Focus on return on relationship, not just ROI.
By Rory Henry
The Holistic Guide to Wealth Management.
There’s no question the pandemic accelerated the accounting profession’s transformation and the entry of private equity (PE) into the marketplace. In many ways the pandemic years were an inflection point. The old way of doing things – meeting clients face to face and providing tax and accounting services – is essentially over. The pandemic and private equity are propelling the profession forward as firms adopt new service offerings, change how they operate, and find innovative ways to recruit, retain and compensate talent.
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PE is considered “smart money” because it has a track record of building better business models, increasing efficiencies and then selling the companies and firms they invest in for a profit. Smart money sees enormous potential by investing in accounting firms thanks to technology that makes it easier than ever to integrate professional services on a much larger scale.
Putting the CPA at the center of a comprehensive client relationship will have a positive flywheel effect as the momentum builds on itself.
It’s a brave new world!
Relationships and Goodwill
While it’s great to leverage technology and have excess capital to spur growth, PE investments in accounting firms won’t generate much ROI without people and relationships. That’s what this post is all about – relationships and maximizing your return on relationships (ROR).
Relationships are the linchpin that allows technology and capital to propel accounting firms forward into the brave new world. Ultimately, a firm’s value and goodwill are fundamentally rooted in its relationships with clients, employees and partners. By aligning these relationships with proper incentives and strategic investments, firms can create a harmonious environment that leads to success for all parties involved.
Accounting professionals should embrace these changes and see them as opportunities to grow and succeed.
Private equity firms (aka “The Smart Money”) are known for building better business models and making smart investments. With the integration of technology, scalability has become more attainable. Private equity sees potential for disruption in traditional ways of operating the accounting firm partnership model. As we’ll discuss shortly, early signs are that the PE approach to running an accounting firm is working. But the infusion of money and best practices, and the integration of wealth management and other ancillary services depends on the continued goodwill of the people who run the businesses, which are still rooted in relationships.
This human element of advice should not be overlooked. Incentives and relationships aligned between private equity investors and accounting firm management can lead to great outcomes for both parties, including increased growth, profitability and high earning potential for the people who work there.
Bob Lewis, president of the M&A advisory firm The Visionary Group, told me recently that leading accounting firms are integrating non-tax services with success. From a smaller firm perspective, those that think strategically can plug into a virtual family office model, expand their services, increase profitability per relationship and help their clients achieve greater financial well-being.
We are transforming from a knowledge and service economy into more of a relationship-driven economy, which companies like Apple have perfected. It’s not just a product or a service, but a holistic relationship including the in-person stores and Genius Bars to help the customer get more out of their products and services. It’s an entire ecosystem in which the customer meets like-minded consumers and the employee evangelists who work there.
As AI takes over more and more of the compliance work, accounting professionals who can help clients in areas beyond tax prep – both for business and personal – are much more likely to survive and thrive. How you choose to integrate tax, accounting, wealth management, insurance, business exit planning, retirement planning, estate and more is up to you. That’s what the Virtual Family Office model is all about.
Integrating services and leveraging human-centric advice is a powerful combination. Offering additional services to clients can lead to an abundance mindset for firms. This approach takes the client relationship and turns it into a financial flywheel, allowing firms to have deeper, more meaningful client relationships that in turn are much more profitable.
For instance, if your accounting firm generated $2 million in revenue primarily from tax work, you might be able to sell it in a few years for $1.6 million to $2 million (i.e., at 0.8x to 1x revenue). But if you had a wealth management firm generating the same $2 million in revenue, you would likely fetch $4 million to $6 million for it – two to three times as much. But if you integrated wealth management and accounting, it becomes a force multiplier worth even more.
Shortly after a sizeable RIA (Creative Planning) announced it would acquire IPA 100 accounting firm (BerganKDV), accounting industry transaction guru Allan Koltin wrote in Inside Public Accounting that “it’s only a matter of time before we see Apple, Microsoft, large family office groups or sovereign wealth funds express interest in buying accounting firms.” He wasn’t being facetious.
It’s no secret that PE firms have been taking stakes in professional services firms for decades. But when TowerBrook Capital Partners invested in the Top 20 firm EisnerAmper in 2022, many believe that deal put PE officially on the accounting industry map and there’s been no looking back.
Not everyone is thrilled about this trend, of course. Some worry that the relentless focus on technology and the bottom line will push out the personal side of accounting. And of course, PE stakes in accounting firms don’t always pan out.
An accounting firm may look like a transactional type of business because it is numerically focused,” observed Lewis. “But accounting is deeply relationship-driven. There is a unique bond that occurs when a client is dependent on their accountant to help them affirm or build their profitability and impact their tax liability.”
“People ask me all the time what PE sees in the accounting space,” recalled Randy Crabtree, CPA, co-founder of Tri-Merit, a specialty tax credit firm based in Schaumberg, Illinois. “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.” According to Crabtree, 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,” he added.
The growing interest of PE, wealth management funds and other strategic investors in accounting or CPA firms is driven by several key factors, noted Phil Whitman, CEO and president, Whitman Transition Advisors LLC. “Since accounting firms perform tax planning, tax compliance, and other audit and attest function services, the stable nature of these recurring revenue streams enables them to remain resilient even in economic downturns. This stability, coupled with high client retention rates due to long-standing relationships, offers predictable and reliable returns for investors,” he added.
As many have told me, firms are merging aggressively to expand geographically and to expand their products and services at a time when boomer partners are retiring at a record clip. In addition to the TowerBrook/Eisner deal, here are some of the other more significant ones:
- BDO USA, a Top 10 tax and accounting firm, acquired Morrison, Brown, Argiz & Farra, a Top 50 firm in Miami.
- Springfield, Missouri-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.
- BDO USA’s $1.3 billion ESOP will allow 10,000 employees to buy a stake in the firm.
What makes CPA firms attractive to PE? Crabtree shared six compelling reasons:
- CPA firms are low-risk and recession-proof compared to other industries. Many accounting firms had one of their best years in 2021 and 2022 with 2023 tracking similarly.
- Valuations are relatively low, considering the profitability of the firms and consistency of revenue.
- Balance sheets have little debt.
- Strong cash flow. More than 50 percent of the revenue (in some firms up to 80 percent) 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.
Beyond acquisition financing, why else would CPA firms agree to take PE money?
Koltin pointed to a “perfect storm” of factors on a podcast we did together. In addition to firms’ strong need for capital and a tidal wave of boomer partners retiring, he said there’s a “major transformation of the platform of public accounting, from simply compliance to consulting.” He believes there will be an evaporation of compliance because of the bots, machine learning and blockchain. According to Koltin, 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.”
Crabtree agreed. As with so many industries, he said 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 – he believes that can help a firm’s bottom line in terms of growth and scalability. On his Unique CPA Podcast, he said he had recently had a guest who firmly believed that technology would not reduce the number of humans we have at accounting firms because technology will free up human workers from doing routine grunt work so they can focus on higher-level, higher-margin work. That is what contributes to the bottom line, according to Crabtree. “Who wouldn’t be in favor of that?” he asked.