During the global financial crisis, many professional service firms reduced their headcounts and focused their management efforts on partner earnings and survival instead of expansion. But, confidence is now returning to the economy and, with it, the appetite of management teams to look for growth once again, along with an improvement in earnings. Growth materialises in many ways and management need to prioritise the options that deliver real value and sustainable results for their firms.
Options for growth
Management will need to choose between organic national growth, lateral practice development or international expansion. The speed at which a return is required, along with the level of investment available, will play an important part in this decision-making process.
Organic growth is often slow and requires a long-term view.
Domestic lateral practice development can be achieved by taking on new teams and expanding the firm's offerings. This will usually involve paying a premium to attract new teams. The firm's brand also needs to be strong enough to break into the particular market.
International expansion is also an option for many firms. For some, it is also becoming a necessity driven by the needs of clients expanding internationally and requiring the support of their advisors in those markets. The move into the international arena can be a formidable challenge for management, with numerous hurdles. However, the returns can be significant.
Making the decision
During the global financial crisis, the UK economy was hit with its deepest recession in decades. Other economies fared better or are now recovering at a faster rate. These differentials can make international expansion an attractive option for UK firms seeking faster growth.
In many cases, the choice of country will be driven by existing relationships or market knowledge. In some cases, however, management will need to research the various markets to ensure the best return is gained from the investment.
Once a decision to expand overseas has been agreed in principle, the next step is to consider how. Again, there are a number of options available for management to review. Firms can look to establish 'greenfield' sites or to undertake M&A activity.
Greenfield sites would have the advantage of being focused on a very specific target area and allow management to dictate the size and culture of the new offices. The downside would be the need to build a brand in the region, which can take time unless the brand already has international depth.
In determining the country of choice, management will need to articulate the rationale for expansion. Professional service firms often have a diverse stakeholder base which, depending on the governance structure, will need convincing before funds are released for investment.
For firms that have a corporate structure, the decision-making process may be easier. The board may already have the mandate to make these investment decisions on behalf of the shareholders.
For partnerships, whether a general partnership or a limited liability partnership (LLP), firm governance may require a partner or member vote, which could mean a more detailed explanation to a wider stakeholder group. The articulation of the expansion vision will need to be crystal clear in relation to the level of investment proposed, the opportunity to the firm and the payback period.
Communicating the vision to the wider stakeholder group to obtain permission (particularly if key clients are approached for their view) carries the risk of details being leaked to the general business community. For greenfield site expansion, this is not necessarily a bad outcome, as it shows the strategic direction of the firm. However, if the expansion is via M&A, this could be extremely damaging to any potential deal. Disgruntled stakeholders can leak information, which can increase the pressure on getting the deal done or derail the process in its entirety.
It therefore becomes a choice for management as to the time they consult and engage with the wider stakeholder group to gain permission, as opposed to putting time and effort into negotiations before this permission is granted.
Considering culture
The culture of any organisation will evolve over time as economic conditions change and lateral hires join.
Culture will always play a key part in any international expansion. This will include the culture of the country, the culture of any target entity for M&A and the culture of the firm. The one thing that is certain is that the culture of the enlarged group will change when an international dynamic is introduced. There will need to be flexibility and adaptability within the firm's own culture and style to ensure any expansion is bedded down successfully.
Culture is also an incredibly difficult feature to define and, when expanding via M&A, the culture of the target entity will need to be assessed. It cannot be covered by formal due diligence, as there is no real measurement.
Hence, the best way to gain an understanding of the culture is to spend time with the target teams to get an understanding of how they work and what makes them tick. This will also give them the ability to see how they can work with you. This requires time, which is often a scarce resource and removes focus from the firm's core activity.
Structuring expansion
Assessing the impact of different structures when expanding internationally is important and requires time and thought. It is better to spend the time at the outset rather than having to restructure post set-up, as this can carry significant cost or open the UK firm to additional tax costs
or restrictions which were unknown at
the start.
