Delivering Dividends: Investing in Accounting Firms

Since 2020, private equity firms and accounting firms have experienced a mutual attraction, with multiple deals making their way to the finish line, and experts say that trend is likely to continue. Allan Koltin, CEO of Koltin Consulting Group, joins the podcast to discuss why accounting firms are transforming, how acquirers can determine which accounting firms are attractive targets, and the opportunities emerging in the sector.

MMG: Welcome to the Middle Market Growth Conversations podcast, I’m Carolyn Vallejo. Private equity investment in accounting firms has risen over the past two years, signaling that investors see the sector as an appreciating asset. Researchers agree, projecting a $1.5 trillion market size for accounting services by 2032. Here with us to discuss what’s behind acquirers’ rising interest in the space is Allan Koltin, CEO of Koltin Consulting Group. Allan, welcome.

Allan Koltin: Carolyn, thank you. A pleasure to be here.

MMG: Thanks for being here! Let’s first look back into the recent past: What do you think kickstarted this trend of PE interest in the accounting sector?

AK: I think PE had so much money they didn’t know where to park it, so they took out the dictionary and accounting was the first letter!

No, I’ve been working with private equity for about 17 years. They tried to come into the accounting profession with a roll up in 2007 and 2008. It failed, probably partially because it was the summer of 2008 and you know what was going on that summer. A couple of firms tried again in 2011 and 2012; in fact, I worked on that initiative. The PE firm was New Mountain Capital. I mention that because years later they did officially enter the market.

We talked to the CEOs of 20 of the 25 largest accounting firms in America and they all said the same thing: ‘We’re a steady-eddy business, we don’t need capital, thanks for the offer but when we need a line of credit we go to the bank and we sure don’t need to give 10 to 15% of our profitability away when the banks are making loans at 1 or 2% over prime.’

Fast-forward to the first quarter of 2020: Someday if I ever get time to write a book about PE and the accounting profession converging together, that to me was the ‘wow’ moment. Three or four things all happened at the same moment, sort of in the category of ‘you can’t make this stuff up’: The war for talent accelerated in a way we never thought possible, with five straight years of double-digit decreases in the number of college graduates getting their accounting degrees. The truth was, it wasn’t paying enough and there were a lot of other great opportunities, ranging from going to work for private equity, investment banking, data analytics, technology, you name it.

Number two: For the first time in our professional lives, [since] the accounting profession was founded in 1887 and 135 years later, we needed real capital because of technology—to go out and build those bots and AI and machine learning and blockchain and to do what used to take 200 people hours and now do it at the flip of a switch.

But it was the third thing that I think caught everybody’s attention, and that was transformation—transformation from being bean counters, compliance providers. If you look at the accounting profession, we do two things historically: We provide financial statements and tax returns. I will tell you that [with] either one, rarely does a client ever say ‘thank you.’ Nobody wants an audited financial statement. We do it because the bank, the lender, the PE fund, the surety, the bonding agent demands it if you want the loan, and nobody ever says on October 16 or April 17, ‘Thank you for doing my tax return, that was a great experience, I don’t know if I can wait another 364 days.’

We’re in the business of providing what we call Type 1 services, services that clients need but don’t want. Type 2 services is where the future is. It’s all about building up the suite of advisory, consulting, outsourced services, but to do that—and this is critical—you go out and you do M&A. The problem is, with those kinds of companies, you have to put real cash currency on the table and we don’t do that in the accounting profession. We do something where we say, ‘Come join us, you get nothing, if you make it to 65 and you fully vest in our firm, we’ll pay you two times your compensation spread out over ten years as ordinary income without interest.’ Simply stated, the deal sucks, but it [was] all we knew.

Game on, fourth industrial revolution. If you’re going to thrive, survive as an accounting firm, you’re probably going to need a capital and strategic partner.

Allan Koltin

Koltin Consulting Group

So private equity has come into our world: A, we need capital for technology. B, we need capital for transformation to go from compliance to consulting and advisory. And C, we need capital because talent is going the wrong way and what we’re finding from many firms is offshoring, going into India or the Philippines or wherever and actually acquiring companies that provide workers. And those workers are every bit as good as ours and would cost us $125 in the U.S. but guess what, it’s $25 offshore. To make matters even more important, the young kids today coming out of the schools, they don’t want to do the mundane. The reward they get if they’re really good at doing that is you give them more, and they show you, they leave and they go somewhere else. As you know, the Wall Street Journal reported [that] over the last couple of years, 300,000 people left the profession, the great resignation.

So, game on, fourth industrial revolution. If you’re going to thrive, survive as an accounting firm, you’re probably going to need a capital and strategic partner.

