Ernst & Young’s proposal to divide its audit and consulting businesses would provide thousands of its partner’s multimillion-dollar bonuses and depends on optimistic predictions for growth to justify the transaction, according to internal company papers and individuals familiar with the situation.
The idea would break off the firm’s accountants who audit corporations like Amazon.com Inc. from its faster-growing consulting division, which advises businesses on tax difficulties, mergers, and technology, among other things.
The internal records suggest that EY thinks both businesses might expand quicker and be more lucrative on their own. The separation of the 312,000-person corporation might come as soon as late next year.
This version of EY’s strategy, code-named Project Everest, is based on confidential papers provided to senior EY officials in May and obtained by The Wall Street Journal, as well as persons familiar with the situation.
Under a May version of the internal plan, the consultancy division would go public, intending to sell a share of approximately 15 percent of the company for more than $10 billion, while borrowing $17 billion, the sources said. The present partners would hold roughly 70 percent of the firm with around 15 percent earmarked for stock awards largely for personnel.
Much of the money produced in the IPO and borrowed by the consulting company would go to pay off the firm’s auditing partners, who would stay in the conventional but slower-growing industry of scrutinizing and signing off on companies’ financial statements.
Those partners would get a cash dividend of generally two to four times their yearly income under the proposal. For the U.S. and U.K. partners, who make on average roughly $850,000 to $900,000 a year, it is a typical windfall of around $2 million or more. The firm’s most senior partners would presumably earn substantially more.
The partners entering the consultancy firm would obtain shares in the newly public company valued generally seven times to nine times their yearly income, paid out over five years. That company would compete with large consulting companies ranging from International Business Machines Corp. to Accenture PLC, plus the other accounting firms that have built up their consulting divisions.
Earlier plans for the agreement saw the top partners obtaining significantly greater multiples of their compensation as windfalls, compared with more junior partners. The extent of the senior partners’ windfall has been lowered as the scheme has matured. The amount of the average planned dividend for EY’s nearly 13,000 partners has been adjusted down because of the market fall since the data were reported in May.
EY’s move to seek a separation comes as authorities tighten up pressure on auditing companies to resolve conflicts of interest in their operations. Regulators in several countries are worried that the advisory services the businesses provide might damage their capacity to perform impartial audits of public companies’ financials. Auditors are compensated by the corporations they audit and must comply with rigorous laws that limit to who they may offer advisory services.
EY is facing investigations and lawsuits connected to a litany of alleged frauds and failures of its audit clients. It has lost significant customers owing to its troubles, which caused its top executive to break with industry convention and argue auditors should have a stronger role in spotting fraud.
EY has defended the quality of its audits and claimed these errors didn’t alter its conclusion on a split.
Project Everest started in November, when Carmine Di Sibio, EY’s global chairman and chief executive, decided to restart conversations about separating the business. It was a turnaround from his NextWave goal to develop the corporation as a whole.
Project Everest acquired pace in February, when EY engaged bankers from Goldman Sachs Group Inc. and JPMorgan Chase & Co., as well as independent law firms, to assist in the acquisition. By May, an early feasibility analysis had come down in favor of an IPO.
“Our companies are solid but constraints are holding us back from attaining our full potential,” one EY paper wrote. The downsides of the firm’s existing structure include “limited development in both [audit and non-audit branches] owing to independence restrictions,” the letter noted.
On May 17 and 18, Mr. Di Sibio and other top global EY executives met in London to discuss the merger with the CEOs of several key EY member businesses and bankers from Goldman and JPMorgan. The two-day Project Everest summit, featuring a 6.30 p.m. supper on the first night, was hosted at EY’s U.K. offices near the Shard building on the River Thames.
After word of the prospective separation surfaced last month, EY started hustling to piece together a public declaration of its official intentions. The corporation wants to deliver a “go or no go” judgment in principle before the July 4 holiday.
Assuming EY chooses to continue through with the proposal, it will need to persuade partners in the majority of the approximately 140 nations that make up its worldwide network. The firm’s senior executives will undertake roadshows this summer to propose the acquisition with votes anticipated between this autumn and January 2023. A split and IPO are penciled in for late next year, later than the initial goal date of June 2023.
