Professional services firms have increasingly diversified over recent years as they have sought new opportunities to serve existing clients and attempted to attract new business by offering a wide range of services at greater scale. This is particularly evident among the so-called Big 4 accountancy firms, whose business lines extend from audit, tax and assurance to software engineering, cyber security, real estate, legal services and much more. The trend can also be seen in other professions, such as management consultancy, real estate, engineering and law.
Diversification has its advantages in providing opportunities for growth and the cross-referral of business within a firm. However, shifting markets, regulatory issues and difficult economic conditions can often reduce the benefits that diversification once provided.
With a combination of the COVID-19 pandemic and Brexit-related challenges facing the UK economy, many professional services firms will undoubtedly recalibrate their strategy and business plans in order to bolster business resilience while maintaining growth and profitability in challenging circumstances. For some firms, this may lead to a concentration of focus and future investment in core and profitable business lines, and the scaling back and divestment of non-core and unprofitable business areas. This is usually achieved through either a sale of the non-core business to another firm or a demerger of the relevant business into an independent spin-off.
Typical demergers
Typically, a demerger of a firm that is organised as a partnership or a limited liability partnership (LLP) involves a transfer by the divesting firm of the demerging business and associated assets and people (the demerging business) to a newly formed partnership, LLP or company (the new entity).
Some of the first issues that need to be considered include exactly what portions of the business are being transferred and which partners, if any, are transferring with the business or whether the demerging business is being sold to a third party. The partnership agreement will need to be reviewed carefully to establish what terms it contains that may apply to a demerger.
A demerger can often be a complex and sensitive process that requires careful handling and preparation, not only to ensure successful implementation, but also to avoid disruption to the business and clients, and the potential destabilisation of the partnership and workforce if the demerger ultimately does not succeed.
Identify the objectives
It is important for the senior management team in the divesting firm to identify and clearly articulate to the partnership the strategic imperatives and the advantages and disadvantages of demerging part of the firm. A successful demerger is largely dependent on the wide support of the partnership and, in particular, the partners of the demerging business (demerging partners). There are several common drivers of a partnership demerger.
Streamline business and expenditure and improve profitability. A firm that has rapidly expanded into a diverse range of practice areas may now find that some of those business lines have consistently underperformed or no longer align with the firm’s future strategy, or both. Realignment of the firm’s focus on its core competencies and divestment of non-core and less profitable parts of the business are likely to reduce the firm’s overheads and improve its profitability.
For the demerging business, financial and management autonomy and the freedom to pursue a strategy that is specifically tailored to the demerging business and its clientele, has the potential to unlock untapped value for partners and employees in the demerging business and can be a compelling driver to spin out as an independent firm.
Navigate regulatory issues. Certain professional services and activities, such as audit, reserved legal services, insurance and financial services, are highly regulated. Compliance with a regulatory regime may involve significant costs and management time, and even restrict certain business activities. For example, the regulatory duties of independence and confidentiality that apply to solicitors and auditors can often cause intractable conflict issues in multi-disciplinary legal and audit practices. Brexit has also complicated the regulatory landscape for many regulated professions. For example, UK law firms with offices in the EU may no longer be permitted to practise in certain EU jurisdictions through their existing legal structures and a reorganisation of the firm’s operations in those jurisdictions may be unfeasible or unattractive.
The divestment of parts of the firm’s business or certain non-core offices may therefore be necessary to avoid these conflicts and regulatory issues.
Plan and prepare
The substantial legal steps to undertake a demerger require careful planning and preparation. There are also numerous practicalities to be considered alongside the legal steps (see box “Practicalities”).
Establishing the new entity. A demerger involves the establishment of a new legal entity, which may be a partnership, LLP or limited company, that is directly or indirectly owned by some or all of the demerging partners.
Any ownership and control rights, and the duties, liabilities and financial entitlements of partners in the new entity will need to be agreed and set out in a new constitutional agreement, whether articles of association or partnership agreement, for the new entity. This usually involves significant consultation and negotiations between the partners of the new entity.
Employees of the demerging business. The employees of the demerging business may be transferred to the new entity under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (SI 2006/246) (TUPE). A transfer under TUPE requires employees to be given information and to be consulted within specified timescales, and they are also protected from changes to their terms and conditions of employment. Any issues in relation to compliance with TUPE and the consultation process will need to be carefully considered and factored into the timetable for the transaction.