MMG: Now, you just mentioned the great resignation which I do want to get to later on in our conversation. But first, you just touched on this evolution of the accounting space: Accounting firms need the capital as you say, private equity acquirers will want to acquire businesses that are evolving of course, so it seems like a mutually beneficial scenario when it comes to M&A here. How do you see interest among PE firms in terms of acquiring accounting firms developing today and into the future? Would you say that interest is still strong on both the buyer and the seller sides?

AK: Great question, Carolyn. So you know, the first official deal—there were other ancillary deals, but within what I’ll call mainstream public accounting—took place on July 1, 2021. Since that time, in the pure accounting firm space, there’s been about six or seven deals, most of them happened in 2021 or 2022.

2023 unfortunately was sort of the year that wasn’t: Deals that would have crossed the finish line, [but] three things happened. Number one, in some of them there was litigation that took place and the deal’s out. Number two, in some of them there were pitching changes, where CEOs left and new ones came in and the PE funds wanted a little time to get their arms around that. And number three, and probably the biggest reason, is just the doubling of the cost of capital, the cost of debt, which was now two times higher than it had been as recently as the year before.

Most of the firms I talked to said, we’re going to wait until 2024, but interestingly most of the accounting firms that had big transaction advisory practices, due diligence, Q of E practices, said the same: We’d rather show our numbers based on 12/31/23 results and then as we continue discussions through 2024, move more to the trailing 12 months which we know are going to be stronger and better. So my bold prediction is a quiet 2023, I think 2024 will probably see no less than a half dozen PE firms enter the market and probably three or four of those will be with top-20 CPA firms.

MMG: For those PE firms entering the market, what are some of the challenges of investing in an accounting firm? What do these potential acquirers need to consider?

AK: You know, there’s a group of PE firms and I know they all talk within EBITDA and size of check; we in the accounting profession talk in terms of firm revenues.

There’s a group I call the heavyweights; if the firm is typically $500 million of revenue and above, they’re interested. There’s what I call the middleweights; they’re looking more at firms in the $100 million to $500 million space. And then I’ll call it the welterweights; I’ve seen private equity looking as small as $5 million of revenue up to $100 million.

The good news on this is there’s a place for everyone. The bad news is I’d say judging by the number of PE firms that want to get into this space, there are probably more PE firms that want to get in than there are available accounting firms. I should probably just put this out there for those listening: There are 45,000 accounting firms. It sounds like a staggering number, [but] 33,000 are sole practitioners, 12 or 11,000 are 2-3 partner firms. Looking at it the other way, the 100th largest firm you’re already down to revenues of $50 million, the 200th largest firm is $25 million, the 300th largest firm is $13 million, and the 400th largest firm is $10 million. So in an industry of 45,000, one could argue that there’s really only 500 firms that matter, that are probably in the wheelhouse of what private equity wants to go after.

MMG: You touched on this a little bit before but I’d love to get further into some of the ways that the accounting sector is evolving, not only so we can forecast where this industry is headed but so that we can take a look at how this space could be even more appealing to acquirers and create an opportunity for value creation.

AK: I feel like I’ve become a fundraiser with accounting firms. Our wheelhouse is pretty much the top 200, 300 accounting firms and we do a lot of strategy work and I think the last couple years it’s been more like being a fundraiser. Because what we really say to firms is say, look, there are three doors here: Door number one, I don’t know if you’ve seen the move Groundhog Day with Bill Murray but it’s sort of, do the same thing over and over, and lots of firms just keep doing that. The last three years have seen great profitability, they’ve been able to raise rates, they’ve been able to get rid of crappy clients, and honestly if you couldn’t make money the past couple years in public accounting, you probably should look for some other job. That’s the good news.

The bad news is we’re all killing ourselves because we can’t find people. We have a capacity problem. Because of that, we’ve raised rates dramatically for our A clients and we’ve fired more C clients than we’ve done in probably a decade before. So, making great money but not a sustainable way to do business. The question becomes, how much—as you know, accounting firms have zero EBITDA, they clear the till every year—how much money are you willing to give back to the cause to, if you will, transform the firm? As we call it, the fourth industrial revolution. For 100 years, the accounting profession sort of got a free pass. Now, they’ve got to have a wakeup call. The message is, do you want to just keep grinding like you’re grinding until you can’t?

That’s door one, door two is: Do you want to put the current company out of business? Do you want to sort of reinvent yourself and move from being a compliance shop to a consulting and advisory firm? If you do, we need capital.