The particular outlines of that arrangement are still being worked out by EY’s executives. As the arrangement stood in late April, the new consulting business would earn approximately 60 percent of EY’s expected $42.5 billion in revenue for the current financial year, with around 40 percent going to the primarily audit partnership.
Under the Project Everest framework, the primarily audit company is named AssureCo, with the motto “trust and transparency,” while the consulting arm is called NewCo, with a purpose to “advise, reform, operate.” AssureCo will presumably preserve the EY name. It would derive roughly two-thirds of its income from audits.
EY thinks both businesses might perform better when they are free from regulatory restraints. “Now is the moment to move to new growth curves for both businesses,” one internal EY memo wrote.
The consultants, for example, might be barred from forging relationships with tech businesses to market compliance and other services. These multi-year outsourcing contracts are an important target market for consulting businesses.
EY has long been the auditor of choice for tech startups and Silicon Valley heavyweights. The business audits Google parent Alphabet Inc., Amazon.com, Salesforce Inc., and Workday Inc. That drastically reduces the number of prominent tech businesses it can link up with.
In justifying its possible split, EY cites the success of Accenture PLC, which was split off from auditor Arthur Andersen after a bitter feud more than 20 years ago. Andersen crumbled shortly after under the weight of its failed audits of Enron Corp.
Accenture is now worth around $175 billion, up from $6 billion after its 2001 IPO, according to FactSet. In the Andersen split, the consultants left the company after a bitter fight with the auditors. In the EY plan, the consultants will effectively pay off the auditors to let them leave.
EY predicts that profit margins in its consulting sector would improve by several percentage points to roughly 16 percent in a year, largely via cost reduction. The firm is also predicted to raise sales by 15 percent to 20 percent per year for the first three years. That would likely have to be done via internal development since the consulting firm’s debt level might make it challenging to finance significant acquisitions. The consultants will also likely have to put up a new brand.
The business thinks auditors might leverage their image as independent and devoid of conflicts to acquire an advantage in recruiting clients dissatisfied with their existing auditor.
Critics argue the separation would weaken the auditing business and leave it subject to litigation. They claim that partners would enjoy windfalls while many workers would simply suffer the disruption of the separation. And they note the difficulties of having the acquisition authorized by partners in several countries, whose enterprises are affiliated to EY but are autonomous organizations.
For Mr. Di Sibio, the proposal might entail a payoff of tens of millions of dollars and a chance to remain on at the consultancy firm, which wouldn’t have any predetermined retirement age. Mr. Di Sibio hits 60, EY’s retirement age, in March. Several other top EY executives are pushing 60, including Steve Krouskos, the London-based global managing partner of business enablement.
Critics say lawsuit settlements and regulatory fines could take a bigger toll on a smaller mostly audit EY than they would on a bigger entity. The firm disagrees.
Either way, the firm has suffered reputational damage from a string of failed audits. EY’s German arm is being sued over its audits of German fintech company Wirecard AG, which filed for insolvency in 2020 after saying that 1.9 billion euros (around $2 billion) in assets likely never existed. In the U.K., EY faces a demand for $2.7 billion from the administrator of hospital operator NMC Health PLC, which in 2020 filed for bankruptcy following the discovery of billions of dollars of unreported debt. EY was also the auditor for China’s Luckin Coffee Inc., which reportedly utilized phony orders to exaggerate revenues.
The scandals cost EY. Commerzbank AG and Deutsche Bank AG’s asset-management unit, which lost money when Wirecard went bankrupt, have both fired EY as their auditor, claiming conflicts of interest.
EY has claimed it stands behind its work and maintains high-quality audit standards. Liability for claimed audit malpractice isn’t a consideration in the decision to possibly break apart EY, and the primarily audit business would have the financial resources to cope with the case, according to individuals familiar with the subject.
After the failures were revealed, Mr. Di Sibio addressed a letter to clients suggesting auditors should play a stronger role in spotting such misbehavior, questioning the accounting industry’s longtime argument that its mission isn’t to seek out malpractice.