To split or not to split: EY confronts the question

Of the hundreds of climbers who set out every year to scale Mount Everest, only about two-thirds reach the summit.

EY’s global chair, Carmine Di Sibio, thinks he has better odds for his own ambitious adventure: a plan, known internally as Project Everest, which would split the Big Four accounting firm by spinning off its advisory arm from its audit business, reshaping the profession in the process.

After consuming tens of thousands of hours of staff time and gripping the attention of rivals for the best part of a year, the project will soon be put to EY partners for a vote. This is akin to the Hillary Step, the steep ascent that used to confront climbers just before the summit of Everest.

EY’s top bosses believe partners understand the rationale for the deal: splitting the businesses would liberate both from conflict-of-interest regulations that prevent them advising companies for which they also act as auditor.

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But falling company valuations have changed the landscape since Everest became public in May 2022 and some partners remain unconvinced that the break-up devised by Di Sibio is the best path.

“The strategic rationale of what we’re doing, our partners understand,” says Andy Baldwin, EY’s global managing partner for client service. Their question, he adds, “is not ‘should we do something?’ I think that train’s left the station.”

EY’s top leadership, who met in New York in recent days for intense negotiations between the two sides of the business, are still grappling with details, including which business will be responsible for various legal liabilities and exactly how many of EY’s 150-plus countries should be included in the new consulting company. US audit partners have been particularly forceful in pushing for their interests, says one person with knowledge of the planning.

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Executives hope to finally start sending information to partners this month, leaving time to address questions in the roughly 75 countries currently expected to take part.

“Most partners, if you ask them at the moment, they’re going to be for [the split], with a ‘but’,” says Hywel Ball, EY chair in the UK, where a 75 per cent supermajority is needed for approval. “And the ‘but’ is they need to see the detail.”

Ballots were pushed back from November, 2022, to the first quarter of 2023, and now late April or May, and among rivals there is a suspicion that EY’s bosses have been reluctant to risk calling the country-by-country votes until they are sure they will win. But insiders say partner sentiment is “positive” and the aim is to win by a comfortable margin.

“If we don’t think we’re going to [win] the vote, we won’t vote. We’re not going to go into a vote if we think it’s on a knife edge,” says Baldwin.

A yes vote would trigger the biggest upheaval in the sector since the collapse of Enron auditor Arthur Andersen and a wave of consulting spin-offs at the turn of the century.

The advisory business, including consultants, deal advisers and most of EY’s tax practice, would seek a stock market listing, aiming to emulate the success of Accenture, which floated in New York in 2001 after securing independence from Arthur Andersen.

The rest of the Big Four – Deloitte, KPMG and PwC – have disavowed the idea of following EY’s lead but would be hard pressed not to respond if their rival’s spin-off results in two faster-growing competitors.

EY has deployed more than 2,000 of its 390,000 staff to work on Everest, with dozens of working groups across scores of countries planning out details such as how to split the IT, real estate and human resources systems.

Splitting in two could provide a windfall for EY’s partners: big cash payments for about 6,000 on the audit side and shares in the yet-to-be-named public company for the other 7,000.

But dividing up the cake among so many people in so many countries is proving complicated, even more so since market conditions deteriorated. EY has told partners the advisory arm will raise about $30 billion to settle liabilities and fund the partner windfalls on the audit side.

Executives have described it as a “$100 billion (€93.6 million) company”, based on revenues that were $25 billion in the year to June 2022. Figures circulating internally in September, seen by the Financial Times, indicated EY expects to raise $11.5 billion from selling 15 per cent of the advisory business in an IPO, for a market capitalisation of $77 billion, and to add on $18.7 billion of debt.

But in recent months debt has become more expensive and equity valuations have fallen. Consulting partners are being asked to take a chance that their shares will be worth what management has projected.

Retired partners have also asked for a cut of the proceeds to reflect their contribution to building the business, though they do not have a stake in the firm or a vote on the deal and some inside EY argue that giving them more would reduce the amount available to incentivise younger staff, who represent the future of the firm.

