The Big Four firm EY is considering a split between its auditing and advisory businesses. The move comes as regulators in both the United Kingdom and the United States heighten scrutiny in the accounting sector on concerns related to audit independence under their respective laws.
The split of audit and advisory businesses is not new to the Big Four. The last round of such separation happened after Arthur Andersen’s collapse following the Enron scandal. Twenty years on, the Big Four firms have reinstated their former business models of maintaining both audit and advisory arms in their operations.
Big money is always the suspect for the regulators — as consulting businesses in the world have seen exceptional growth in revenue in recent years, the pressure to regulate conflicts of interest rules has resurfaced.
At present EY is the first in the Big Four to consider a formal spin-off. Reports on the ramifications of the split-up are well-circulated in the market in the past few months, with the latest saying the deal shall move forward in the next few days.
The natures and growth prospects of the respective businesses are factors to consider in understanding the impact of the split-up, as it is a foremost concern to all stakeholders.
Traditionally, auditing operates on lower fees and margins. In FY 2021, EY global’s audit business saw a revenue of US$14 billion; whereas the advisory services amounted to US$26 billion. The auditing business bears low growth potential as well, as it has grown 27% during 2012 and 2021; while the rest of the business experienced revenue growth as high as 93% in the same period.
The split-up will bring benefits depending on who it is in the picture, and it seems to lean, significantly more so, in favour of the partners of EY’s advisory businesses. There are already talks of a US$10 billion public listing of EY’s consultancy, or a private stake sale, once the split is finalised.
An IPO could hand existing partners a windfall of shares of the new consulting establishment, when the plan envisions the public listing of 15% of EY consultancy’s shares, with 70% shares to remain privately held by the existing partners. 15% will be preserved as equity incentive for the employees.
The provision for the auditing business, which will likely remain a private partnership, is said to offer audit partners no less an attractive amount of cash payout.
All sounds lucrative but is it the case in reality?
This shareholding arrangement of a new EY consultancy is a significant departure from EY global’s existing structure, under which partners do not keep a stake in the business when they leave. In this way, capital is preserved for the next generation. A shareholding arrangement enables former partners to exert influence via corporate governance. The company must also answer to the regulatory demands and shareholder expectations of its publicly listed shares.
As a business, the advisory arm may reap an immediate advantage post-breakup. Once becoming a separate business, EY’s consultancy will no longer be bound by the U.S. restriction that bars them from providing consulting services to a listed business within one year of an audit. Big-name audit clients in the United States, such as Amazon, Salesforce and Google, will therefore become fair game for business solicitation. Surely, business referral across the service lines will be lost, but the relationship networks of EY’s advisory partners should well compensate for this loss.
Although it seems like EY’s advisory businesses will receive immense benefits from the division, the last Ernst & Young selloff of its consultancy two decades ago does serve as a measure of caution. The French IT services company Capgemini acquired then Ernst & Young’s consulting business for US$11 billion in 2000. Both internal issues and external mishaps have resulted in the evaporation of value in Capgemini shares thereafter. The dotcom downturn caused a global economic slowdown. The EY consultancy partners that received Capgemini shares could not sell their lots due to a lock-down provision. By the time the lock-down period was lifted, after four years, the shares lost 80% of their value. Some EY partners were also let go in between as a result of Capgemini’s need for cost-saving during the global drop in tech spending this time.
In hindsight, EY’s audit partners, who did get some payment from the sale of the consulting business, were rather the winners in the last sale of EY’s consulting business. They went on to rebuild EY Consulting after the non-compete clauses expired, and re-entered the consultancy market in 2006.
Whether history will repeat itself in this round of potential separation remains to be observed, although the chances of a similar disaster as Capgemini are low if EY’s advisory business operates independently after the spin-off. This does seem to be the global management’s intention. The more pertinent concern at this point is how the new consultancy business may rebuild its brand name. Being a listed entity, the financial burden on meeting shareholders’ expectations and business KPIs could be overwhelming. One should also bear in mind the already well-known consultancy firms such as Accenture, BCG and McKinsey to imagine how aggressive the competition will be for the newly established EY Consulting company.
The U.S. regulators have already made clear that audit independence must be both in fact and in appearance. It is highly unlikely that EY Consulting will be able to keep its name after the split. The rebuilding of a brand name can be an expensive and time consuming priority for the new company.
As for EY’s audit business, despite the relatively modest payday provision, enjoys a clear benefit from the separation. The split-up will allay concerns on independence that both regulators and the clients have. The Enron scandal in 2000, which caused the collapse of then Big Five firm Arthur Andersen, did result in a demand of integrity from all stakeholders. In the wake of this scandal, the Sarbane Oxley Act was passed in the United States and it continues to govern conflicts of interest issues for auditing firms. Being free of conflicts of interest will bode well for EY’s audit business.
Yet some other issues will become a concern for EY’s audit business after the separation. Due to the lucrativeness of the consultancy business, some talents in the field think of auditing as a stepping stone to a career in consulting. If EY splits its operations, this career track will no longer be available. EY may lose the competitiveness for talents, especially if the said career path remains a possibility in the other Big Four firms.
And finally, the regulatory intent of ensuring independence of the accounting sector may result in unintended adverse consequences in audit quality. After the consultancy’s spin-off, audit partners will be under the dual pressures of meeting the company’s bottomline while retaining quality staff, for consultancy was a lucrative business that helped subsidize pay at the auditing business, especially for the top management. Without this, EY’s audit business may experience a drop in the quality of auditing services. This will damage its competitiveness given that other Big Four firms are still operating in the multidisciplinary model.
As a matter of practicality, some current service offerings in EY’s advisory business are necessary for both audit and advisory businesses, given tax specialists as an example. The current service line structure enables efficiency and cross-selling on both experience and expertise.
What is the rush in splitting the firm? The failed experience with Capgemini shows that timing can make or break a deal. Despite increasing regulatory pressures, the other three firms in the Big Four have not expressed any similar intention to separate their audit and advisory businesses like what EY is doing. While it is true that the U.K. authorities have already demanded such separation by 2024 for all firms concerned, the current economy and developments in world events are causing significant headwinds for business. EY must be mindful of its historic lesson and weigh carefully both the benefits and pitfalls along with a thorough consideration on the right timing.
