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07 May 2009
Twelve months ago the idea of another Big Four accountancy firm disappearing from the map would have perhaps been far-fetched.
The pole-position firms, PricewaterhouseCoopers, KPMG, Deloitte and Ernst & Young are, on the face of it, financially sound and with strong regulatory processes to prevent another Andersen from happening.
Together they control just over 70% of a market worth more than £9bn in the UK alone. But factor in the current economic climate, poor strategy and the consequences of ‘The Rule of Three’ (more of that later), and this gloomy proposition becomes all of a sudden very real.
One could argue that the large accountancy firms should, to some extent, be sheltered from the current crisis.
Their type of client, the large private and public multinational company, will invariably have a legal requirement for an audit. This type of client is usually large enough to withstand economic downturns so audit fees from such companies should, in general, remain stable.
Balance of power
Firms, however, live off fees from non-audit services and these are not selling. Clients are simply not buying them to the same degree.
As the majority of firms do not have the right balance between audit and non-audit clients, the deficit created by the sales decrease in non-audit services is just too wide to be bridged by new audit clients alone, especially as there is little to no market to grow into as the crisis deepens. The real impact of all this will be seen in the 08/09 and 09/10 results.
To accentuate the problem and perhaps expedite the ultimate outcome, in comes a market law called The Rule of Three. This rule postulates that for a market to reach equilibrium point, the point at which customers get the best value for their money and where competition flows at levels that encourage innovation, a certain balance of power needs to be in place. The balance is achieved when three top players control around 70% of the market, sharing the rest with smaller firms.
This structure can be seen in a wide range of industries, for example in the US:
In the UK, the mobile network suppliers market has reached equilibrium point with O2, Orange and Vodafone as its dominant players. The current climate will accelerate the process in other markets as well.
The UK accountancy market is not immune to the gravity pull of the Rule of Three. It’s a certainty that consolidation will take place and that it will affect the top players. The unanswered question is which three firms will prevail? If you apply the rule based on revenues then the answer is simple number four, E&Y, is the weakest link and therefore the one to go. However, the rule is not linear and needs to be applied in the light of the two factors - strategy and leadership.
So does E&Y have the right strategy and leadership to withstand the market forces?
In the light of the firm’s current strategy, the answer is that, in the long term, it probably won’t survive. Their current strategy perpetuates the mistakes made in early 2000 when the firm sold its management consultancy arm to Cap Gemini. At the time, they pushed hard to recover the fees gone with the consulting arm, by focusing on growing its global accounts. The strategy flopped to a large extent though, as it lacked a key motivational ingredient - profit sharing.
E&Y’s recently announced EMEIA merger will not resolve the above pr oblems. Although operational savings may be achieved, real growth will only arise when the right financial incentives and global client profit/loss sharing processes are put in place.
The firm will only withstand the economic climate and the dictates of the Rule of Three if it pursues an external merger campaign that will give it access to the audit client base it needs to regain market share.
For the other three firms the time is ripe to also re-evaluate their positions and decide whether to stay put or instead to take advantage of this window of opportunity to challenge the market and push it to its equilibrium point.
For instance, could two Big Four firms become one? Could the mid market, especially Grant Thornton and BDO, step up by assimilation as opposed to organically? Could we see a Big Four firm merging with a mid market firm to create a two stream operation, where the mid market ‘arm’ would use the processes and innovation applied to larger companies, in order to help build strong UK mid market companies that would eventually become either large corporates, or part of existing large corporates?
The worst scenario is where one of the Big Four is taken apart and sold to a range of firms interested in different specialisms.
There is no question that changes are brewing in the accountancy sector and that the dominance of the Big Four as we have known it for the past few years will come to an end.
The question is whether one person or one team is capable of captivating the imagination of their staff to lead them into a new era; whether one firm will have the vision to write history and its own chapter in it.
Competitive advantage
Answering these questions will require re-evaluation of the strategy of each firm: What customers do they want to serve? Which services do they want to offer? Can they provide new and innovative services in addition to the traditional ones? How can they create a differentiation and a competitive advantage for themselves?
To continue to do ‘more of the same’ is probably the best way to lose their dominating market position, or to be swallowed by one of the other big fish.
Dr Michael Perry is the founder and president of Mitzuv, a marketing strategy consultancy with operations in the US and the UK. Rute Pinto is a freelance consultant at Mitzuv Israel and UK
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Visitor comments Add your comment
Half-Baked Article
What's the point of this Article? Why single out E&Y? For your kind information, E&Y is ahead of KPMG in terms of revenue numbers Globally! We would have liked to see the strategies of all the Big 4 being compared rather than just one of them being targeted.
Posted by: Anurag, 06 May 2009 | 00:00
Pointless Article
No facts to back up most of what seemed biased judgement.
