By Ashish Nanda
In advertising, investment banking, and asset management, and especially in strategy and technology consulting, the acquisition of successful partnerships by public corporations has led to enormous value destruction. Demotivated professionals quit the acquired entity in droves, and the acquirer finds that most of the value it paid for has walked out the door.
Recent years have seen a string of acquisitions of private partnerships by public firms — A.T. Kearney by EDS in 1995, several technology consulting boutiques by roll-up companies during the dot-com boom and bust, Ernst and Young Consulting by Cap Gemini in February 2000, PricewaterhouseCoopers by IBM in October 2002 — that have proved challenging.
In general, acquisitions of professional partnerships by public corporations fail more often than they succeed, and more often than do other types of acquisitions. The principal reason given for failed acquisitions is that professionals accustomed to the privileges of partnership find it difficult to adjust to the culture of a corporation. But a key reason for the failure of these acquisitions is the lack of appreciation among partners of the acquired firm of a basic economic reality — they have to choose between receiving high valuation at the time of acquisition and high compensation after the acquisition.
The reason for this trade-off is straightforward. The acquisition price reflects the expected profit stream from the acquired enterprise, capitalized to the present. The value created by the acquired firm has to be divided between compensation paid to its professionals and profits accrued to its owners. High valuation implies high future profits, which, for a given amount of total value, implies low compensation of professionals in the future. Professionals who seek a significant one-time payment for the acquisition of their partnership should be prepared to take a significant cut in compensation.
One way to think of this reduction in compensation is to recognize that, as a partner, a professional is earning the combination of two income streams — return on professional effort and return on ownership equity in the firm. For sale of an ownership stake in the firm to the acquirer, the professional receives a one-time payment. However, the professional's subsequent compensation comprises only one income stream, return on professional effort.
The decline in professionals' compensation might be assuaged partly by merger synergies. Future profits do not have to be created solely by reducing professionals' compensation; part of the profits arise from the greater value created by the merger. But whereas synergies alleviate post-merger compensation reductions, tax considerations typically exacerbate the negative effect of mergers on professionals' compensation. In most regimes, the tax rate on self-employed professionals is lower than the tax rate on employees. Consequently, the post-tax compensation of professionals becomes even lower as employees than their post-tax compensation as partners. On balance, most acquisitions of professional partnerships result in significant decline in the partners' post-tax compensation.
If the trade-offs between acquisition price and compensation are clearly discussed before the acquisition takes place, the acquired firm's partners know what to expect after the acquisition and choose a mix of valuation and compensation with which they are comfortable. If the partners do not clearly understand these trade-offs, then they are surprised by the post-acquisition reduction in their compensation, think that the acquirer took advantage of them, feel demotivated, and quit.
Negotiations involving the acquisition of a professional partnership must include not only the acquisition price but also the post-acquisition compensation of the acquisition target's professionals. The acquirer would want that professionals continue to feel, post-acquisition, that they are receiving fair compensation in comparison to outside opportunities. If their compensation declines too drastically, they are likely to leave the firm for other opportunities.
This consideration places a floor on the compensation of the acquired firm's professionals and hence a ceiling on the valuation the acquirer places on a professional partnership.
But partnerships are not monolithic entities. Different partners may have different preferences regarding the valuation-compensation trade-offs. If some partners of the acquired firm are not joining the merged firm, they will desire to maximize the purchase price even if that implies a very low compensation, post-acquisition, for the continuing partners of the acquired firm. Even among the continuing partners in the acquired firm, senior partners, who have large ownership stakes in the firm and are close to retirement, will want high valuation, whereas junior partners, who have small ownership stakes but are planning on working at the firm for several more years, will prefer high compensation.
The acquirer must guard against paying an acquisition price that pleases exiting partners or partners close to retirement but is likely to lead to unhappiness and increased departures among continuing partners because of their low post-acquisition compensation. Because partner votes might disproportionately reflect senior partners' preferences, whereas the acquirer might be counting more on the junior partners' ongoing loyalty, the acquirer might seek not only a majority partner vote in support of the acquisition but also a majority vote among the junior partners whom it hopes to retain over the long term. The acquirer also might offer different valuation-compensation trade-offs to different partners of the acquired firm — higher valuations at the expense of considerably lower compensations to senior partners and lower valuations but also a smaller cut in compensation to junior partners.
If the corporate acquirer and the target partnership understand and negotiate the valuation-compensation mix clearly and carefully, acquisitions of professional partnerships by public corporations are likely to be far more successful than they have seemed to become.
Ashish Nanda is Associate Professor of the Harvard Business School. A member of the Negotiations, Organizations, and Markets unit at the Harvard Business School, Professor Nanda teaches the MBA course Professional Services. He teaches in the Harvard executive education programs Leadership in Professional Service Firms, Changing the Game, and Colloquium on Participant Centered Learning.
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