In the late 1990’s and early 2000’s there was a lot of activity in the accounting services sector as the rules relating to ownership of firms were being relaxed to allow non-accountants to own equity in firms. The accounting services sector was then (and now!) highly fragmented which presented an opportunity for consolidation, owners of firms were ageing and many were thinking about retirement at a time when the next generation of prospective owners were not showing much interest in partnership, and the competitive landscape was becoming more intense dues in large part to a somewhat disruptive impact of technology and other things.
At the time I was the CEO of Results Accountants’ Systems. We had a large number of small and mid-sized member firms in our global network and we had been thinking whether our members and their clients would benefit if we were to orchestrate a consolidation. We decided not to for the reasons outlined in this memorandum.
When I read through it I realized that much of what I had said in 2000 would apply to the private equity plays we’re seeing today. So I thought I’d share it. Some of the points I made have not turned out to be correct but I believe the essence of my essay is close to the mark. The big difference between then and now is that the targets for consolidation were small and mid-sized firms. Today, private equity seems to be focused on much larger firms but I suspect smaller PE players will appear on the scene and become part of an PE ecosystem about which I will say more in another post.
The Challenges Faced By Consolidators Are Going to Be Huge
About 6 months ago a client asked my opinion on whether his firm should sell out to a consolidator. He mentioned that he’d just become a partner, was 29 years of age and did not really relish the idea of spending the rest of his life working for a faceless boss in another city.
The question he was asking is “what’s in it for me?” He should also be asking “what’s in it for my clients?”
I suggested to him that, in my opinion, there was little in it for him or his firm and little, if anything, in it for the firms’ clients.
In the face of de-regulation of the industry there has been a rush by organizations to consolidate the accounting profession. Hardly a day goes by without another new player announcing that it intends to roll-up a group of firms, IPO and then pursue an aggressive acquisition strategy.
If this made long term economic sense—as opposed to the opportunity for short term entrepreneurial profit for the promoters—my own company would have done it two years ago when it started in the US with Century Business Services (CBIZ) and American Express Tax and Business Services. We looked very seriously at doing a roll-up of the very large number of firms in our global network and came to the conclusion that the concept of consolidation flies in the face of the fundamental economics of the industry and it will not work.
The scoreboard in the US seems to bear out this conclusion. For example last year American Express managed to lose $US100 million on its consolidation business. CBIZ’s share price is languishing at around $US1 (from a high in mid 1998 of $US20) and by all accounts is in serious trouble with a daily exodus of executives and the sale of several subsidiaries as it attempts to rationalize its operations. Centerprise, another consolidator that planned an IPO, has not yet made it to the line. The only ‘success’ to date, and the jury is still out on it, is the H&R Block acquisition of McGladrey & Pullen.
At the end of the day, an industry’s structure is driven by the economics of the industry not the other way round.
The Economic Forces That Determine the Structure of the Accounting Profession
Business clients tend to gravitate to professional advisors who ‘look and feel’ like themselves and to the extent that there are a very large number of small businesses with revenues in the $500k to $20 million range there will be a natural demand for smaller accounting firms. This has been one of the main reasons why the profession has always been fragmented and it is arguable that it will remain fragmented.
To establish an accounting practice does not require a large amount of capital. The technology needed to provide core accounting services is readily available and relatively inexpensive. Most of the value created by a small accounting firm comes from the “head” of the principals. When barriers to entry are low attempts to gain advantage through consolidation are thwarted by a continual stream on new entrants to replace those who are acquired or disappear for other reasons. This tends to keep prices low and unless there are economies of scale that a larger group can exploit, margins will also remain low.
Typically there are few scale economies in fragmented industries. Production processes are standardized and tend to utilize more or less the same technology available at relatively low cost to any organization that wishes to enter the industry. Furthermore, because the principal industry processes are not complex there is little experience curve effect that might otherwise give incumbents a cost advantage over new entrants. For these reasons the cost structure of firms in these industries is more or less the same.
If the product or service offered by an industry is generic and clearly defined, as it is in the accounting industry, and there is little if any need for investing in continual R&D to remain competitive, small firms will tend to dominate the landscape. This is reflected in the absence of scale economies and is one of the reasons for low barriers to entry. Because professional service firms generally can’t claim access to exclusive valuable proprietary technology or uniquely branded products, their value proposition is built on ‘personal’ service and a relationship with clients and that is difficult for large firms to match.
I have seen some reference in the business plans of consolidators that they intend to create group synergies (another word for scale economies) in the areas of back office support including technical research, systems integration and marketing as well as offering their firms access to an extensive array of financial products. It makes for great reading and seems to make sense. But very large firms have been doing this for years and yet their cost structure is almost identical to smaller firms. In fact I would go a step further and say that the most profitable firms (measured by net profit per partner) in the industry are categorically not the big ones.
The key to practice profitability comes down to two things: the prices charged for services and the degree of people leverage. The highest profit performers are to be found amongst firms that have an employee to partner ratio of greater than 6:1 and who charge prices that are in the top 2-5% for firms of their type and size. Because of the nature of the work that accounting firms typically do and the fact that they all utilize the same technology and people with similar skill sets, there is limited scope to improve productivity and I will be staggered if the consolidators will be able to do anything about this.
Small firms are more adept at absorbing seasonal fluctuations than large scale operations. One reason for that is that small firms tend to have lower relative fixed costs in their total cost structure than large scale operations, which means they have lower break-even points. The accounting services sector is characterized by seasonal demand fluctuations. Many firms hire part time people during their busy periods or the team are willing to put in extra effort. During quieter times they can scale back their operations – this type of capacity management is very difficult for large scale businesses to manage.
