Mergers and Acquisition Blog - 3 Unique challenges with Professional Services Acquisitions

The last five years have seen a dramatic increase in mergers and acquisitions of Professional Services Firms. There have been two main drivers fueling this trend – larger firms tucking in firms that bring unique capabilities and/or operating in new geographies; and Private Equity led roll-ups of firms with vertical capabilities. Unlike other sectors, mergers and acquisitions in Professional Services present some unique challenges.

We will briefly discuss these challenges and how best to address them here.

The 3 main challenges with Mergers and Acquisition in Professional Services

  1. Valuing the business
  2. Effective due diligence
  3. Post-Merger Integration

Two of our three challenges stem from the fact that in professional services firms we are primarily dealing with human assets. Assets that have expertise and relationships.

Human assets, while valuable, present two challenges – how to value them (both their expertise and their relationships); and perhaps more importantly, how to keep them from leaving.

1. Valuing the business in Mergers and Acquisitions

Professional Services firms typically possess the following assets –

  • Brand/Reputation
  • Clients and Book of Business
  • Intellectual Property – Proprietary methods, tools, frameworks, etc.
  • Human Assets

Other than the client list and the book of business, the rest are intangible for the most part. Sellers will typically try to hype the intangibles to boost the valuation.

Buyers will be best served if they approach valuation in the following way –

  • Base the bulk of your valuation on the growth rate, EBITDA, and backlog.
  • Assume some level of attrition in developing your valuation. While no one wants it, it is unavoidable.
  • Evaluate the IP and factor in a consideration if they are truly differentiating.
  • Factor in retention arrangements for the top performers, folks with unique skills and expertise, and folks with deep and meaningful client relationships.

2. Effective Due Diligence for Mergers and Acquisitions

Due diligence in professional services can be tricky as potential risks can be buried in contracts, in project/client financials, and project plans. It is important to employ knowledgeable folks in this activity. Failure to do so can have a significant negative impact on the business case.

Here a few of the typical issues that trip up the due diligence effort –

  • Review every statement of work to determine project success criteria as well as payment arrangements.
    • There are often disconnects between clients and providers on the success criteria that can lead to additional, unplanned services/costs as well as potential litigation.
    • Not all payment arrangements are based on delivered services being billed in arrears. This is particularly important in fixed priced deals payments may have been received in advance of services being delivered making the project financials appear stronger than they are.
  • Not many firms do earned-value analysis on projects. In the absence of this, it is incumbent on the due diligence team to dig into the details of major projects to determine if delivery has deviated from the pro-forma.
  • While larger firms with well-staffed finance departments will be fully conversant in the IRS rules around revenue recognition, particularly around managed services, the same cannot be said for small, niche firms. This is another area of potential exposure that must be covered by the due diligence team.

3. Post-Merger Integration

Post-Merger integration in a potential minefield in professional services. In short, the work culture, reporting relationships, review and rewards criteria of the new organization are likely to be substantially different for a segment of the combined entity.

If their aspirations, work preferences, don’t align with the new status-quo or if the transition is executed in a heavy-handed way, it can lead to departures of significant talent.

This will negatively impact the business case but it could also cause operational challenges if critical personnel on specific projects leave, and client losses if the person with the primary client relationship leaves.

Conclusion – Mergers & Acquisition in professional services

Mergers and Acquisitions in professional services presents unique challenges as discussed above that can compromise the overall business case.

A careful approach, employing knowledgeable people in the valuation, due-diligence, and post-merger integration phases is critical to avoid a suboptimal outcome.

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