Getting Picked For PE

Given the familiar horror stories that seem to follow when private equity converges with business—think: Red Lobster, Payless Shoes, Sears—it’s no surprise that for some the trend in accountancy firms joining those ranks sounds warning bells. Restaurant and retail chains are one thing, after all, but businesses responsible for the integrity of our financial infrastructure, and in turn our lives, are another. In arenas where professional ethics are as important as profits, is a private equity presence enhancement or threat?

According to Cathy Allen, a former Board of Accountancy member in New York, while there is reason for caution, she notes that outside investment in accountancy firms is not a new phenomenon, although she acknowledges the trend has been accelerating since 2021—and with such notable names as Baker Tilly, Grant Thornton, and Cherry Bekaert included in that upswing.

“Accounting as a field is attractive to PE,” explains Allen. “For one, it’s a fragmented industry that lends itself to consolidation and scaling small to large. It’s also a business that has regular and stable sources of revenue. And for firms, the infusion of PE cash allows them to invest in critical technology, as well as to offer better compensation to recruit and retain talent. Plus, with AI reducing the demand for some accounting services, firms with more resources can offset those losses by offering more types of advisory services.”

But while the capital advantages to a firm’s bottom line may be clear, how PE impacts these firms’ public protection mandates is less so.

In an interview with the Institute for New Economic Thinking, federal prosecutor Brendan Ballou, who wrote Plunder: Private Equity’s Plan to Pillage America, describes PE’s specialty as finding legal and regulatory holes that allows it to make profits quickly and shift risks and costs to others. Private equity is a simple idea, Ballou says, but it has three basic problems. “One is that PE firms tend to invest in the short term to get a return on their investment in just a few years. The second is that they tend to load up the companies that they buy with a lot of debt and extract a lot of fees from them. The third is that private equity firms tend not to be held legally responsible for the actions of their portfolio companies. All this means you’re on a very short timeline with a very risky leverage model and you’re not necessarily going to be held responsible if things go bad, leading to business strategies that can be very extractive and hurt consumers and employees.”

Ballou adds that PE has increasingly taken on the role that investment banks used to have, but unlike investment banks, “private equity firms are vastly less regulated. What this means is that PE firms are doing a lot of the work that these companies did prior to the financial crisis, but they’re doing it with even less oversight.” He adds that “the basic story here is that private equity firms are able to use strategic bankruptcies to slough off obligations they don’t want to pay.” Obligations like—in the case of restaurant chain Friendly’s—pension obligations. Such moves can result in significant windfalls for PE investors but in others losing out.

“One of the things that was surprising to me about private equity firms,” notes Ballou, “is that they often target industries that are highly regulated or those where a big chunk of the money comes from the government.” It’s possible that some of these firms, Ballou says, may take “an awfully narrow view of their responsibilities to their customers, to their employees, to society as a whole.” Recently, the Center for Popular Democracy estimated that, over the last decade, private equity firms were responsible for approximately 600,000 layoffs.

It’s this narrative which worries regulators. “Private equity’s business,” says one executive director of a State Board, “is to invest in companies in hopes of gaining a good return on their investment, either by selling later at a higher valuation or through some other means. CPAs, though, have an obligation to the public before profit.” This executive director, who asked to remain unnamed, acknowledges that CPAs and their firms are entitled to be successful, but “they must follow a high ethical standard along the way. And sometimes this includes turning down lucrative opportunities.” For accountancy regulators, concerns are growing because, as the director points out, “we’re seeing a partner that [historically] has a bad habit of focusing on profit versus people.”

Connected to profit pressures, regulators also worry that under PE management sloppier financial work could ensue. That, says the director, could be detrimental to the reputation of the CPA profession—and hard to come back from. “The hospitals that became involved with PE—what they’ve experienced—are good analogies.”

According to attorney Matthew Bosher, however, PE investors are, in his experience, sensitive to the unique nature of attest work and the fact that outside investors cannot control or influence such work. Bosher is a partner at Hunton Andrews Kurth; his specialties include corporate governance and regulatory compliance. “I don’t think you can talk about PE and PE’s activities in this space as monolithic. Different investors are approaching firms in different ways. Accounting firms are approaching PE in different ways. There are many different variations.”

