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October 14, 2007

Moving upstream

Moving upstream

There has been a growing number of mergers within the accounting industry worldwide in recent years. Carolyn Canham speaks to three US industry experts about some of the drivers behind the trend and where it is likely to lead in the years ahead.

The number of mergers and acquisitions in the US accountancy market is “off the chart”, according to Allan Koltin, the chief executive of PDI, a consulting firm with a client base that includes the largest 500 accounting firms in the US. “I would say I average almost one call per day now from a firm that is looking to merge upstream. For every potential seller, there’s probably as many has a half-dozen acquirers, typically top 100 firms [excluding the Big Four, BDO Seidman and Grant Thornton US], that will have an interest in that firm,” Koltin says.

Citing an example, Koltin says he recently had a $5 million firm based in the Midwest approach him to enquire about merging up-market. “I proceeded to send five e-mails to larger firms… I kid you not, within one hour of sending the e-mail, all five responded and were very interested,” he says.

Demographics

Marc Rosenberg is a management consultant who works exclusively with certified public accountant (CPA) firms in the US and is president of his own firm, Rosenberg Associates. He has noticed the merger trend pick up during the past five to six years. “It is going on very hot and heavy now, it has been for a few years and it is going to be even more frenzy-like in the coming years,” he says.

Rosenberg says demographics – most specifically, ageing partners and a lack of students – are fuelling the trend. “There is a tremendous number of what we call baby boomer partners at CPA firms. They’re five to ten years away from retirement and they take a look at their staff and their younger partners and they shake their heads and they say ‘these guys cannot take over the firm’,” he explains.

Rosenberg says partners in CPA firms, especially as they reach their 50s, need to make a choice between developing the younger people in the firm in the hope that they will buy them out, or deciding to wait until they are ready to retire before approaching a larger firm that they hope will merge them in. More partners seem to be opting for the merger option.

“It’s not easy to be a partner of a CPA firm, and because there’s been such a talent drain in the US, most small- and medium-sized firms have just not been able to recruit and develop and retain staff and bring them along to the point that they could be a partner,” Rosenberg says. “CPA firms have never been strong at this by the way… I’ve never seen any statistics on this, but if I had a guess, I’d say that probably at least 75 percent of all CPA firms never make it past the first generation. They’ve always been bad at that, they’re very busy people and they have some very highly specialised skills.”

Koltin suggests there are also significant financial gains for partners who merge up-market. He says the majority of the firms he has worked with which have merged up-market have seen their individual partner compensation increase dramatically. “I would guess that for every three firms, all three of them for the most part have seen their compensation increase, probably one of those three has seen their compensation increase by 50 percent, probably [another] one of those three has seen their compensation increase by 100 percent,” he says.

Jim Metzler is the American Institute of Certified Public Accountants’ (AICPA) vice-president for small firm interests. He provides some statistics on what he calls the greying of the profession. “In 1993, 53 percent of [AICPA] members were aged over 40. In 2004, 68 percent were over 40, so I would guess that in 2007 it is probably pushing 70 percent over 40. So we have just a tonne of firms out there where those owners, those partners who all came into the business at the same time, are looking around the partnership table and looking at what they’re going to do for retirement and saying ‘holy smokes’, all of us are going to have to leave at the same time, or none of us can leave, and so we have a huge initiative on succession,” he says.

Changing work ethic One reason that has been regularly cited for the lack of suitable successors for retiring partners is a change in work ethic. Many young accountants are not willing to work the long hours their predecessors clocked up, preferring instead to maintain a family and leisure-friendly work/life balance.

Metzler explains: “Those baby boomer partners… say the next generation is not ready – they don’t quite have the work ethic, they don’t have the leadership skills, they don’t have the entrepreneurial skills. [On the other hand] if you go to the next generation in those same firms, which those ageing partners are talking about, the younger practice leaders will say, ‘are you kidding me? I don’t want to be like those guys, I don’t want to work night and day, I don’t want to fund a buyout and live in poverty until I buy out the old partners’. They don’t follow that carrot that many of us followed many years ago, rightfully so. You know families are different, the drivers are different.”

Rosenberg says another main reason for the lack of successors is that between 1995 and 2000 there was a one-third drop in the number of students achieving a degree in accounting. “That’s anywhere from 12 years ago now. The seven-year people would probably be the solid manager core now, the step just below partner, but the 12-year people, they’d be in their mid-30s right now and would be prime candidates for partner,” Rosenberg says.

Koltin suggests that even though the graduation rate for accountancy students is on the rise, it is not necessarily a solution. “The problem isn’t just the graduation rate, it’s making sure that those kids, if you will, stay in public accounting and right now the pendulum is swinging in a way that a lot of private companies are offering these kids chief financial officer positions. As long as they can make comparable money in private industry to what they can get in public accounting, and not have to work the crazy hours, they’re going to continue to leave public accounting and go to private industry,” he says.

