, are dissuading many from pursuing careers in the field.
This comes at a time when tax and audit compliance are getting more complex. The once idolized image of becoming a partner at a CPA firm has lost its luster among the younger generation after considering the time it takes to earn partner status following graduation (approximately 10-15 years). Instead, they are considering other career opportunities that utilize the same skill sets.
Deferred compensation
The path of partnership is more palatable for people who've been in the profession for some time already. They've seen how deferred compensation plays out in the end from watching others retire and receive benefits. They know they will work till (or almost till) mandated retirement age to accumulate length of service and other compensation awards that will be deferred till after retirement.
Each firm will use a different formula, but generally, it is one that pays a multiple of the partners' average last few years salary distributed over a fixed number of years. For example, let's say a partner earns an average salary over their last five years of service of $500,000. This can get a multiple of two, which equals $1,000,000 in deferred compensation paid out over 10 years, so $100,000 per year in retirement.
In practice, this structure has worked well. Senior partners retired and transitioned their book of business to younger partners. The younger partners then grew that book of business until they retired and so on, with each new class of partners' success contributing to pay the firm's deferred compensation liabilities. The cycle continues.
Fast forward to today, and the profession has evolved. Deferred compensation liabilities have become larger as more and more partners retire. Demographically, a significant number of firm partners are eligible for retirement now, and one can't help but wonder how many members retired earlier than planned due to the pandemic. This model begins to falter if you are not regularly ushering in a new generation of rain makers.
Whether you are investing in new technology or looking to fuel growth through M&A, these initiatives all come at a cost. Decreasing business investment due to capital being allocated to deferred compensation liabilities can lead to a business losing its edge over time.
How do you fix an industry in consolidation? Enter private equity.
Growth
Take a recession-proof business with positive cash flow and significant operational hurdles and inject strategic capital, deal-making expertise, and a growth mindset.
Strategic capital can allow firms to be more aggressive to attract and retain top talent by offering competitive compensation packages and growth opportunities through stock units and earnouts. It can alleviate the burden of deferred compensation on a firm's balance sheet by addressing short-term liabilities and refinancing long-term debt under more favorable terms. It can facilitate more and perhaps larger M&A to further achieve growth objectives and enhance profitability, countering a profession struggling with organic growth.
Beyond the capital infusion, private equity firms offer a wealth of transaction expertise and strategic insight. These are qualities in business that compound value over time. In our view, sourcing, advising on, and executing M&A will be among the most significant contributors to enterprise value growth over the life of an investment.
Additionally, with private equity taking on stewardship and holding management accountable for strategic growth initiatives, a renewed sense of purpose within the organization can drive sustainable growth and enhance shareholder returns.
Additionally, we believe we are in the early stages of generative AI's impact on the accounting profession. As firms gradually adopt LLMs to automate business processes and enhance staff workflows, having a strategic partner with access to leading startups and intellectual capital can significantly aid in integrating emerging technologies across the organization.
So, how does this financially impact its partners? And is this a good thing for partners of CPA firms?
The firm will effectively be restructured, and partners will typically receive a mix of cash and stock consideration at closing. It can be presumed that partner capital loans would be paid off as part of the restructuring. From a financial planning perspective, this is a great benefit because capital loans can significantly hinder the wealth effect for many partners if they are not managed appropriately.
This mixture of cash and stock consideration can be predicated upon many variables such as age, length of service, industry group, and may vary greatly by organization. The cash consideration is to be paid to a partner at closing along with unvested stock units. These units will be assigned different vesting schedules, but usually align with the private equity fund's projected monetization timeline.
This structure creates an alignment of interest between the private equity firm, the CPA firm, its partners and all the employees. As the firm grows, creates value, and operates more efficiently, a monetization event will be targeted — typically within five to seven years — during which the stock units would ideally be worth a multiple of what they are worth at the time of closing.
Note that the timing of monetization and value of shares will be predicated on a variety of factors, including but not limited to:
1. Performance of the underlying asset;
2. Macroeconomic conditions; and,
3. Capital market activity.
Potential buyers at that time could be strategic buyers, such as another accounting or professional service firm, or financial buyers, like other private equity firms.
Overall, the strategic investment activity in this space over the last three years has been encouraging. We believe this presents a significant opportunity for partners of these CPA firms to participate in their firms' value creation while actively generating earnings, rather than waiting until retirement to reap those benefits. This new partnership structure allows partners to build personal wealth earlier in their careers, enabling longer periods of compounding growth — a concept we are very passionate about.
We are excited to see our peers, clients, and industry professionals at the forefront of this transformation.