Bosher has advised dozens of clients on forming alternative practice structures and outside investment in the non-attest entity in those structures. Alternative practice structures, he says, are designed to safeguard independence and ethical conduct.

Alternative practice structures arise when the accounting firm splits into two separate entities: attest and non-attest. The attest entity remains (at least) majority-owned by CPAs and maintains its own governance, partnership agreement, and decision-making. In short, there are controls that limit interference by the new, non-attest entity, which is usually reconfigured with its own services (tax and advisory being the notable ones) and overseen by its own board, which may include representatives of the private equity investor. The two entities often then enter into an “administrative services agreement”, pursuant to which the non-attest entity leases to the attest firm such assets and burdens as equipment, office space, and marketing. The attest firm might also lease employees from the non-attest entity. But “the first step is separating the attest and non-attest businesses into two separate entities,” says Bosher. “At no point does the outside investor own the licensed accounting firm.”

Bosher, who has served on the Virginia Board of Accountancy, calls the alternative practice structure model “tried and true. The model has been acknowledged in the Code of Conduct for a while. A couple of State Boards have acknowledged the model. And this model can be implemented in a way that is wholly compliant with regulations. Whether every party engaged in this model will always implement it correctly, I can’t say for sure. But I can say I think the basic model itself is compliant. And of course,” he notes, “I expect State Boards of Accountancy to ask questions about alternative practice structures. Regulators will be looking to see if parties are confusing the public. I assume regulators will also rely on peer reviewers. Peer reviewers are a big part of how firms are monitored and evaluated. But in my experience the parties engaged in this space are all very much trying in good faith to comply with the regulatory rules and expectations.” Bosher says when he talks to PE firms these days, they understand they cannot be involved in the attest practice.

Alternative practice structures are also not established in isolation. They’re typically reified by disclosures and disclaimers to clients so that those who receive the services of the non-attest entity know what they’re getting—or not getting, as the case may be. “In my experience,” Bosher says, “these firms have gone out of their way to avoid public confusion. There’s generally explicit and clear disclosure language in relevant client materials.”

The State Board executive director is not so sure, however, noting that when private equity purchases a stake in a firm, large or small, there is often very little to notify the public that it’s no longer dealing with a CPA firm. “Especially when the firm still maintains one website and a single letterhead. The bedrock of accountancy regulation is that no one can hold out as a CPA firm without being licensed. If notification to the public is limited to a long disclosure at the bottom of a webpage, few will read that. As such, the protections that the public will assume they have are no longer there. Individuals will call Boards like ours with complaints and they’ll struggle to understand why we can assist if it was a bad audit but not a bad tax return.”

For many regulators, there are still grey areas within an alternative practice structure. Beyond disclosures and disclaimers, can a perception of influence by the non-attest entity over its attest counterpart ever be dispelled? Also, are there enough bright lines so that what might inform, say, an individual accountant’s bonuses and compensation does not undermine his or her ethical obligations?

Bosher notes two issues where the rules or guidance are inconsistent across states. If you’re a non-attest CPA leased back to the attest firm, who is your employer? The second is whether in an alternative practice structure an individual CPA who works in the non-attest firm can still hold out as a CPA. Some states say that individual may not. Bosher says he has first amendment concerns about the latter issue, not to mention the public policy concerns of telling those who have earned a CPA license that they can’t present themselves as one. In both cases, he says there may be an opportunity for regulators to clarify.

“But I think we all need a high-level acceptance that this model is here, has been here, and is here to stay. The work is to take the model and provide clarity where there is still regulatory ambiguity or inconsistency.”

Allen points out, however, that these aren’t the only sources of murkiness when PE enters the equation. “The company culture is likely to change,” she explains, “as will the systems in decision-making,” both of which she notes could be impacted by the significant lack of expertise PE typically has when it enters the accounting world. “PE often experiences shock at what regulatory compliance requires. It’s a totally new language for them.” She also cites the short-termism of PE as a long-term concern for regulators and the profession. Because private equity is known for its volatility, the idea of an accounting firm changing hands—perhaps changing often—is not implausible. What effect might that have on integrity and public protection?

The State Board executive director agrees that while it does seem PE firms understand there are certain rules that have to be followed, it’s less certain “they understand the public protection mandate CPAs have been steeped in throughout their training.”