Global leaders will need to convince partners that their valuation expectations, upon which the distribution of money and equity depends, can be achieved.

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Internal figures indicate pro forma earnings before interest, tax, depreciation and amortisation of $4.4bn for the advisory business, giving it about the same profit margins as Accenture.

But whether the new business will be valued at a more generous multiple of profits than its rival – a key assumption of EY’s leadership and bankers last year – depends on whether it can sustainably achieve that level of profitability and how plausible the market finds its ambitious growth targets. On both questions, investors and analysts say, the new company would have much to prove.

“A lot of people made a lot of money on Accenture, and if they can find a smaller version, great,” said Denny Fish, portfolio manager at Janus Henderson.

The financial uncertainty for partners – the 13,000 people who will actually decide Everest’s fate – is heightened because the new stand-alone advisory business will abandon the traditional partnership model, like Morgan Stanley did in 1986 and Goldman Sachs in 1999.

The split was sketched out against a backdrop of unusually strong growth for consulting businesses and EY in particular. Accenture’s enterprise value peaked at more than 22 times Ebitda at the end of 2021, Refinitiv data shows, and several consulting company acquisitions were based on valuations of 20 times Ebitda that year, according to an assessment by Truist Securities. The historical average is 14 times.

But growth in the sector has since slowed and brought valuations down from historically elevated levels. Rivals KPMG and McKinsey have been cutting staff and EY has been relentlessly pruning costs. Its US business cancelled staff bonuses in December and made 53 recruitment staff redundant in late February.

Its assumptions have become more conservative, according to people familiar with the matter. But EY believes the ingredients for success are still there.

“We remain confident we can get to the absolute amounts that we need to get to for Ebitda ... that allow us to raise both the debt and the level of equity we need for the deal,” says Baldwin.

The cost of the split will have run to hundreds of millions of dollars before a single partner has voted, and is set to rise to about $2.5bn by completion even before banks such as Goldman Sachs and JPMorgan take their fees, according to people familiar with the figures.

Some of the cost is “not real” because the work is being done by EY’s own staff and the overall bill is in line with those on similar transactions, according to one of the people involved in the planning.

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EY has deployed more than 2,000 of its 390,000 staff to work on Everest, with dozens of working groups across scores of countries planning out details such as how to split the IT, real estate and human resources systems.

At every level of the firm Everest has raised questions about the impact on individuals’ career and financial prospects. People in the industry say conversations with EY partners invariably turn towards the split. Each national firm must work out its own plan on how to divide up partners and staff in a way that makes sense locally. Tens of thousands of staff in functions such as human resources and communications do not yet know which entity they will be working for.

“It’s hugely distracting, partly because every layer of EY leadership runs its own Everest meetings,” says one EY consultant in the UK, adding that even people not involved in the main planning can be on multiple Everest-related calls a week.

“[Employees] still don’t know if we will be offered any shares or options, and over what period,” the person adds. “Nor if equity partners will be locked in or disappear to the beach ... They seem to be firefighting at the moment to get through the partner votes. Sentiment is nowhere near as positive as might be expected”.

An unscientific poll of EY staff conducted for the Financial Times by Fishbowl, a social media app for professionals, suggested leadership may not yet have won over hearts and minds.

Of 2,172 respondents to the question “do you support Project Everest”, 39 per cent said yes, 29 per cent said no and 32 per cent said they were undecided. Among EY staff who identified themselves as consultants, 24 per cent said they did not support Everest; among accountants, the opposition was 41 per cent. Almost 90 per cent of the respondents were in the US.

With so little public information on EY’s consulting business – and since exactly which parts of the firm will be included in the split is still being negotiated – it is difficult to predict how investors will assess the company when it floats.

EY said the survey was “unrepresentative and unreliable” and that the sample was less than 1 per cent of its global workforce.

