The deal will almost certainly result in post-merger headaches
As we learnt at the end of October last year, PwC and Booz & Co are planning to merge.
PwC Chairman Dennis Nally and Booz CEO Cesare Mainardi were very upbeat about the proposed deal. Nally stating that the merger will strengthen the scope and quality of PwC’s service offering. Mainardi, even more effusive, stated that the merger will “help reinvent management consulting for the next century.”
We believe Mainardi is wildly optimistic, and the deal poses big risks for PwC that Nally is either underplaying or overlooking.
But before discussing our reservations, let’s first take a look at the background to the deal.
1. Background to the Deal
1.1 Enron Scandal
PwC is widely known as one of the world’s Big Four accounting firms.
People sometimes mistakenly believe that PwC only provides accounting services, when in actual fact its audit business generates less than half its revenues.
There is a good reason for the confusion.
Why would a trusted global accounting firm like Arthur Anderson fail to properly audit Enron’s books? Well, as it turned out, Arthur Anderson earned more from Enron in consulting fees than it did in auditing fees.
Small conflict of interest.
In the wake of the Enron scandal (among other accounting scandals), regulators took a stronger stance on auditor independence, and PwC ultimately sold its consulting arm to IBM for around $3.5 billion.
And so, as of 2002, PwC was just a big old accounting firm.
1.2 Gold Fever
The consulting industry continues to grow and, in search of higher margins, PwC has thrown itself back into the consulting game head first.
While assurance services are PwC’s traditional bread and butter, revenues have stagnated. Less than half of PwC’s revenues now come from its assurance business, and consulting is one of its fastest growing operations.
Since 2009, PwC has made numerous acquisitions including Paragon Consulting Group, the commercial services arm of BearingPoint, Diamond Management, PRTM, and smaller firms in the digital, social media and environment space.
If the PwC-Booz merger goes through, PwC will gain an additional 3,000 employees in 57 locations worldwide.
The deal received the green light from Booz’s partners in December last year and we expect it complete without any major hiccups, pending clearance from regulators in various countries.
1.3 Industry Consolidation
On the other side of the table, Booz & Co appears to be responding to increasing pressure for industry consolidation. While there is strong demand for consulting firms with global reach, the value proposition of medium sized firms like Booz is becoming harder to sell. As a result, commentators are expecting a wave of consolidations, and we understand that Booz received multiple propositions before accepting overtures from PwC.
2. Headaches Ahead
The proposed PwC-Booz merger is likely to create headaches for PwC and government regulators.
There are 3 issues that the merger is likely to throw up.
2.1 Cultural Integration
Booz describes itself as a firm of practical strategists, collaborative by nature, and committed to its clients’ success. They are a mid-sized consulting firm that provides dedicated and flexible support to senior management. In stark contrast, PwC is a gigantic behemoth which comprises a network of offices in 158 countries with over 180,000 employees offering a smörgåsbord of services.
Our intuition is that the marriage is likely to be a difficult one, and the honeymoon period will be short.
Our view is informed by three observations.
Firstly, cultural integration is a difficult and delicate process. PwC will be tempted to do too much too soon, for example, by forcing Booz to adopt its branding, work practices, and support services. The more hoops that Booz employees are forced to jump through, and the faster the transition period, the more tension this will create.
Secondly, there will be conflicts of interest. Immediately post-merger, some of Booz’s clients are likely to be in doubt. Strategy consulting for audit clients is banned in some countries, and even where it is legal it raises serious “conflict of interest” issues (think Enron). This will place pressure on any Booz partners whose clients are affected and, to the extent that this prevents PwC and Booz from cross-selling, it will limit opportunities for revenue growth.
Thirdly, strategy consulting is more prestigious than auditing, and so Booz consultants may consider joining PwC as a career step backwards.
2.2 People Have Legs
Cultural integration may be the least of PwC’s worries.
In exchange for its $1 billion investment, the main asset that PwC will obtain is people. The problem with this deal is that people have legs.
We expect that the most talented Booz consultants will leave Booz even before the ink on the merger agreement is dry. As a case in point, shortly after the merger plans were announced in October last year, the Australian Financial Review reported:
Booz & Company management consultants have rushed to update their resumes and LinkedIn profiles after a proposed takeover by big four accounting firm PwC was announced…
Luckily for PwC most of the human capital is held by Booz’s partners with their years of experience and client connections, and key rainmakers will be required to stay with PwC for a number of years if they want to receive their full payout.
The real test then of the merger’s success will come in a few years time when Booz’s partners are free to leave. If they depart en masse, then PwC will be left holding the bag.
The problem is not just that many Booz consultants and partners are likely to leave, but also that the most talented graduates, the ones who may have considered working with Booz, are likely to stay away. For one thing, PwC is not as prestigious as Booz. In the coming few years, smart students will also want to avoid the turmoil that inevitably accompanies post-merger cultural integration.
2.3 Conflicts of Interest
In buying Booz and other consulting firms, PwC is not only purchasing revenue growth, it is also acquiring conflicts of interest and the reputational and regulatory risks that go with them.
Reputational risk destroyed Arthur Anderson 13 years ago. The conflicts of interest between Arthur Anderson’s consulting and audit practice encouraged a small number of its partners to turn a blind eye to the substandard auditing of Enron’s books. When the accounting scandal came to light, Arthur Andersen lost credibility in the market and experienced a mass exodus of clients. It ultimately went belly up.
In the wake of the Enron scandal, PwC placated regulators by retreating from consulting work altogether.
In 2011, following the 2008 collapse of Lehman Brothers, the European Commission published plans for the Big Four to sell their consulting divisions due to concerns about the quality of company audits. To our knowledge, the Commission’s plan wasn’t followed through, but the high-profile PwC-Booz merger will place the conflict of interest between auditing and consulting in the regulatory spotlight once again.
Arthur Levitt, former head of the Securities and Exchange Commission, warned that firms are slipping back into old, bad habits. Levitt noted that “as the accounting profession becomes more committed to consulting, their audit activities have got to be questioned.”
If regulators decide to take a stronger stance on this issue, as well they might, then any gains that PwC achieves from its acquisition of Booz may end up being substantially offset by the cost of responding to a regulatory crackdown.