The choice of vehicle will include a subsidiary company, branch, partnership or an LLP, including parallel structures. Each of these has very different consequences in terms of incentivisation, remuneration, profit extraction and taxation.
If a subsidiary company is used, how will the 'partners' be recognised and rewarded? The lack of ability to reward a senior team member with equity can be restrictive in terms of attracting them in the first place. The status of being a partner as opposed to an employee can have a great impact on the motivation and market perception of the individual.
Rewarding growth
Profit extraction is also a key element to consider when looking at the structure of the investment. The rationale for expansion is likely to be driven by improving underlying profit to the UK firm. With this being the case, thought needs to be given as to how to efficiently extract profit from the new venture that minimises the tax consequence of the expansion decision, including the administration burden that comes with it.
Partners will not be thankful if they all need to make complex tax returns in an overseas jurisdiction, opening up their affairs to scrutiny or an overseas tax inspector. They may, however, be pleased to benefit from the tax relief on start-up losses that they are investing in, which careful structuring could enable.
The extraction of profit is also linked to the ability to share profit on an international basis. If a partnership structure is used, then thought will need to be given as to how to share the global profits. This can be an incredibly divisive negotiation and can cause real tension.
Profit shares based on a single country is always a point of debate within firms, regardless of the model used (such as lockstep or merit-based). When an international element is introduced, this increases the tension within the stakeholder group. For partnerships, members in the UK are likely to see a profit dilution in early years to fund the expansion for which a return is not guaranteed and also may be some way off in the future. For the overseas partners, they may look for a higher profit share, given that they are taking a risk in joining the new venture, which could increase the dilutive effect on the UK partners.
Relocation and taxes
Other factors to be considered when expanding overseas will include local cost of living and local taxes. When a firm moves into the international arena, the impact of tax on the individual will need to be evaluated. Should tax equalisation be introduced or are profits distributed on a gross basis? These have a real impact on the perception of equity and individual motivations within the partner group. Decisions made now may also set a precedent for future ventures overseas and should therefore be considered with this in mind.
Tax equalisation will also feature when looking at the mobility of staff. Often, when a firm expands internationally, domestic staff and partners will be relocated to the new offices to help transfer skills and approaches between locations. This can be a great advantage to a firm that is looking to retain and attract talent, as the opportunity to travel with work is a proposition some individuals look for in
a firm.
When asking someone to relocate, the firm will need to consider the implications for that individual in terms of remuneration. Should they move onto a local package which may be vastly different from their domestic package? What impact does tax have in relation to the net package as compared to the gross? These factors need to be considered when secondments and relocations are being proposed so that the benefit of the transfer of skills is seen as a reward to the individual and not just the firm.
When establishing a presence in an overseas country, other tax implications need to be considered. Some countries have a 'short-term business visitor' regime which can result in visits of a matter of days, opening the UK firm up to a reporting obligation and tax liabilities in respect of the employees.
Understanding the various tax regimes is essential to realising value at the net return level of the investment. The ability to repatriate profits and reward employees and partners are all affected by tax. The penalties for not adhering to local tax regulation can be severe, so a thorough understanding is essential.
Other considerations
International business brings the additional requirement of setting up a bank account and the risk of foreign currency. This will impact reported results in terms of the revenue, balance sheet position and cashflows per the local financial statements.
Hedging can be used for effective control of currency movements and can help to protect the business from large swings in foreign exchange rates. However, treatment of foreign exchange movements from an accounting perspective can have quite a different impact for the financial statements.
Each jurisdiction will have its own specific factors to consider when firms are looking to expand their business overseas. Over the coming months, we will be looking at a number of countries which are currently attractive to professional service firms in terms of expansion and discuss the specific areas that management should consider when looking at expansion. Although there are risks when expanding overseas, there is also a real opportunity to benefit in the longer term.
Matthew White is partner and international practice leader for professional services at BDO (www.bdo.co.uk)
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