The financial uncertainty for partners – the 13,000 people who will actually decide Everest’s fate – is heightened because the new stand-alone advisory business will abandon the traditional partnership model, like Morgan Stanley did in 1986 and Goldman Sachs in 1999.

In a partnership, profits are distributed almost in their entirety to partners, while in a public company “partners” would be paid only a salary and forgo the rest of their remuneration in exchange for shares which they can sell in the future.

One of the thorniest issues EY faces is how much to cut from the take-home pay that consulting partners are used to. In order to fatten the profits on which its stock market valuation will be based, there is concern internally that cuts will be deeper than first envisaged, said one departed partner. “It is a matter of robbing Peter to pay Peter,” he said.

People familiar with the plans say EY is working on a tiered system where some junior partners would not have their cash pay cut at all, but the most senior could see reductions of over 50 per cent. The average reduction for partners would be 40 per cent, according to one of them.

How quickly advisory partners can cash in their shares, and whether these will be tied to staying with the company, are also questions of keen interest to partners – and to potential investors, who do not want to see their most valuable assets walk out the door.

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People familiar with the matter indicate EY has put in more restrictions than previously communicated, and the terms could still change depending on market conditions. Partners could be limited to selling 10 per cent per year in some countries, says one executive. Shares could also be clawed back from partners who join rival firms – even those who go back to the audit side of EY.

With so little public information on EY’s consulting business – and since exactly which parts of the firm will be included in the split is still being negotiated – it is difficult to predict how investors will assess the company when it floats.

EY argues that it will be a different proposition to Accenture, combining high margin advisory businesses with managed services, or outsourcing, and a tax practice, which will provide steady income to offset more cyclical service lines.

But its pitch to investors centres on the speed of its growth, turbocharged by the split itself. Separated from the audit division, consultants in the US alone would be free to chase business at close to a third of S&P 500 companies, including tech giants such as Google and Amazon, that are currently off-limits because EY acts as their auditor.

Baldwin says the consulting practice could notch up $4bn in revenue from audit clients in the first three years after the split, plus another $2bn from alliances with tech companies and $2bn in extra managed services work, where clients outsource functions such as tax compliance.

Revenue growth projections have drifted lower, though, from 25 per cent a year when Everest was first mooted, to 21 per cent when it was agreed by the global leadership last year, to 19 per cent now.

Executives say that forecast is conservative, but it would still be historically high for a consulting firm, so investors are likely to subject EY’s assumptions to heavy scrutiny. “We’ll have to see its margins, and have to see its full debt schedule, but all else being equal, if it is growing faster, that argues for a higher multiple,” says Fish.

In the near term there remains a risk that partners will vote against Everest, but EY’s top leadership is pressing on.

The new consultancy will also face competition from the accounting side of EY, which will retain some tax and other experts to support audit work and rebuild advisory practices of its own.

EY sold its consulting arm to Capgemini 23 years ago only to build it back up. Baldwin, who moved from EY to Capgemini but ended up returning, says there would be non-compete agreements covering most of the business, but not in areas such as international tax and the lucrative sustainability consulting market where both sides of the business would continue to operate.

The speed with which EY is racing to split and go public also creates risks, since the advisory business will have new IT, a new model for paying its partners and a new brand all at once.

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“The lack of a record will be an issue,” said one analyst. “It may be better to wait two years, run them separately, especially if they think the growth numbers will hold up.”

Tobey Sommer, an analyst at Truist, says the advisory business would probably get a better valuation when the risk of an economic downturn lifts. “I don’t think any company wants to come public in the middle of a recession. You want to be on the other side of it, if you can choose the timing.”

In the near term there remains a risk that partners will vote against Everest, but EY’s top leadership is pressing on.

“One only has so many hours in the day and those hours at the moment are focused on doing the plan,” says Ball. “I don’t think the status quo is an option so if it’s not this, we’ll have to think about something else.” – Copyright The Financial Times Limited 2023