Professional services : mergers, acquisitions and goodwill

My Saturday July 8 report focused on role clarification within partnerships. My key point was the need to separate equity returns from payment for work. Once this was done, the definition of roles and the remuneration to be attached to those roles could then be dealt with using conventional job analysis and remuneration principles.

In response, one of my colleagues commented that this sounded simple and effective. He asked what I saw as the potential pitfalls or points of resistance.

Key Resistances

I suggested to Mike that there were a couple of key difficulties/resistances.

To begin with, the very transparency/accountability offered by the approach is of itself a key difficulty. Partners don't want to loose control, while the approach also forces them to address differing performance levels between partners that may have simply been swept under the carpet.

This problem can hit early in that you have to start with some allowance for existing levels of partner remuneration before you can strike a notional real profit.

In simplest terms this can be done in two ways. Take existing partner drawings (most partnerships have some form of drawing system) as a given and simply deduct them. Alternatively, agree among the partners a national existing base salary level for partners or partner equivalents and then deduct this. The balance between the notional salary and existing drawings represents the equivalent of dividends.

A second linked technical issue is to get an agreed definition as to what constitutes profit. This may sound simple and it should be, but difficulties can arise simply because partners are not used to thinking in these terms.

Structural issues can arise. Most partnerships have service companies. Some have other companies as well. Then there may be trusts. The issues associated with income stripping, transfers of costs and income to maximise tax benefits, have recently become a real issue with the Australian Tax Office. So the existing partnership structure needs to be analysed and understood to identify issues that might arise from a partner perspective. It may simply be too hard to do something.

Finally, practical issues can arise in terms of the way existing accounting and information systems are structured. The firm really needs to be able to fit the approach within its existing systems.

Introduction to Mergers and Acquisitions within Professional Services

The idea of separating returns from equity and work links to another key issue within professional services, the increasing trend towards mergers and acquisitions.

Why is this important?

All professional services firms are facing the challenges created by structural change within the professional services sector broadly defined.

Increased compliance costs are one element of this. We have seen this among my own Ndarala Group members because of the impact, for example, of increased professional indemnity requirements and costs. A second element is increased investment requirements for new systems and services.

These changes are placing great pressures on both smaller and mid size practices to get bigger or get out.

Demographic changes are adding to these pressures.

The average age of partners/senior managers is rising especially among smaller practices, while recruitment of new staff with partner/senior manager potential is becoming more difficult. Not only are numbers in entry level age cohorts in decline, but attitudes have also changed. Staff are less willing to stay with the one firm, have greater immediate expectations, are less interested in partnerships or ownership, demand greater flexibility.

The scale of the challenge posed by these changes is far greater than commonly realized. Without having crunched numbers in detail, my best guess is that over the next five years as many as a quarter of current practices across a wide range of professions will have to close or merge.

This makes issues associated with succession, mergers and acquisitions of great interest to all those within professional services and especially to those of us advising professional services firms. The very scale of the challenge makes for significant market opportunities in assisting firms to manage the change process.

Goodwill and the Change Process

One technical element forcing change is the changing treatment of, and valuation placed upon, goodwill.

Traditionally realization of goodwill, the value placed upon the business over and beyond its immediate tangible assets, has been the major way of realizing value upon exit. However, this has become more difficult for two reasons.

First, the value of goodwill depends upon the stability and sustainability of the income stream attached to that goodwill. Heightened competition threatens sustainability, making sale of goodwill more difficult.

Secondly, the number of people willing and able to take on the responsibilities of ownership has declined. This has hit hardest at the small end of town, but has also been a problem for the bigger practices where traditionally entry level junior partners have essentially mortgaged their assets and alienated immediate income in order to get future rewards. With professionals less willing to do this, many of the bigger firms have responded by abolishing goodwill, admitting new partners in return for payments linked simply to net tangible assets.

This may have assisted firms to meet immediate needs, but it has also created a new set of problems.

Problem one is a behavioural one, the way in which the new approach has shifted partner focus from creation of value for later realization to maximization of cash now. Investment still takes place to meet immediate development needs and to ensure maintenance of cash flow, but the time horizons and service focus have shifted.

Problem two is a structural one, the way in which abolition of goodwill has in fact opened up professional services to further structural change. The reason for this is simple.

Regardless of all the arguments, the reality is that the firm's intangible assets do have potential value. Obviously the real value depends upon the firm's business. In some cases, the real value may be very low or even zero. But in other cases, the real value may be very significant. So long as these intangible assets are valued at zero, then opportunities are opened up for acquisition of the firm by someone who can offer the owner/partners some capital return.

Two cases to illustrate the point.

So long as market P/E rates are higher than the value offered by existing realization paths (and this almost definitionally follows when intangible assets are valued at zero), then listing or the acquisition of the practice by a listed vehicle holds out the possibility of unlocking capital value.
At the smaller end of town, people's inability to sell their practices creates opportunities for profitable bolt-on mergers or acquisitions to build volume or enter a new service or geographic area.

Consequential Issues

While the changing treatment of goodwill opens up opportunities, these have to be handled with care. We only have to look at the failure of some of the listed aggregators within accounting to see the risks that can be involved.

Four issues are of critical importance from the viewpoint of the acquiring firm.

The first is the need to be absolutely clear on the reasons for and potential value of the potential acquisition. The second is the need to set a price that locks in the potential gains. The third is the need to do proper due diligence. Finally, there needs to be a clear and effective strategy for ensuring effective integration of the acquired entity