And number three, if you don’t want to give capital, door number three is, let’s merge upstream, either with what we call a mere mortal—that’s a larger firm that’s not PE-owned—or one that is PE-owned. What we’ve found the past couple of years is many, many fiercely independent firms that [used to be] door two have moved to door three because what they used to say is, we never needed capital but now we need it, and number two the economics of merging up was terrible. There was no win, you get nothing. You just get that unfunded chain letter that you already had.

Hence the question is, will it be our own money, reducing current comp; will we go to a bank and borrow money; will we do nothing; or will we partner with someone else and together we can accomplish something faster and better that probably neither of us could have accomplished on our own? That seems to be where a lot of the bell-ringing is currently going on.

MMG: We talked about some of the challenges of investing in accounting firms. Let’s switch over to some of the green flags that private equity firms should be looking out for. Do you have any tips on how potential acquirers can determine whether an accounting firm is an attractive target?

AK: I sure do. What a wonderful question. My stats look something like this: I’ve had five or six that have crossed the finish line, but I’ve had 10 to 12 that have died. In our world, accounting firm to accounting firm is really easy: “Come join us, you get nothing, you get the same crappy deal we get when we retire.” Unfortunately, there are three or four rites of passage that private equity, when they come in, cause us to think about.

Number one, the brain of an accountant—trust me, I’ve got about 100,000 hours of studying that brain invested and I can say this because I am one—they’re not risk-takers. They don’t want their world rocked. They’re a product of predictable behaviors, they detest change. But other than that, they’re pretty flexible businesspeople. And I’m being a little sarcastic here but its leadership of the firm and can they sell an alternative way of doing something that up until recently had never been done before?

If they get through that [rite of] passage, the next [one] is, are they profitable enough? As accounting firms are learning more about the PE process, it’s EBITDA times multiples equals enterprise value. Well, if you can’t put a strong EBITDA on the table, in order to do that you probably need to be in the upper-third from a profitability standpoint in our profession, high average partner income, and many many firms just aren’t profitable enough. I get a lot of calls from these accounting firms: Can you help me find a PE partner? And I say, just send me your numbers. And I look at it, and they’re in the bottom half or bottom quadrant of earnings, and I say, you don’t qualify for the loan. They say, what do you mean? I say, you’re just going to get insulted because we can’t scrape enough of the shareholder comp to even get you close to getting you an enterprise value of 1x revenues. Best thing you could do if you need to merge is merge with a mere mortal, a bigger accounting firm, or let’s go find a way to make more money. So the EBITDA is the second one.

The third one is, okay we get to an LOI and we have an enterprise value—the partnership agreements for the most part are silent on how to allocate the funds. Some would say some have an ownership percentage, some would say we’ll take your comp, divide it by the total comp, we’ll create a percentage, that’s what you get. Others would say take out a dartboard and we’re just going to guess. So there’s a navigation that goes on of how to allocate enterprise value, both the cash at close as well as the rollover equity, and some of those deals that I had died right there.

And if you get through all those three, there’s a fourth one called the Big Four. It’s when the PE firm goes out and hires the national accounting or consulting firm to come in and do a Q of E or due diligence. More times than not, those firms—and I say that respectfully, my son Brian works at one of those firms, RSM, in their transaction advisory group—but they kick the crap out of the numbers and now the war starts. We, to get the partner votes, have already sold a certain EBITDA and a certain deal, we thought we’d heard from the PE group that they’d stand behind us, and now they’re nowhere to be found and now there’s a re-trading going on. I’d say if there’s ever one thing that has aggravated, irritated the accounting firms vis a vis the PE partners, it has been that. The messaging has been go do your own Q of E before you go to market, come prepared and assume some of that EBITDA will get reduced. Those are the four pillars that hurt it one way.

You’re probably going to ask me to flip it around: What is it about the accounting firms that they need to look for in a PE partner? Most firms that make it through the PE portal are uber-successful so the last thing they’re looking for in a PE partner is someone that’s going to come in and micromanage the crap out of the business. That’s a nonstarter. But some firms like to get really involved and go beyond being a high-level strategic and capital partner.

The second one is I always love to ask the PE firm, give me your EBITDA range, and they’ll say to me something like, it’s $5-20 million but we can go as high as $50 million. Oftentimes what that means is they’re going to bring another partner in, but it’s a warning sign to the accounting firm that if you’re going to go and two, three, four, five X this business, that capital partner may have to sort of reapply every time to get the funding to make that happen, so you want to get in with a firm that doesn’t just have the financial wherewithal, but more precisely, and it’s probably the most important point, shares the vision of what you’re trying to achieve together.

