The impact of investment committees on accounting firm M&A

The last few years have been a bit of a gold rush in accounting firm M&A. While the appetite for transactions continues to be strong, there have been changes with how opportunities are reviewed. Seasoned acquirers have had guidelines in place from day one, but as they look at an opportunity today there appears to be more scrutiny when enforcing select guidelines. 

Processing Content

Rather than examining deal structures, valuation multiples, purchase-price calculations, or other transaction mechanics, this article focuses on how investment committees evaluate opportunities, which is insight every potential seller should understand. In recent years, every transaction we have facilitated has been with a private equity group or capital-backed firm who all have investment committees. Our perspective comes from sourcing, consulting, and facilitating hundreds of accounting firm transactions. 

For readers less familiar with M&A accounting, a brief history of how transactions were accomplished will provide useful context. Price used to be calculated at 80% to 120% of a firm’s revenue, with little or no cash down and the balance paid over five years based on collections. Decisions were made by the equity partners or often by the main equity partner with no outside party involved in the process. That type of transaction today is almost impossible to find. For smaller firms, Small Business Administration loans were often used.

The turning point came when accounting firms first accepted outside capital by selling equity stakes to investors. That development triggered sweeping change and intense debate about finances, ownership, ethics and regulation. Opinions varied widely about whether outside investment was right for the profession. Private equity groups then began acquiring firms and combining them into larger organizations.

Private equity in accounting has shifted from conceptual to a trend to widespread reality and it is not slowing. Along the way there have been changes in deal structures and how acquirers and their investment committees view a good firm to acquire versus a higher risk opportunity. 

For clarity, an investment committee is typically composed of key leaders of the firm or private equity group and members of the investor group. The committee reviews each potential acquisition to ensure it meets the basic standards in place to control risk and transaction quality. 

The common elements of an M&A deal

There are guidelines that committees have in place, and they vary based on the buyer, but there are common elements they all consider. Examples include culture, service mix, type of clients, cross-selling opportunities, and demographics. The demographics can be market size and location, and this can vary widely based on the buyer. 

There are three core elements we will detail below that always rise to the top. If you do not meet these three fundamentals, it does not mean a deal cannot be made, but barriers may arise. 

The most common issue we see is the 15% at a minimum EBITDA metric. What this means is the firm being acquired needs to have a 15% margin or more after the new, reduced equity partner compensation. There are addbacks involved in calculating this number, but if a firm is operating with a lower profit margin it can be difficult to hit this metric that investment committees require. This can be a major consideration impacting transactions. 

The second element is minimal to flat organic growth over the last three years. The acquirer has more latitude here than they do with the 15% or 20% margin issue, but not all buyers can get a transaction approved if the prior growth is weak. 

However, there may be exceptions. As an example, a firm might have had limited prior growth in the last three years because they may already be operating at a high profit- and revenue-per-equity partner and cannot absorb additional clients. Others may have had staffing issues, right-sized people, reduced office space or had other items occur that are not yet reflected in the current financial results. 

The third factor is leadership age. Often acquirers prefer an average partner age of 55 or younger, not because experienced professionals are less capable, but because buyers want confidence that key leaders will remain with the firm. 

Most investors are targeting a five-year commitment. Risk rises when too many leaders plan to depart sooner, but a strong leadership bench and clear client-transition plans can reduce that concern. Owners who intend to work only two or three more years should disclose their plans early in discussions. A shorter commitment should not prevent a transaction (unless too many partners expect to exit early) but it remains an important risk factor.

When a buyer’s perceived risk becomes too high, several tools can bridge the gap. Common approaches include deferring part of the cash consideration to protect against declining performance and using earn-outs tied to agreed-upon growth targets. However, the use of earnouts will vary widely by acquirer. Some rely heavily on earnouts as part of the transaction as a device to keep the sellers motivated, and other buyers prefer not to utilize earnouts. Whether an acquirer will use these mechanisms depends on its comfort level and investor requirements. Open communication between the buyer and seller is essential, yet many sellers do not know which questions to ask or how to position their firms effectively.

Our strategy has always been simple: You want to be the one in control of walking away. There are always exceptions, and some acquirers will accept more risk than others or have more flexibility to add in anticipated upside that has not materialized yet. 

Just realize that there are differences among buyers and differences in how the elements in a deal are constructed. Education in accounting firm M&A in today’s capital-driven marketplace is critical to understanding the best direction to take your firm.