Is there competitive advantage to large firms in dealing with customers or suppliers?
The mergers amongst the Big 6 in recent years were driven in the main by the need to be able to effectively service their huge global corporations that comprise their client base. It could be argued that capital pooling was also an issue here.
However, the present cohort of consolidators are minnows compared to the Big 5 and none could seriously lay claim to being a contender for the market space they occupy. The question therefore is: will a large consolidated firm have any competitive advantage over smaller independent firms in relation to its client interface and/or will it enjoy any supply chain advantage?
As to the first part of this question, I can’t see any advantage at all. In fact I suspect the consolidator will be at a decided disadvantage in that on a size basis it will be up against the entrenched second tier firms at the top end of town on the one hand and on the other hand it will be up against the smaller independents in its constituents’ traditional franchise. Unless the consolidator can offer clients something that its competitors can’t match it will have nothing other than size as a differentiator.
In relation to the issue of supply chain buying power I find it hard to get excited about the opportunities here. Unlike the video hiring industry where small independent rental shops had no clout against the film industry, accountancy practices simply do not deal with powerful suppliers and apart from their labor expense there is very limited scope to improve margin through buying leverage. There will be some benefit to be sure but in the big scheme of things it will not have much impact on the bottom line.
The most important productive resource in accounting firms is skilled labor. It is also the major cost center. One sure way to destroy an accounting business is to ‘steal’ its key people especially at the present time when there is a shortage of trained and experienced personnel. To the extent that large firms can offer more attractive conditions and benefits to employees they represent a very real threat to small firms in the industry and this alone could be where the battle for market dominance takes place.
Attracting and retaining talent is the big issue in the profession at the moment and all indications are that it is going to remain an issue for some time to come. There is no doubt that labor costs are going to rise because of supply shortages and this will add to the pressure on margins that technology is already exerting. Of all the possible advantages that a consolidator may be able to offer, this is potentially the most viable but it will come at a price—namely employee share options and other benefits including training, opportunities for travel and so on.
Size brings with it diseconomies.
Large firms are usually less nimble than small ones. This is particularly true where there is a need for overhead to remain low, where there is a diverse product line that requires a high level of customization and/or interface between the customer and the service firm, where there is a high level of creative content, where there is a need for close local control or where local image and contacts are critical. All of these things tend to favor small business units and in the accounting industry will favor small firms.
Where products or services are capable of being highly differentiated it is difficult for a large scale firm to assume a dominant position in the market. This is why differentiation is such an important strategy for small firms to adopt to compete effectively with larger firms. But it is not something that is an issue just for small firms. Consolidators will be offering essentially the same products and services as their independent competitors and mere size is not a differentiator that, in and of itself, creates value for clients—if anything, in the personal service business, size is probably a disadvantage.
Will the consolidators be able to retain their acquired personnel?
Once the honeymoon is over it will be interesting to see how many people who sell out to a consolidator happily remain on as an employee. Working with professionals has been likened to “herding cats” and if mergers and acquisitions of the past are any indication it is highly likely that many people who sold out will get out as soon as they can. Clearly this will not apply to everyone but the cultural shock from being your own boss to working in a command-and-control corporate environment is going to have to be reckoned with by the consolidators.
Given the low costs of entry that I have previously mentioned and the fact that clients attach much more closely to their advisors than to their advisor’s employer I suspect that we will see some defections from the consolidation ranks over time and with it, the emergence of new firms.
This will not just apply to partners who sell out but also their employees. The economics of this industry favor small firms and my gut tells me that talented people will see opportunities to start their own practices to offer their clients “personalized service” – does that sound familiar. But this time around, if the employer is a heartless corporation rather that the family firm that the client has been dealing with for years I believe that the client will have no sense of loyalty so it is likely that it will be much easier than it has ever been.
What are the choices?
The future for the accounting profession is very interesting indeed. Personally I think the opportunities are fabulous but the pitfalls are many.
First up, I do not believe the consolidators will prevail at the end of the day. I feel quite confident in predicting that the stock market will not value these businesses at the sorts of multiples that are now being touted (and in fact achieved for the present) once their fundamental business model is shown to be flawed.
There are two flaws in the consolidation business model. First, I do not believe large firms will be able to secure and retain the market share they would need to effectively control the economics of the industry. The barriers to entry are such that they will always have smaller and very capable competitors. Secondly, I do not believe that large firms can offer products or services (including the quality of service) that smaller firms are unable to match through strategic alliances and as members of robust global networks. In the US at this time, strategic alliances and strong networks offering the essence of a multi-disciplinary practice are receiving far more acceptance than consolidation.
There is no doubt that the competitive landscape is changing but to think that the only way to cope with change is to get bigger is absurd. On the other hand, any firm that thinks that it will be doing in 5 years what it is doing today is in for a big shock. Some firms will disappear but not because of consolidation. They’ll go because they lost their way.
If I were a partner today and thinking of retiring I would be happy enough to sell out to a consolidator. In fact I’d be happy to sell to anyone as long as the interests of my clients and my employees was not an issue. If I did sell I’d want 100% in cash – they can keep the script for someone who sees some long term merit in their business model.
If I were planning to spend a lot more time in the profession I would most definitely not sell out to a consolidator. I’d get my firm into shape for the exciting times that lay ahead. Specifically I’d be looking forward to the day when I could go head to head with the consolidators. I would join a global network, I would make sure that at the product level I can match everything the large corporates are offering clients, I’d have the internal operations of my practice fine tuned, I’d be operating my firm as a business along corporate lines, I’d have my key people on profit sharing and an equity option plan, I’d be keeping very close to my clients and I’d be developing highly customized services that they need and want.