For partners considering retirement or wanting to boost investment, private equity (PE) may prove attractive. While private equity investment is an emerging trend, it’s vital to understand exactly what PE investment will mean for the future of a firm and its employees.

PE appetite for investment in accountancy and audit firms has largely been driven by perceptions of a fragmented market ripe for consolidation, the offer of consistent revenue streams, and substantial growth potential for acquired firms, especially in the expansion of accountancy and associated service lines. 

Some UK firms have secured PE funding and have ensured they remain compliant with the audit regulations, through consultation with ICAEW. However, it is critical to engage ICAEW and other bodies to scrutinise the often complex legal agreements. ICAEW and the Financial Reporting Council are urging firms looking to take on PE monies to get in touch in the early stages of a transaction for support in navigating the intricacies of the eligibility criteria. 

Audit regulations, as derived from the UK Companies Act, require a majority of an audit firm’s voting rights to be held by audit qualified persons, which essentially means an audit firm must be majority controlled by individuals with the audit qualification. In this context, ‘majority’ means more than 50% unless a firm’s constitution specifies a higher percentage of voting rights are needed for decision making, in which case ‘majority’ shall mean that specified percentage or more.

Elaine Griffiths, Director, Regulatory Practice, Professional Standards, ICAEW, says: “It can be challenging when you’ve got external investment, because investors might want to control all the companies that they’re investing in. You can understand why investors might want to have some protective measures in place to safeguard their investments.”

So far, PE investors doing deals with accountancy firms haven’t been put off by the audit eligibility criteria. They are indeed finding ways to comply with the audit regulations and ensure a deal succeeds. Some of the ways include setting up a separate audit entity, whose ownership and control structure meets the requirements of the audit regulations, such as in the case of the Evelyn Partners and Apax deal, due to complete this year.

While creating separate entities creates a greater administrative burden, and marketing considerations, PE investors’ appetite is so far undimmed, and with two different businesses firms have been able to retain their audit registration.

While a majority stake is more than 50%, some audit firms may have clauses in their governance arrangements that specify higher thresholds, in some cases as much as 75% or even 100%. “Even before you look at private equity investment, firms will have a mix of partners and may not have enough audit qualified people to hit those higher thresholds,” Griffiths says.

Last September, the Financial Reporting Council published an open letter to audit firms and supervisory bodies confirming that it was not opposed to external investment in principle and acknowledged potential benefits, including increased investment in audit quality, innovation and market choice. However, the regulator emphasised the need for firms to manage risks, particularly those concerning conflicts of interest, and engage with their supervisory bodies.

“Partners might come to us with a governance proposal. We need to make sure it's not just artificial. Something might work on paper, but actually the external investors might still be able to exert influence. When you’re looking at the control it has to be all matters that direct the firm’s overall policy or alter its constitution. So, if you have to go to a third party for approval of something material, that's potentially not giving you unfettered control,” Griffiths says.

Failure to fully comply with audit regulations will have significant implications for a firm’s continued audit registration, and therefore its ability to issue audit reports post-transaction. 

Julie Matheson, partner at law firm Kingsley Napley, specialises in regulatory issues for the accounting sector: “Post-transaction, the constitutional structure of the firm will also have implications for whether any other applications are required, such as audit affiliate applications for newly created entities that might hold ownership interests in the audit firm. And indeed, whether the firm can even continue to describe itself as a chartered accountant.”

One of the biggest issues surrounding PE investment is audit independence and conflict of interest risks, or at the very least the perception of this. Matheson says: “PE-backed firms may be pressured (or even incentivised) to prioritise higher-margin practices, which could be fundamentally at odds with audit independence and quality. 

“There are prohibitions on audit services that the firm can provide to the private equity fund, portfolio companies of the fund, or any significant affiliate of companies in the fund, many of which may be public interest entities. The fund itself may be caught by independence requirements if it is deemed a ‘covered person’, in circumstances where it is in a position to influence the conduct or outcome of an audit.”

PIE auditors are restricted from providing most non-audit services to their PIE audit clients, which are subject to strict audit and governance rules. The Big Four firms continue to dominate the audit market for PIEs.

Griffiths says that any firm partly owned by a PE fund would need to make sure that those investors don’t also have any interests in an existing or proposed new audit client. Although these kinds of issues could arise at the point of investment, private equity firms do forge new and regular acquisition trails so this would be something that would need continual monitoring.

Vipul Sheth, MD of accountancy outsourcing business Advancetrack, says: “Public interest entities, like any other, will be dealt with in a professional manner with most audit firms. Maintaining trust in the audit profession requires robust safeguards, such as appropriate decision-making, declining certain work, or implementing clear ‘Chinese walls’ to separate interests. These measures are critical to ensure compliance and uphold confidence in the integrity of audits.”

Although a new and growing trend, PE investment into accountancy firms is becoming more and more popular in the marketplace, and firms and investors are proving it can be successful even within the strict rules. After all, it is hoped external capital can bring substantial opportunities for technological innovation and increased competitiveness in the audit market, all of which ultimately are beneficial for growth and the public interest. 

However, both aspiring accountancy firms and their fund acquirers should ensure that all regulatory implications are carefully thought through, especially given the risks at stake.