Legal and operational separation. If the demerger and future arrangements are approved by the relevant partners, the demerging business, comprising its assets, employees and liabilities such as office lease, equipment, loans and client contracts, is transferred from the divesting firm to the new entity in accordance with a demerger agreement.
There may be contracts, including contracts with clients and suppliers, that have been entered into by the divesting firm, but which relate to, benefit or are required by, the new entity. These contracts may need to be assigned to the new entity and, if that is not possible or if the divesting firm needs to retain certain contracts, new separate contracts may need to be replicated or negotiated with the relevant counterparty and entered into by the new entity.
Any transfer of client engagements to the demerging firm will need to be managed carefully to ensure that applicable professional duties to clients are complied with. Both entities will need to agree a managed approach to notifying affected clients and obtaining consent to transfer files and confidential information and assign, or renegotiate, any terms of engagement.
Potential issues
There are a number of issues which have the potential to cause complications for a demerger.
Partner approval. The divesting firm’s partnership agreement may set out a specific voting threshold and procedure to approve a divestiture of part of its business. Voting thresholds for these types of decision in a partnership agreement for a professional services firm typically range between a simple majority and unanimous partner approval. If no threshold is specified, then unanimous approval may be required by default.
Practicalities
The practical aspects of a demerger should not be forgotten or left to the last minute. The new entity is likely to need a new bank account, its own insurance policies, notifications to HM Revenue & Customs, its own internal policies and procedures, branding, website, email accounts, headed paper and file management and IT systems.
The new entity may also need to secure its own office space in advance of the completion of the demerger. All physical equipment and assets will need to be transferred to any new premises.
Additional staff may also need to be recruited or outsourced providers put in place if the new entity will not have continued access to centralised support services of the divesting firm, such as the finance team, IT support and HR function.
Most separation practicalities are often governed by the demerger agreement or a transitional services agreement, which allows for a temporary period of co-operation between the divesting firm and the new entity to smooth the separation process (see feature article “Transitional services agreements: a cornerstone of modern M&A”, www. practicallaw.com/2-502-3104).
The divesting firm’s senior management team should consider from the outset whether the requisite approval threshold is realistically achievable. A requirement for 90% or unanimous partner approval can be very difficult to attain, particularly in large, dispersed partnerships. In these cases, management may need to consider potential workarounds, such as an amendment of its partnership agreement, before embarking on a demerger.
Once the demerger process is initiated, it is vital for the divesting firm to engage in advance planning and consultation with the demerging partners as well as the wider partnership to ensure that the requisite partner approval can ultimately be achieved.
Dissenting partners. Even if the requisite partner approval is secured, it may transpire that not all of the demerging partners agree with the demerger, whether for professional or personal reasons. In these circumstances, the divesting firm will need to consider how to treat these partners in the future. If the demerger goes ahead without the dissenting partners, the partners who are left behind may need to be redeployed to other parts of the divesting firm’s business or, if that is not possible, the divesting firm may need to agree exit terms with those partners.
Financial terms. Most demergers of professional services firms do not involve the payment of consideration for the goodwill of the demerging business, although there are exceptions. Typically, the new demerged entity will pay the net asset value of the demerging business to the divesting firm. Both firms will wish to ensure that a fair and balanced approach is taken to determining and valuing the assets and liabilities being transferred, such as the work in progress and book debts, and agreeing how these are collected and dealt with in the future.
Other financial terms to consider are the repayment of capital and the payment of undistributed profits and other reserves that are due to the demerging partners. The payment of these amounts may be accelerated, compared with the usual timescales set out in the divesting firm’s partnership agreement, to facilitate the demerger.
Regulatory approval. Regulatory authorisation or notification may be required for both the divesting firm and the new entity before the demerger takes effect. Prior regulatory authorisation may involve a lengthy process and should be initiated at an early stage to avoid delays in the transaction timetable.
This article first appeared in the April 2021 issue of PLC Magazine.
If you would like to discuss issues relating to a demerger of an LLP or partnership, please contact Zulon Begum who specialises in advising LLPs and partnerships on mergers, acquisitions, structuring and governance, and also partner exits and team moves.