Bosher, however, says he’s not sure the culture ascribed to PE is all that different from the motives and incentives from other enterprises. Some of the fears, he notes, are based on misleading headlines and poor reporting. “PE buys accounting firm—that’s not happening. PE invested directly in a licensed accounting firm—that hasn’t happened as far as I know. Accounting firm adopts alternative practice structure to avoid independence requirements —that’s not what’s happening. In the models I’ve worked on, the outside investors are fully aware they can’t interfere or be involved in attest work. Attest work is separate and there are guardrails so that integrity and independence are not impaired.”

No matter the anxiety or confidence one has, the range of concerns private equity provokes has been a central focus for the Professional Ethics Executive Committee, or PEEC, a senior committee at the AICPA on which Allen serves. The committee is charged with “interpreting and enforcing the AICPA Code of Professional Conduct, promulgating new interpretations and rulings, and monitoring those rules and making revisions as needed.” In 2023, PEEC began examining the intersection between private equity and accountancy firms, focusing in particular on potential threats to independence and public protection. “We wanted to know if we should change the code of conduct [in light of the PE trend],” Allen says, “and the conclusion we came to is: Yes, we probably should.”

In her talk at NASBA’s Eastern and Western Regional meetings this past summer, Allen inventoried three areas that PEEC has been evaluating: 1. whether employees from the non-attest entity should abide by AICPA independence rules when performing non-attest services for the attest firm’s clients; 2. which PE members should be subject to full or partial independence restrictions; and 3. the potential dangers of PE interests (e.g., portfolio companies, funds), or the investors themselves, becoming attest clients of the non-attest firm in which they now have a share. Allen says she expects that in November PEEC will evaluate proposed revisions to the AICPA Code, which represents the first phase of PEEC’s project on private equity. If approved, an exposure draft will be released for comment later this year or early next.

One additional question the State Board executive director has is how forthcoming guidelines—be they from PEEC or elsewhere—could impact private equity’s decision to invest in firms or change how deals are structured. If, for example, the attest entity creates independence issues to the point PE stakeholders feel the need to end attest services. Such moves could be just as imperiling for accounting firms—and ironically for the same bottom-line reason firms sought PE funding in the first place. However, the alternative, says the executive director, may be even less appealing: “That the attest entity is retained but feels a pressure to ‘stretch’ the rules.”

Part of the anxiety from all sides is that the frameworks being forged around private equity and accounting firms—both financial and in terms of oversight—are still somewhat amorphous. Such a state is uncomfortable to regulators, for good reason. While the State Board executive director acknowledges that it’s unrealistic to expect PE firms to suddenly develop a CPA’s understanding of public protection, “giving them clear rules that must be followed will assist them and the regulators in making sure the public is protected. The regulatory response has been lagging because I feel we’ve been working on other issues. But it’s now starting to pick up with the PEEC discussions and the discussions at NASBA.”

What would reassure the director and possibly other regulators is “addressing what I think are the two major concerns regulators have: PE’s potential to lower the quality of services, and public confusion about the PE-based firm they’re now interacting with.” Those, the director said, could and should be resolved by a combination of clear best practices, revisiting the AICPA code, and adjusting model statute language. The director adds that there are issues that are specifically regulatory related that are not being addressed by PEEC that could also benefit from a NASBA committee or task force.

“The concept of a business corporation investing in the non-attest assets of a public accounting firm has been around for more than 25 years,” says Dan Dustin, CEO of NASBA and a CPA himself. He cites the 1998 case of American Express Tax and Business Services purchasing the non-attest assets of New York accounting firm Goldstein Golub Kessler & Company. “At that time, the New York State Education Department hired a consultant to study the controls put in place by the two entities to assure the independence in the attest function. The study concluded that adequate internal controls existed, and independence was not impaired by the transaction.”

Dustin acknowledges, however, that the alternative practice structure model has evolved with the advent of private equity investment, and that this new era offers NASBA an opportunity to work with Boards of Accountancy and other key stakeholders to “learn from the past and collaborate on finding answers that address the concerns of regulators while acknowledging the evolution of the profession.”

To that end, NASBA will be conducting a poll with Boards to gather additional information from members about their experiences with private equity. Dustin says that “following those results, the Association will be asking several NASBA Committees in the 2024-2025 committee year—Ethics, Executive Directors, Legislative Support, and UAA—to incorporate PE concerns and potential outcomes or solutions into their work.”