You know, if you think about it by definition, PE firms are in the business of growing EBITDA and selling that investment. Accounting firms are in the business of building, creating the firm of the future today, which takes capital, which goes against building EBITDA. So you’ve really got to establish what we call the bill of rights pretty early to find out if we really in fact are compatible together.

MMG: As I mentioned, I want to get back to this topic of the great resignation. You said earlier that there were a lot of departures of professionals in this industry. We’re also seeing that interest in the profession overall is dwindling by students and younger professionals. So how big of a concern is this human capital issue for potential acquirers and could an influx of capital help to counteract it?

AK: It’s a huge concern and it should be a huge concern. I will tell you when this shakes out, you’re going to have some winners and some losers. I think there are firms today that are in what I’ll call asset-building mode. They’re investing real capital today, whether they’re part of PE or not, to build that firm of the future. The truth is, in the old days, and this is my visual and I know we’re just on audio, but think of a pyramid: a handful of partners, a decent number of managers and oodles and oodles of staff to do the work. Call it the leverage model. That model no longer exists.

Think of it now more as a diamond shape: some partners, more mid-level people, and not as many people at the bottom. Why? Because 15-20% of all billable hours now get sent to India. You know, the Big Four were way smarter than firms 5-500. 25 years ago, they saw that light and what you’ve had is lots of capital being deployed over the last decade of getting people in other places outside the U.S. to get work done at $25 an hour versus the same $125 an hour we pay here. That’s a competitive advantage.

We’re also seeing in this asset-building model deep, deep investments in technology—in AI, blockchain, machine learning. I was with a firm recently that’s maybe the number one bank audit firm in America and the leader of that practice was asking the group about blockchain and said, “Don’t you get it? You know what blockchain is going to do? Blockchain is real-time reporting. When we do our bank audits, it’s 100 days after the fact. One could argue it’s a report card of the past, it’s stale goods. Well, if they get to a point where they can get real-time reporting, they’re going to eliminate”—this is their words, not mine—”the middle man and the middle man is us.”

So you have this great migration on the compliance side where some of that business could be evaporating over a period of time. People always say to me, “Wait, Allan. We’re going to get the same revenue but we’re going to have less labor, so wouldn’t our profit margin be higher?” And normally you would say yes, but the reality is if you look at the last 50 years of public accounting we have the franchise to do an audit and oftentimes who wins the audit? The lowest price.

I believe any of those technological savings up to a point will be minimized because the marketplace buys a commodity product and they’ll still always be looking for the lowest price. So those are the kinds of investments—talent, technology, transformation—I do think there’s a group of firms out there that have become virtual firms, eliminated the bricks and mortar, that can now recruit talent all over the country and there’s not one size fits all anymore. If you want to work full time and come to the office god bless you, if you want to work part time and be remote we can do that. If you need flexible scheduling, if you don’t want a career path to become a partner we’ve got an alternative career path. I’ve seen accounting firms get more religion on the human capital equation in the last 3.5 years than they’ve had in the last 35. What the leadership of these firms have said, they’ve called the marketing department and they said, I want you and the HR department to merge and I want you to treat recruiting talent as the number one industry niche we’re going after. So millions of dollars, billions of dollars at the Big Four, being spent on how to recruit and steal stars, how to retain and have happy people, and then most importantly is how to get them to reach their potential and ultimately become future partners, future leaders at our firm.

MMG: Well, the accounting industry is clearly looking towards the future. Looking ahead here, as more private equity firms invest in and acquire accounting firms, what are the next four to five years going to look like, especially as these investors prepare for exit? What will the M&A landscape look like? Are strategic acquirers going to enter the fold? Give me a picture there.

AK: Fantastic question, Carolyn. The crystal ball if we look the future, I think one of the things we didn’t plan on was the outside investor being something other than a PE firm. We should probably start there. I’ve received calls and there’s deal discussions in progress from very large family offices, from sovereign wealth funds, every day is a new one. Large teachers’ pension funds. I think it’s out there that accounting firms are good investments. They can be run better, the partnership model is not the best way to run a business, they have sticky clients, they’re good and ethical people, they thrive in good times as well as bad times during recessions, they undervalue their business, and they need capital and a strategic partner to recreate their businesses.

