Creating Value by Splitting: The Cherry Bekaert Deal

by Federico Pasqualone, Giacomo Montaguti, and Marco Neri

Introduction

When looking at ways to create value in Private Equity (PE), most of the time, creating synergies is the first to come to mind, yet splitting a company could sometimes prove to be more beneficial.

A recent example of a deal involving this kind of value creation is the partial acquisition of Cherry Bekaert by PE firm Parthenon Capital.

Cherry Bekaert

Cherry Bekaert is an American audit, tax, and advisory firm founded in 1947 by Henry Cherry. After a few years, the company’s founder partnered with Charles Bekaert and William Holland, giving the firm the name Cherry Bekaert and Holland. In 1988, the firm moved from its original seat in North Carolina to Virginia, eventually relocating the headquarters to Richmond in 1991. In the same year, Howard Kies was named CEO and Managing Partner and ended up running the firm for 27 years, overseeing the re-branding of the firm from Cherry Bekaert Holland to Cherry Bekaert. In 2018 Howard was replaced by Michelle Thompson, who won the ‘most powerful woman in accounting’ award twice.

In the last five years, the firm has executed many acquisitions. Including the following.

Powell, Ebert & Smolik, a CPA based in Texas.
Flieller, Kruger & Skelton, a provider of tax and compliance services based in Texas.
Icimo LLC, an analytics firm based in North Carolina.
PMB Helin Donovan, an accounting, bookkeeping, and audit service provider based in Texas.
TaxGroup Partners, a private equity and transaction tax advisory firm based in California.

Today Cherry Bekaert employs more than 1350 people and reported a revenue of $250m in 2021.

Parthenon Capital

Parthenon Capital Partners is a PE firm that employs a research-driven investment strategy within the core industries where it has a depth of operational understanding and investment experience. Parthenon was founded and established in 1998 by Ernest K. Jacquet and John C. Rutherford, it focuses on three key industries; financial services, healthcare, and business services. It invests in middle-market companies with enterprise values ranging from $75m to $750m. During its lifetime, it embraced 55 investments and had 29 portfolio exits with an average net IRR of around 24%, and it currently has $2bn of AUM.

With offices in Boston, San Francisco, and Austin and roughly 35 investment professionals, over the course of its existence, Parthenon has managed funds at over $5.5bn in total capital commitments, achieving strong investment returns through economies of scale earnings growth, operational improvements, and strategic upgrades.

Its investment method involves a “Deep Dive Mission”; it starts with finding new niches, becoming “insiders” in those niches, finding the right starting place, and finally creating a blueprint for building the market leader.

The Split

On June 30^th, Parthenon Capital purchased a stake in Cherry Bekaert with the intent of splitting the company into Cherry Bekaert LLP and Cherry Bekaert Advisory LLC, turning them into a licensed CPA firm and an advisory firm respectively. The split will allow Cherry Bekaert LLP to provide attest services while allowing Cherry Bekaert LLC to focus on business advisory and non-attest activities. As mentioned by the auditing firm, “The investment will help enhance the firm’s offerings in its core practices, accelerate the firm’s growth plans and expand the […] offerings to the clients, ultimately improving the experience of customers”.

The purpose of the investment clearly mirrors the plan announced by Ernst Young in 2022 about separating its firms into two distinct accounting and advisory businesses. As we shall see, these have not been the only two splits occurring in the audit sector; the same decisions were made in 2021 when Towerbrook Capital Partners invested in EisnerAmper. But what has created this trend of splitting audit firms into distinct branches with different purposes?

One plausible reason would be to reduce the conflict of interest that may arise within the firm. Traditionally, audit companies manage the books of companies and verify the quality of the information produced by firms, with the aim of reducing potential information asymmetries that may stand between the firms’ shareholders and managers. The threats to truthful reporting can occur when an accounting firm provides its clients with both auditing services and non-audit consulting services, such as advisory on management, taxes, and business strategy. Auditors may be willing to skew their judgements and opinions to win consulting businesses from the same clients. At the same time, auditors may be auditing information systems or tax and financial plans proposed by their non-audit counterparts within the firm. They, therefore, may be reluctant to criticise the system or advise of any potential improvement. Both these conflicts of interest may eventually lead to biased audits, resulting in unreliable information in financial markets, which in the end, may complicate the investors’ efficient allocation of capital. Furthermore, the third conflict of interest that may arise in such circumstances occurs when an auditor provides for a favourable audit to solicit or retain audit businesses.

The lack of transparency between the stakeholders may lead to the firm’s demise. An evident occurrence of this striving to generate profit while disregarding and manipulating auditing practices occurred in the early 2000s with the collapse of Arthur Andersen. Until the 1980s, auditing was the most important source of profit for the Illinois-based accounting firm. By the end of the decade, however, the market for advisory and consulting grew extensively, posing a significant threat to the firm’s profitability. Consulting partners, therefore, began to assert more power within the firm, resulting in an internal conflict that split the firm in two. Eventually, Arthur Andersen Auditing and Andersen Consulting were established as separate companies in 2000. During the period before the split, Andersen’s audit partners were pressured to increase revenue and boost profits for the auditing business side. Clients they handled at the time included Enron, WorldCom, Qwest, and Global Crossing. The loss of a client like Enron or WorldCom would have been destructive for the firm, even if that client only represented a small percentage of the overall revenue and profits of Arthur Andersen. The high internal pressure translated into significant incentives for regional offices to provide favourable audit stances for large clients. These offices then neglected the problems in Enron’s reporting. Arthur Andersen was indicted and then convicted in 2002 for obstruction of justice for impeding the SEC’s investigation of the Enron collapse.

The motive of value creation may also drive the firm’s split into auditing and advisory branches. The greater specialisation in their focus area, and the increasing engagement of specialists in tax valuation to support auditing, will further increase the transparency between audit firms and clients, who will be willing to engage in business under increased audit fees. From the advisory standpoint, they will be free to pitch without worrying about conflicts. They could raise capital from PE funds or go public to scale up. In the end, combining such factors will offer more prospects for increased profits.

Conclusion

While these may be seen as significant assumptions, to date, all firms that have restructured their businesses into those two separate divisions have achieved great revenues, sometimes accounting for twice the levels they could reach before the split.

Whether audit firms should be allowed to continue providing both audit and non-audit services as a single entity is an issue that’s coming to a head, especially after the Enron and WorldCom cases. Indeed, regulators are considering stepping in with rules to improve audit quality and reduce the potential for conflicts by splitting firms up.