Three is the magic number for market equilibrium? - what about markets like oil, pharma, banking? - this 'dreamed up' theory doesnt seem to apply..
And how about taking a more global perspective on things because all the big 4 are global firms and their futures are not dictated solely on the UK markets alone (especially as emerging markets become more important)
For a guy who supposedly owns a marketing consultancy firm..doesnt seem to know much about the markets
Posted by: Ted Johnson, 07 May 2009 | 00:00
Mystic Meg would be embarrassed to publish such drivel
So Ernst & Young is doomed because its UK practice is currently smaller than those of the other big four firms - what utter rubbish. Any serious academic or competent business analyst would have to acknowledge that there are other relevant factors even if the premise of a rule of 3 is accepted. Which brand of cereal gave Dr Perry his PhD?
Posted by: Disgusted, 08 May 2009 | 00:00
Half Baked is the word
This is a peculiar article - is it perhaps driven by a lack of knowledge of the other Big4 practices? Or trying to stretch the article to fit the arbitrary 'Rule of Three'?
Why not postulate on other possible considerations...
- audit focused accountancies such as PWC being particularly susceptible to intense downward pressure on Channel 1 fees?
- increasing competition in the consultancy space, a traditional strength of Deloitte, with scope for growth into this area across the board at other Big 4?
- over-extension of expansionary objectives at KPMG, retrenching vs. recessionary pressures far sooner than other Big 4?
Posted by: Mark, 08 May 2009 | 00:00
The rule of (multiples of) three
Does the rule of three work if we start to talk about the Big 6 ? (I saw reference in one article on these pages a few weeks ago to the Big 6. ) Maybe we don't need to see any change if we think in those terms? Not sure there's huge value in starting the debate however as its likely to just cause more concern in an already turbulent market. Staff at the "Big6" are unlikely to thank you for giving air time to this subject
Posted by: matilda, 08 May 2009 | 00:00
The Rule of Three Applies
If you examine many markets and industries, you will see that the Rule of Three does apply. It depends on the correct definition of the market, geographically and by industry.
If we define the UK market as a separate market, the Rule of three can definitely apply, but global forces may also have an affect.
Posted by: George, 09 May 2009 | 00:00
Litigation
I would have that the more likely possibility of one of the Big 4 collapsing was a litigation case. KPMG would seem to be the most likely candidate based on the number of cases pending.
Posted by: Brendan Brady, 10 May 2009 | 00:00
Reply to comments
In reply to those who felt threatened by the article, we would like to clarify a few points:
1. The effect of the ?Rule of Three? can be observed in many markets and in many countries around the world (See ?The Rule of Three: Surviving and Thriving in Competitive Markets?, by Jagdish Sheth and Rajendra Sisodia, Free Press, 2002)
2. Its effect is not seen at every point in time. A typical competitive market that is largely free of regulatory constraints and major entry barriers (such as restrictive patent rights or government-controlled capacity licenses), starts out in an unorganized way, with only small players serving it. As markets expand, they become organized through consolidation and standardization. This process eventually results in the emergence of a handful of "full-line generalists" surrounded by a number of "product specialists" and "market specialists."
3. With uncanny regularity, the number of full-line generalists that survive this transition is three.
4. We did not say that it is inevitable that number four will not survive, but only that it has the highest likelihood for such fate. The ultimate outcomes depends if it will apply the right strategy and leadership to withstand the market forces.
In a personal reply to ?Disgusted?: The?brand of cereal? who gave Dr Perry his PhD is Columbia University in New York. Have you heard of it?
Posted by: Michael Perry, 12 May 2009 | 00:00
Big 3, 4, 6, 8 - how many do we necessitate...
This article is "fun" and I hope the author's meant it that way, because it is quite insulting to the readers' intelligence if it claims to be anything else.
Without any facts or support, one shouldn't quote some hair-brained theory, and present it as fact (you would think that someone writing TO a community of Accountants and Auditors would know better!).
Yes, the Firms are in hurting right now. The SEC ruling on prohibiting consulting services if the Firm is the Auditor has changed the game completely. Andersen was the perfect example of how a firm flourishes by piggy-backing core audit services with multi-million dollar, multi-year contracting services, and those hey-days are long gone. Firms out there right now trying to re-live that hey-day (e.g., EY) need to wake up and smell the coffee, because I agree, it will hurt them (in many more ways than one) in the long run. But I don?t believe that this means they are doomed. I think they just need to come to their senses on their strategy. I believe that means simply ? focus on what you are good at ? Auditing, and leave the ?consulting? work for the real consultants.
There is PLENTY of room for growth in core audit services, and plenty of work for 4,5, or even 6 ?Big? firms to flourish.
