EY Bets The Farm On Advisory With Vision 2020: A Guest Post From Mark O’Connor

I asked Mark O’Connor, CEO and Co-founder of Monadnock Research, to comment on the Going Concern post about Ernst & Young’s “Vision 2020” announcement.

Caleb Newquist at GoingConcern.com thinks Ernst & Young’s goals are a bit ambitious.

One of our sources at EY thought so [too] and told us there are a few key things that would have to happen for the firm to come even remotely close to achieving it:

1) A rapidly expanding advisory business

2) More acquisitions and

3) A lot more Partners, Principals, and Executive Directors.

Caleb also mentions the “I” word.

As the advisory business expands, the more potential there will be for conflicts with the firm’s audit clients. Since EY and the rest of the Big 4 want to be known as trusted business advisors rather than simply auditors or tax preparers, the advisory business gravy train will continue to be a priority and circumventing independence will become an ongoing exercise. We’ve already seen EY cross the line in this area with the revelation that it was lobbying on behalf of audit clients, so it stands to reason they can make make arguments in other cases for the sake of expanding business lines that expand their influence can command larger fees while the audit business gets pushed into the background.

Really, the timing of all this is perfect for EY because all the firms are doing it and they don’t give a damn if people think they’re less independent. The advisory businesses have momentum and since independence is in the eye of the beholder, it’s easy for any firm to say, “That’s just, like, your opinion, man.”

The reality is the consulting practices of the Big Four audit firms – and of their lesser competitors – exist in a regulatory no-man’s land. The PCAOB legally can only address audit quality and SEC won’t touch it unless there’s an independence issue with consulting to audit clients. The SEC’s enforcement actions for independence violations have, since Sarbanes-Oxley initiated the additional nine prohibitions against consulting to audit clients, been few and far between. That’s in spite of numerous examples that independence violations are still occurring and occurring in a big way.

It’s up to renegade regulators like Ben Lawsky and private plaintiffs to keep the consulting side of the audit firms honest.

Here are Mark O’Connor’s comments on Ernst & Young’s Vision 2020 strategy.

One important aspect of Ernst & Young’s “Vision 2020” is a global strategic initiative to reach $50 billion in revenues by 2020. That’s a very aggressive goal, and there are a few important reasons why that might be both out of reach and bad for global business.

Lofty goals like EY’s Vision 2020 serve a promotional purpose to attract top talent, and create the rationalization for promises of vast internal opportunities to keep top performers engaged. Beyond that, it allows current “EY” partners to move from the global advisory leadership sidelines to join principals at other Big Four firms reaping the rewards of higher-margin consulting work. But it is on this point that unintended consequences would likely foreclose any real possibility that the $50 billion aspect of EY’s 2020 strategic plan could be executed as currently conceived.

Big Four firms tend to move in lock-step without huge percentage year-over-year gains relative to one another in any line of business without large M&A transactions – buying or selling. Unless the firm’s strategy was to lower its quality or margin expectations in an attempt to go after the audit business of other Big Four firms and large auditors around the world, almost all of EY’s proposed growth will need to come from advisory. Otherwise, such dramatic growth in assurance would come at the expense of lower margins across a sector that already has very low margins. Anything far beyond the current Big Four average audit growth rate of 3.4% is unlikely, so any EY scenario with $50 billion in revenues by 2020 based primarily on assurance practice growth has a probability close to zero.

Given this, virtually all of EY’s extraordinary growth would need to come from advisory. EY had around $13.5 billion in non-assurance revenues in fiscal 2012, so it would need to grow that by around 266% to reach that goal. That would require a 12. 9% compound annual growth rate (CAGR) coming out of our “great global recession”, assuming that the assurance revenues independently grow at a 3.5% annual rate. EY’s 2012 advisory non-assurance non-tax growth was close to 13%, so in isolation a 12.9% sustained advisory CAGR might seem aggressive, but reasonable.

The consulting and advisory services market is starting to turn around, which increases acquisition multiples and makes inorganic growth less attractive. This is especially true for the Big Four, who have proven they can grow their consulting and advisory services businesses organically faster than any other type of firm. But for EY to accomplish its aggressive growth goals, a significant amount of that will need to come from M&A activity, which will continue to get more costly over that period.

And then there’s the competition factor. Let’s say the consulting space is around $330 billion globally with just under half of that coming from the US. The Big Four had around $61 billion in non-audit revenues in fiscal 2012, including tax advisory. Most, but not all of that is counted in the $330 billion global consulting revenue figure.

That means that the Big Four will collectively work to grow their non-audit business to close to $160 billion by 2020. Today, if we count all of the Big Four advisory and consulting business in the $330 billion global figure, that’s around 18.5% of all global consulting revenues attributable to Deloitte, PwC, EY and KPMG.

Assuming the global market for consulting services grows at a 4% CAGR through 2020, it would be a little over $450 billion market by 2020. And assuming EY can achieve its goal, it is also be reasonable to assume that Deloitte, PwC and KPMG can come close to achieving their goal of neutralizing the relative impact of EY’s growth. That would mean that the growth will come at the expense of other consultancies, with Big Four firms either acquiring them or winning a larger proportion of the new business. Ultimately, the Big Four, in this scenario, would account for around a third of the total 2020 consulting market, doubling their current share.

This is theoretically possible for two reasons. First, it is much easier for accounting firms to sell advisory services given the cozy relationships large multi-nationals have with audit firms, despite the inherent conflicts of interest posed by it. Second, clients have begun to leverage their relationships with a smaller number of large strategic suppliers during the recession. The Big Four and other large firms have been the beneficiaries of this, and have been insulated from some of the recession effects, putting them in a very attractive fiscal position to make strategic acquisitions and win even more business.

The problem that EY and other Big Four firms will face in their aggressive growth plans is not the growth itself. It is managing that growing proportion of advisory business relative to each firm’s core audit and assurance work.

The Big Four generally oppose the notion that non-audit services present any risks that cannot be effectively mitigated. Those advocating that perspective claim that limiting the ability of auditors to expand advisory practices is not warranted, since they have effective internal systems and processes that ensure regulatory compliance. We believe, however, that there are substantive regulatory compliance risks, and other risks, to stakeholders of public and private entities that must be transparently acknowledged, identified and addressed.

The aggregated fiscal 2011-2012 ratios for audit to non-tax advisory revenues for the Big Four continued its shift toward increased conflict risk (audit shrinking in relative proportion to non-tax advisory), from a mean of 1.522 at the conclusion of Fiscal 2011 to 1.4 at the end of Fiscal 2012 (see exhibits below).

Whether or not the firms themselves believe they can manage that inherent conflict, it is a key focus of regulators, and is one that will likely be too much for even the most liberal of regulatory environments to allow.

EY’s plans will likely trigger a competitive response to neutralize the relative impact of EY’s growth plans, driving up the cost of M&A and decreasing the margins of advisory work in competitive client environments. And while each of the Big Four might not be completely successful in neutralizing the competitive impact of EY’s aggressive plans, they will be close.

Main page photo from this site. All graphics ©Monadnock Research 2013.