Carve outs in the professional services sector
The tightening of regulatory regimes and changes in strategic priorities across the professional services sector have combined to deliver some interesting carve out opportunities over the past 12 months. The most high profile examples are the restructuring services divisions of Big 4 powerhouses, Deloitte and KPMG, as well as the pension advisory business of KPMG.
The private equity community has been quick to embrace the opportunities presented and see the upside which can be delivered from a range of factors, notably:
- Increasing revenues through removing independence constraints
- Reducing costs by delivering leaner overhead structures
- Improving efficiencies by deploying new IT suites without legacy system constraints
- Motivating partners as owners of the business with direct and aligned equity incentives
Of course there is no doubt that there are enormous benefits from being part of global professional services organisations with brand recognition and networks which are often undervalued in the “dash for the exit”. However, on balance many private equity investors see the upside opportunities outweighing the loss of the brand, wide ranging in house expertise and internal referrals.
At Liberty Corporate Finance we have advised on many of the most high profile professional services carve out transactions including the Deloitte Restructuring business (acquired by Teneo, backed by CVC) and the creation of Isio on the carve out of the KPMG Pensions practice by Exponent. As such we are ideally placed to advise exiting Partners, contemplating life as an independent business, on the range of issues they need to address to help them negotiate the optimum package on the way out of their existing organisation and into the “brave new world”.
So what are the key factors to focus on in professional services carve outs?
Alignment of interests between the selling firm and the exiting partners – it should be abundantly clear to all that this is essential to delivering a successful carve out. Partners in large professional services organisations have typically invested many years in growing their businesses and contributed to the growth of the whole firm. Equally the Partners across the firm will be clear that they have contributed to the success of the exiting partners business. The exiting partners will be leaving behind a huge amount of security which comes from being part of a business with wide ranging service offerings which mean that there is downside protection for a division going through a tough period as well as the upside available with delivering highly leveraged service propositions. Determining a fair basis on which to share the exit proceeds between the selling firm and the exiting partners is vital to delivering alignment of interests. The exiting partners will be entirely responsible for “selling” the deliverability of the future business strategy and will have been largely responsible for generating the goodwill in the division being sold so there needs to be a direct correlation between the price paid for the business and the proceeds delivered to the exiting partners.
Separation planning – do not underestimate the complexity and detailed understanding of the operations of the business which are needed in the separation process. It is vitally important that the ground rules between the selling entity and the exiting partners are agreed up front. This is on everything from the big fundamental points such as the precise service offerings being sold (the transaction perimeter), use of the brand, office locations and IT systems through to less obvious items such as employee flexible benefits offerings.
Standalone costs – another obvious one. However it is often the case in carve outs that the selling entity underestimates the stand alone costs required for the division being carved out. This is not surprising given the seller is seeking to maximise price by presenting the most attractive standalone profit numbers they can. Getting independent and experienced advice including thorough costed quotes for standalone costs is vital.
Transitional services agreements – tenure, basis of charging and service standards will all be important and agreeing these with existing colleagues can be challenging.
Loss of internal referral networks – lots of time is spent assessing the revenue upsides available from removing the shackles of independence rules. These are clearly very significant and often at the heart of the motivation for the proposed transaction. However much less time is spent assessing the real revenue generation delivered via internal networks. This should not be overlooked.
Remunerating partners post transaction – this is a very tricky aspect of the process. Partners in professional services organisations are highly remunerated through annual income based on the profits of the partnership. Typically there are monthly drawings which are at significant levels with additional profit distributions lagging the earning of profits. This means there are a large number of people with very significant annual remuneration (i.e. multiple partners with annual remuneration in excess of a typical mid-market CEO) and this will need to be reflected in the P&L going forward. Determining the balance between base pay / salary and annual bonuses and the variability of those bonus levels is an important aspect of the deal. For private equity investors used to keeping key managers focused on equity upside and not on high levels of bonus this goes against the “natural order” of the MBO. However high annual remuneration is vital for professional services businesses as attracting and retaining the right partners is critical to the success of the carve out and competitors in the market will be all too keen to exploit any perceived underpayment of partners to attract them away.
Alignment of interests with investors – this is the area where professional services carve outs are most like other buy outs. The Partners of the carved out business will be attracted by the potential to make capital gains alongside the investors and will seek to get the best economic package they can. The equity will need to stretch across the whole partner group and a reserve pot will be required to attract in new talent and reward internal talent promoted to partner during the hold period of the investor. This means that the capital upside, while significant, is just part of the overall package rather than being the key driver for independence.
Succession planning – arguably a typical private equity hold period of 4 – 5 years provides a useful aid to succession planning within professional services businesses. Partners can use the investor exit as an ideal point to pivot around for retirements and promotions. Clearly this cannot be the only point where these things happen but it does allow for a natural internal debate about how best to maximise value for the business and the individual partners and demonstrate how succession is being managed for the good of the business.
More to come?
My personal opinion is that there will be more carve outs of professional services businesses from the large multi service-offering players in the professional services sector. Whilst there are gains for all stakeholders in being able to access a range of services from one supplier the risks to independence (or at least to perceived independence) are always evident. Regulators and professional services firms want to ensure all stakeholders have confidence in the markets they serve and this is likely to result in further tightening of regulatory requirements and a small but steady stream of new carve out opportunities.