A conversation with RSM: what do ownership changes in professional services mean for partners’ wealth?
Changes to your firm’s structure may require you to revisit both your financial planning and your investment strategy.
Authors
Profitability, regulation and client demand; these are just some of the reasons why professional services firms have been combining over the past few years. The trend is well-established in financial services and is becoming increasingly apparent in other professional fields, such as law and accounting. Last year, Allen & Overy and US law firm Shearman & Sterling agreed to combine and create one of the world’s largest law firms. More recently, Chicago-based accounting and consulting firm Baker Tilly, and the US arm of accounting firm Grant Thornton, both sold stakes to private equity firms. The trend is not just impacting global behemoths, but also smaller, regional firms, whether as consolidators or targets.
To find out more about the issues involved for partners and senior employees, Simon Barker and Darren Chaplin of Cazenove Capital spoke to Mark Waddilove of professional services firm RSM. Mark leads the professional services business group and advises both firms and individuals on tax and business issues relating to partnerships and other structures for professional service firms.
Simon: Mark, thank you for joining us. Perhaps you could start by telling us a bit about the changes you are seeing in how professional services are structured? As you may know, Cazenove used to be a partnership, but it is now part of Schroders, a listed business. Do you still see much of this in UK professional services?
Mark: Great to be with you Simon and Darren! For many years, before the introduction of limited liability partnerships (LLPs), we saw a lot of professional partnerships incorporating – or converting into companies. It was regarded as a way of limiting liability, securing more access to capital and providing greater flexibility over staff compensation. It also allowed existing partners to crystallise their investments in the business.
This approach has been less popular in recent years, with LLPs leading the way. Some firms underestimated the cultural change that came with incorporation, especially those that more recently also chose to list on the stock market. In the UK, the law and accounting firms that have gone public have not had the easiest experience - and this has probably deterred others. Tax changes have also made incorporation less appealing, with the effective tax rate on partnership profits slightly lower than the combination of personal tax and corporate taxes on profit extraction.
So today, in law and accountancy at least, firms are generally retaining the partnership model, sometimes in combination with a corporate structure, and are looking for other ways to grow and become more efficient. Mergers are part of this. But we are also seeing sales of partnerships, sales of non-core businesses as well as a keen interest by some of the mid-tier and larger private equity (PE) houses.
Darren: And does that involve significant changes in pay for partners?
Mark: It can do. The most important consideration is how profits will be distributed in the new partnership. It could be a lock-step or partial lock-step system or an “eat what you kill” approach, which is more common amongst American firms. Whatever the mechanism, firms will be keen to incentivise partners, which could mean higher pay. And, of course, if a merger goes well, it can boost profits as firms take on more work and benefit from economies of scale.
Having said that, mergers can be expensive and require investment in the business. This could mean partners are expected to put a higher share of their earnings back into the partnership, at least for some time. Meanwhile, partners would still be subject to tax on that income. There is also the investment of time – management, technology, human resources etc.
The impact of a PE transaction will probably be even more dramatic, typically including features such as capital payments, earnouts and deferred consideration. The impact of PE on professional services is probably a subject all of its own!
So, taken together, there are quite a few ways in which corporate activity can change compensation in professional services.
Darren: We can definitely help plan for those changes. One area for partners and senior professionals to consider is whether they can put more money into tax-efficient investment vehicles on a regular basis. Pensions are of greater interest, following the increase in the annual allowance and the removal of the lifetime allowance. However, the Labour party has said it will reinstate the lifetime limit if it comes to power. Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS) also remain attractive, allowing higher earners to build a portfolio of private market investments. It’s also a good idea to review changes to any benefits – such as life and health insurance.
Simon: One observation we’ve made is that firms can have very different approaches to retirement. Do you see this a major factor in consolidation?
Mark: Yes, very much so - it’s a key cultural consideration that firms need to think about carefully. Some firms have very formal requirements about when they require partners to make way for the next generation, others less so. A mandatory retirement age was actually challenged in court by a law firm partner on the grounds of age discrimination – and the judgement went in favour of the firm. Based on the judgement, most firms that have a retirement age do so with a carefully drafted members agreement that reflects the future business and commercial needs of the firm.
We have also seen many firms taking a more pastoral role with their partners. They have introduced financial training and are helping retiring partners plan for the future, covering both financial and mental wellbeing.
So depending on whether there is a merger, consolidation or PE investment it is almost certain that partners will need to change their retirement plans. For example, a few firms still have annuity arrangements for retiring partners but a PE exit would provide a very different dynamic to their cashflow. I’m sure you can help them with that Darren!
Darren: Absolutely! We help many professionals plan for retirement and aim to provide them with a lot of flexibility for the next stage of their careers. We also help those with surprise windfalls.
I’d emphasize that retirement is something that even higher earners must plan for. Very often, they are incredibly focused on keeping their clients happy, but end up neglecting their own finances. It’s less of an issue in today’s higher interest rate environment, but I saw cases of partners leaving significant sums of cash in the bank when interest rates were very low. That has been detrimental to their wealth.
Simon: The other point I’d make is that a wealth manager can help partners manage the compliance around personal investments. As firms grow larger, they are likely to have dealings with more companies, which are then subject to trading restrictions. Even if you have a good understanding of markets, this can make it hard to manage your own investments. Outsourcing investment management can make life much easier.
Mark – I also wanted to ask about international trends. Are you seeing many firms expand overseas?
Mark: Yes, it’s definitely something that firms are thinking about, but with caution. There is still expansion, but after Brexit, and more recent geopolitical tensions, we are also seeing firms retreat from some overseas markets. The Middle East and Asia remain attractive locations for investment.
In general, law firms are more likely to expand their partnership when they enter new markets, running everything from their head office. They may work together with a local “best friend” for a period of time before going into serious talks about a merger – sometimes this may be necessary for regulatory reasons. Accountancy firms tend to favour a network-type approach, perhaps with agreements on branding and marketing but run locally – sharing some of the global costs but not profit. These type of structures also help to manage global risk.
Expansion is often being driven by clients’ expectations of a “one-stop shop” type of service. This has driven quite a few of the transatlantic tie-ups we’ve seen over the past few years. However, it is not just mergers that we are seeing. Many firms look at bolt on and/or lateral hires within their teams. This can be seen as a more cost-effective way of expanding and with less interruption to the business and fewer cultural issues.
If partners are moving to or from the US, they are likely to need specialist advice to make sure their investments work from both a US and UK tax perspective.
Simon: And that is of course something we can also help with, given we are one of a handful of firms with a specialist team investing for individuals with US tax reporting requirements. Mark – thank you for your time, it’s been fascinating talking to you.
Mark: My pleasure! We have only just scratched the surface and I would be delighted to talk further.
To talk about personal investment or financial planning, contact Simon Barker or Darren Chaplin at Cazenove Capital.
To discuss partnership issues at your firm, please do get in touch with Mark Waddilove at RSM.
Email: mark.waddilove@rsmuk.com
Phone Number: +44 20 3201 8121
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way.
Statements concerning taxation are based on our understanding of the taxation law in force at the time of publication. The levels and bases of, and relief from, taxation may change. You should obtain professional advice on taxation where appropriate.
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