This change in strategy may affect gross revenues temporarily, but removing the overhead associated with support for consultancy will allow for a more market friendly price structure. This CANNOT be done half-baked - ie "changing the org structure", so that the consulting ?branch? reports to someone else?, etc. All non-core services need to be removed completely (or, like in the old days ? odd jobs can be done by core audit staff IF and when there is any down time).
Trying to do both is an outdated concept. Consider the following:
Any firm?s first and foremost goal is to "secure the audit".
Do the math. With overhead so high, even the most discounted "consulting" fees are high - forcing them to go after only large companies. Companies that they would much rather have as Audit clients. If that is the case, then logically, how can an Audit firm build a sustainable "consulting" structure, if their clients are ultimately being schmoozed for the audit? What ambitious consultant would want to work there is he or she new that all of their hard efforts would be squashed is some random Partner down the hall wants to ?secure the audit? at his client?
Lets face it ? EY is NOT Cap Gemini, IBM, Accenture, or McKinnsey. Firms like EY trying to chase after big system implementations, and Finance Transformations is a sad joke. Stealing washed up "could-have-beens" from other firms, and trying to right-size traditional IT audit people into these roles will not cut it - the firm cannot support the infrastructure needed to do it properly.
In my opinion -I dont think the Firms need to close down, merge, nor is there any "magic" number. Once they realize that they cannot relive the pre-2001 business model, and get back to focusing on "core auditing" - they will be OK. They will be a bit smaller, but they will rebound in the long run.
Reputation is everything in this business, and Firms like EY trying to act like they are "slick" consultants is, in my opinion, what is killing them. Do your audits, and train your people to do good audits ? everything else is just noise
Posted by: Frederick, 13 May 2009 | 00:00
Very Simplistic!
I accept that the authors have only a limited space in which they can make their points, but this is still a worryingly simplistic article.
Whilst I accept you can see the "rule of 3" in some countries / industries, in a great many cases, it simply doesn't apply over the longer term. For example, if you looked at the US car industry 40 years ago, you clearly had a "rule of 3" situation - i.e. Ford, GM & Chrysler. Needless to say all of these 3 are in or v. close to Chapter 11. However, if the rule of 3 was so dominant & all powerful, you should simply not have firms like Honda coming along from nothing and beating the "big 3" car firms. Honda only started producing cars in the early to mid 1970s!!
Similarly, the authors appear to have no understanding of the importance of the various competition authorities around the world. The reality is that most competition offices were v. concerned when the Big 6 became the Big 5 and it is literally impossible (who seriously believes they would have approved the PW / Coopers merger, if they'd foreseen the collapse of AA in 2001?), to see them accepting a move to a big 3. This is still the case, regardless of whether one argues that the laws of "natural survival" in business happen to be pushing things towards a big 3.
Posted by: Robert, 16 May 2009 | 00:00
Financial Reporting Council's report on audit choice
For all readers who would like some more background on whether or not there is a real danger of one of the Big Four firms exiting the market, please follow the link - it's from the UK's audit regulator and it extensivelly ellaborates on the real potential of it happening. It further advises all firms to have a continengy plan in place in case it happens.
Enjoy!
http://www.frc.org.uk/documents/pagemanager/frc/FRCMPG%20Final%20Report%20for%20web.pdf
Posted by: Scott, 20 May 2009 | 00:00
And who were the people most upset by the article I wonder.....
It stirkes me that a number of the respondents to this article might themselves be nervy Big 4 types, who are quick to line up behind their mutual businesses/business models and defend them to the hilt. It smacks of the arrogance and ignorance I all too often see displayed by Big 4 when some person or institution seeks to challenge their raison d'etre. Come on - open up a bit, get outside of the box for goodness sake and take on board some interesting views from outside of your cosy oligopoly!
That said, the reactions are quite funny really!
Posted by: Peat Priceoitte-Young, 01 Jun 2009 | 00:00
Arrogance
It's interesting to see the respondents accused of arrogance (Peat Piceoitte-Young) when the article includes the following:
"In the light of [EY]?s current strategy, the answer is that, in the long term, it probably won?t survive."
and
"There is no question that changes are brewing in the accountancy sector and that the dominance of the Big Four as we have known it for the past few years will come to an end."
So an organisation of over 100,000 people which seems to be doing OK is pursuing a strategy that probably means it won't survive. Quick - somebody had better tell them! And there is "no question" that the dominance of the Big Four will come to an end apparently. Well, I suppose if your horizon is far enough away that's bound to be true some time, but the implication is that it will be relatively soon. That's a big call.
The article seems to analyse what might happen, and then conclude that it is what WILL happen. Now that's arrogance.
Posted by: Paul F, 09 Jun 2009 | 00:00