"My hero's Warren Buffett. I wanted to build a holdco and intend to do it for a very long time... I have a long-term value mentality, and I intend to a, hold the shares; and b, keep control of the group forever." - Brett Kelly, Kelly Partners Group CEO, H1 21 earnings call

If you’ve ever listened to Brett talk, it’s clear he’s rigorously studied Buffett. A focus on intrinsic value, owner earnings, and an aversion to issuing shares are all principles Brett is applying to his own attempt at creating long-term value: Kelly Partners Group (KPG).

KPG is a listed holding company that owns a controlling stake in accounting firms across Australia. KPG acquires practices that provide accounting and taxation services to small and medium-sized enterprises. Over the last 20 years, there has been many failed attempts to roll up accountancy services, especially in Australia. Stockford Ltd was a major Australian bankruptcy in the early 2000’s which, on the surface, followed the same strategy as KPG. However, there are important differences. We interviewed a Former Director at Stockford to understand exactly how and why KPG is different to previous accountancy roll ups.

Our executive explains how roll ups are all about incentives:

I think that goes to the heart of the questions I always have around why do you roll up and why professional services? Rolling up is all about incentives. Are the incentives aligned? What are the benefits to the practices, to roll up? If it is purely succession planning and allowing people who have built a professional services practice to cash out and to keep running their business for a while, then I think it’s fraught.

Aligning incentives between the buyer and seller is crucial to any durable roll up strategy. Kelly’s M&A transaction structure is different to other successful roll ups such as Constellation Software or TransDigm. KPG buys 51% of the equity of the practice and the partners keep 49%. This structure incentivises partners to grow organically and improve the free cash flow of their practice. KPG also doesn’t keep any working capital debt at the holdco level. Acquisition and working capital debt sit at the opco level, secured against the operating assets with personal guarantees from the partners. This is a huge incentive for partners to keep the opco lean and profitable.

Kelly’s structure provides owners with a liquidity event whilst maintaining enough skin in the game for owners to benefit from growth in their practice. This aligns incentives on the upside, as partners benefit from future opco FCF growth, and on the downside as partners have 49% of the opco equity with personal guarantees on working capital debt. Stockford, on the other hand, had misaligned incentives on both sides: 

Stockford and Kelly are quite different; Kelly is probably much better aligned. Stockford bought 100% of the businesses, with some buy back entitlements for some of the people, for equity in Stockford. They were paying a little bit of cash out, but it was mostly in stock and they acquired 100% of the organization. The incentives were great while Stockford’s share price was going up. As soon as it turned around, the incentives were appalling, because everyone wanted to own their own business again.

Acquiring 100% of the equity in cash plus holdco equity or an earn-out for selling owners is common practice for most roll ups. This has proven successful for TDG or CSU but wouldn’t be optimal for Kelly. Professional services are unique in that the large majority of the cost base is labour and the value is the partners’ time sold to clients. Accountants, consultants, or lawyers all sell their time in exchange for dollars which isn’t as scalable as selling software or aerospace components. Kelly seems to have found an optimal structure that truly aligns incentives for an accountancy roll up.

Once incentives are aligned, the next question is: what are the real benefits of being part of a holdco?

M&A benefits can be broadly split into two buckets: cost synergies and revenue synergies. How does the holding company reduce the cost base or generate more revenue for the opco?

This is where KPG gets interesting. Accountancies are simple, sticky businesses. Customer churn is <5% and net revenue retention is typically >100% per year. Clients very rarely leave. The cost base is mainly labour plus office rent, IT, and marketing. The economics are also attractive: for a $2m revenue accountancy practice, the average EBITDA margin is around 18%. Post-acquisition, KPG increases the EBITDA margin to over 30%.

This margin improvement is driven by a few key factors:

  • Centralising IT, HR, and ‘tucking in’ partners into existing offices
  • Improvement in working capital

KPG runs a centralised back office, IT, and marketing function which the opco pays 9% of the 49% of opco revenue attributable to the partners. Given the majority of the cost base is labour, the cost synergies don't lead to huge savings for the opco. However, the major benefit is saving partner time which is arguably the most important asset. Most accountancies are fairly inefficient in that the partner will be spending time on non-revenue generating activities. After KPG acquires the practice, the partner has more time to win and retain clients. This drives higher EBITDA margins.

The working capital advantages of joining KPG are substantial and seem to drive most of the margin accretion. ‘Lock up’ is one of the most important metrics for any professional service company. It measures the efficiency of collecting receivables and billing work in process. The accountancy industry average is around 80 lock up days; 25 WIP days and 55 debtor days. KPG is ~55 lock up days with only 9 WIP days. This means the productivity of KPG is far higher than the industry which improves the cash flow profile of the company. This is likely driven by the culture Brett has built at Kelly.

The improvement in EBITDA from 18% to 30%+ makes the deal potentially attractive for partners. If you run a $2m revenue practice generating $360k EBITDA, you could sell 51% of your practice to KPG at 1x revenue and receive ~$1m. With 49% ownership and a 30% EBITDA margin, you would still earn $210k per year after paying 9% up to KPG. It’s an interesting deal for relatively young partners that want liquidity but also potential income growth.

One question that remains is how KPG drives organic growth for opcos. There is optionality through cross-selling wealth management and other services but it's not clear how much incremental business KPG drives for opcos. The operating subsidiaries are separate, decentralised businesses ran by the partners and the unique sales process doesn't lend itself much to centralised marketing strategies to close new business:

the prime sales people were the partners and near partners in each of the practices. You could do marketing but it had to get closed by the partner or near partner. These are relationship and trust businesses. You can’t do an online sale for this easily. In the end, the sale is made by the service delivery team. Good, hot leads are fantastic from your marketing function, but it has to be closed at the practice level, I think.

Kelly relies on the willingness of partners to adopt the KPG 'Flight Plan' to increase productivity. The Flight Plan is clearly Kelly's secret weapon and partners have to be willing to adopt these measures to fully benefit from being part of the KPG ecosystem. If partners fail to adopt the Flight Plan, organic growth could be challenged. Even if a practice has 5% annual churn, the opco needs to generate 10% organic growth to grow 5% net each year. Maybe 2-3% comes from price increases but it still requires 7-8% organic growth. And what happens if organic growth stalls? Maybe the partner slows down and fails to retain clients? Given the opco has all the working capital debt and also pays 9% of revenue up to KPG, this could cause tension with the parent if the net distributable cash to partners materially declines. Given the large minority interest, if something does go wrong, the opco partners could have more power than expected. This also highlights why aligning incentives is so important for the long-term growth of KPG.

Brett has clearly thought long and hard about the structure of deals. KPG prefers debt to finance the 51% of equity purchased at an average multiple of 4-5x EBITDA. Because of the low dollar amount, this is typically 100% debt-financed. After the productivity improvements, $1 invested in a new practice generates ~33c of EBITDA and ~12.5c of post-tax earnings for shareholders.

Kelly has a long runway of over 10,000 acquisition targets to choose from with a potential outsider CEO who has modelled his life’s work on the greatest capital allocator of all time. We will be following KPG closely in the years to come.