Sarbanes-Oxley impact Rosenberg points to the Sarbanes-Oxley Act as another reason for the talent drain. “Sarbanes-Oxley work is absolutely the pits,” Rosenberg says. “There’s long hours year-round, not just in the tax season, there’s some travel involved in it and the work is as boring as it can get. These young kids who are joining these large firms are getting burnt out, they’re quitting. What normally happens when many young people join a large firm, they work there for a few years, get some good education, good experience, but then… they’ll go to a smaller local firm, that’s the normal migration. And that’s not happening, they’re just leaving the profession altogether, so we’ve just had a tremendous drain of people.”

The talent drain not only creates an incentive for partners of smaller firms to merge upstream to secure their retirement funds; it also provides incentive for larger firms to look for smaller merger partners to boost their ranks.

Koltin relates a recent encounter in which a managing partner of a top 50 accounting firm told him, somewhat sarcastically, that the perfect merger for his firm would be a firm with 50 staff and no clients. “The whole paradigm shift that’s going on in the last decade is it used to be you merge or acquire a practice, grab their client base, and then maybe get rid of the people. Today it’s all about getting the talent, and the clients are a distant second,” Koltin says.

Buying people as well as clients Rosenberg says the bigger firms have a “tremendous appetite” to merge the smaller firms in. “By merging a firm in, that’s a way of buying people as well as buying the client base,” he says.

Koltin suggests the demand from the larger firms for smaller firms to merge with also stems from a vacating of the “whole middle market opportunity base” that followed the demise of Arthur Anderson.

He illustrates the upward movement in the accounting profession with figures: “In 2007, to make the top 100 list of accounting firms your gross fees had to be $26.5 million. In 1997 the 100th largest firm had gross fees of $6.5 million. So it has quadrupled and what’s happening is all of these top 100 firms have figured out that if they truly can become bigger and cover a broader geographic landscape, they too can go after larger clients, more profitable clients.”

Koltin estimates that at least 90 of the top 100 accounting firms have defined merger strategies. This excludes the Big Four, BDO Seidman and Grant Thornton US. “Those six firms today are just so inundated with public company and Sarbanes-related work that their merger strategy is either non-existent or has been put on hold,” he says.

Metzler suggests that by acquiring more people, large firms acquire more skills they didn’t have before, which gives them the capacity to serve public companies well. “Years ago there was the Big Eight, and we’re seeing large firms position themselves to kind of become a Big Eight again,” he says.

Metzler says firms are joining international associations for the same reason. “I guess that’s not quite a consolidation, but joint venturing, partnering, alliances, you know that is kind of like a consolidation in a way. A lot of that is going on today and if you’re a forecaster of the future you’ll see a new worldwide firm [somewhere in the top ten largest firms] get announced, not too far off in the future. You kind of see the market forces shaping up,” he says.

Metzler observes that the very smallest firms are involved in what he calls “pseudo-consolidation”. “The smallest firms are aligning with other small firms like crazy around the country,” he says. “What keeps them up at night is they don’t want to have a client out-grow them.”   He explains that years ago small firms tried to be “jacks of all trades” in order to keep clients. Now they are more likely to team up with a “firm across town” to jointly serve a client. Those types of alliances are up in gigantic amounts, Metzler says, adding that an AICPA survey of firms found these alliances grew 68 percent between 2004 and 2006.

Rosenberg believes the merger trend is going to “heat up even more”. He predicts that it will heat up so much that it will shift from being a sellers’ market to a buyers’ market. “At present it’s still a sellers’ market from the standpoint that if you’re a firm that wants to merge up, to a larger firm, and there’s no skeletons in your closet, you’re in a fairly major area and are reasonably profitable. You can pick up the phone and call five bigger firms and all five of them will be foaming at the mouth, wanting to have a meeting with you,” he says.

“That’s going to change, because there’s going to be so many firms looking to merge that it’s going to become a buyers’ market and these bigger firms are going to say ‘oh we’re not going to get married to every single firm that calls us, we’re going to be a little bit more choosy now because there’s so many to choose from’.”

Rosenberg suggests this swing will occur in about four to five years, though admits that it’s very hard to predict the behaviour of people. “These entrepreneurial partners in five, six, eight, ten partner firms, they’re used to being their own boss and having a nice tight cadre of colleagues… I sarcastically joke that one of the main reasons why partners like being in smaller firms is that they don’t have to be accountable… when you get to be a bigger firm, by golly, there is accountability. So on the one hand, they sort of, in the back of their mind, know that they can always merge into a bigger firm, but to actually pull the trigger and take that action, that remains to be seen whether or not they are going to do that.”

Metzler predicts the merger trend will continue for about ten to 15 years. He agrees it is going to swing towards being a buyers’ market. “In years to come, there is definitely going to be more sellers than buyers, so a lot of the dreams partners had about the value of their firms are going to diminish a bit because the acquirers or mergers of firms will look to the best and the brightest and merge only that way,” Metzler says. “So, bottom line, you’d better be building a good firm, if you have an exit strategy that can run without any individual stars, that has processes and client service in place that does not reside in one person. I mean, getting ready for succession is at least a five-year process.”

Addressing the challenges Rosenberg believes there are a number of things accounting firms do to address the demographic challenges. One idea is to look at the pay structure for partners.

Rather than the traditional formula of allocating the income based on how many clients a partner has, or how many billable hours they have worked, firms should change the pay and incentive programmes for partners so that they are motivated to put their focus on developing people, Rosenberg says.

 

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