This perfect storm is something that’s attracted not just PE but all these kinds of businesses. You know, Carolyn, you can’t make this stuff up, about a year and half ago, I’m out in the backyard doing work on the lawn and I get a call from an 816 cell phone number on a Sunday afternoon. I think it’s my cousin trying to prank me again, he’s always doing that, and he says, ‘Is this Koltin?’ I go, ‘Yeah.’ He says, ‘I hear you’re the guy.’ ‘Okay, to do what?’ And he says, ‘To go find me a billion dollar accounting firm.’ I go, ‘Oh, that’s funny. That’s a good one, yeah. There’s hundreds of those out there.’ Truth be known, there’s only ten of them in America. And I said, ‘So, why?’ And he said, ‘Well, we’re a big wealth management firm and we think that if we can find a great accounting firm with a substantial tax practice, we can take our business to the next level.’ I’m obviously paraphrasing a little bit. Finally I asked the individual who I thought was my cousin if they could spell the name of their company, trying to sort of end this call, and he says, ‘Okay, first word is “Creative,” C-R-E-A-T-I-V-E, and the second word is “Planning,” and that’s with two N’s.’ He said to me, ‘You have no idea who I am, do you?’ And I said, ‘Uh, I don’t.’

He said, ‘I’m Peter Mallouk, I’m the found and CEO of Creative Planning. We’re a 200-something billion dollar wealth management firm based in Kansas City.’ I said, ‘Peter, I feel terrible, I thought you were my cousin. Why would you slum it? Why would you go buy an accounting firm at a time when accounting firms want to go buy wealth management firms because they make a lot of money, more money than us?’ And classic, it was almost like I was talking to Sam Walton from Walmart, you remember Sam’s thing? ‘I get in the river in the boat and I watch how the competition’s rowing and I go the other way.’ Counterintuitive. What does he say? He says, ‘Look, Allan, the world of wealth management—when the market’s up, you’re a hero; when the market’s down, they leave you. What we have is 20, 30 prongs, the value-added services for high-net-worth clients that we like to stick in them. We find the more of those we deliver, the less likely they are to leave in good and bad times. We are that trusted advisor. The problem is if I go to a national firm and bring one tax person over, there’s no scale. So we’ve concluded we need to find a great accounting firm that’s heavy in high net worth [and] tax and bring them in.’

To which I said to him, ‘But you can’t just bring that in, you’ve got to bring in audit, you’ve got to bring in cyber, technology, forensic, business valuation, client accounting services.’ And his comment was a really intelligent one; he said, ‘You know what? If they’re good businesses and we can grow them, bring it on. If that’s what we need to do to unlock all that tax talent, let’s go for it.’

So, every day, I kid you not, Carolyn, since that first quarter of 2020, I wake up, I get a call, I hear something, and I say, ‘Wow, that’s never been done before.’ And here you have it playing out right in front of us. So, when I talk about the future, I would say that private equity and other outside third-party investors will be in the accounting profession in a major way not just with the Big Four, who I happen to believe at some point will all be PE-owned and/or an IPO. I know there’s some jockeying and some trash-talking going on right now about who’s in and who’s not, they’ll all be in. They all need capital.

Think about that, when 20, 30, 40 billion dollar firms need capital, and that’s not enough for what they have, that just tells you the thirst for transformation and the investment needed in technology and talent. But I also believe you’ll see midsize accounting firms being PE-owned and it’ll go all the way down to the smallest firms in America.

A good friend of mine here in Chicago became a bit of a trivia question. Jeremy Dubow, his firm is NDH, they became the smallest accounting firm, $10 million of revenue, to be co-owned by a PE fund, Unity Partners. That happened last February. So when I see investments going all the way down to $10 million of revenue, which in our profession would be the 400th largest accounting firm, I can’t help but think by the time this is over there are 30, 40, 50 PE firms playing ball in our profession.

I think you were alluding to what happens after the typical hold period of five to seven years: I think the next wave of buyers will be there. It’s lots of the ones I just identified. But I would tell you the first two that have really stood the test of time: EisnerAmper and TowerBrook Capital, that was in July of 2021, and Citrin Cooperman and New Mountain Capital, that was in October of 2021. Those two I’d say if we had them on the call they would tell you they’ve not only hit a home run, they’ve hit a grand slam home run. Those firms have more than doubled their revenue, two to three times their EBITDA, more than double the rollover equity, they’ve got happy partners and they’re already getting inquiries from buyers saying, “Hey, you did an amazing job, you took a $400 million business and in a couple of years made it a $1 billion dollar business. We’d like to come in and take it to $2 to 3 billion.” Stories like that. So game on, it’s not going away. Carolyn, the interesting thing is I was warned early on that once one PE group cracks the code, they’ll all be in and boy did that play out in its entirety.

MMG: And it sounds like it’s still playing out. Allan Koltin, thank you so much for joining the Conversations podcast, it’s been such a pleasure.

AK: Thanks, Carolyn. Thanks for having me.

This transcript has been edited and condensed for clarity.

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