UK Accounting Regulator Mandates Disclosure of Private Equity Investments in Audit Firms

The Financial Reporting Council (FRC), the UK's accounting watchdog, has issued a directive to major audit firms, requiring them to disclose any plans to sell stakes to private equity (PE) investors. This move comes as the accounting sector anticipates a possible influx of private equity capital, raising concerns about maintaining the integrity and independence of audit practices.

Regulator’s Directive on Private Equity Involvement

Richard Moriarty, CEO of the FRC, addressed the heads of the UK's top accounting firms in a letter dated Thursday. While the regulator does not oppose private equity investments in principle, Moriarty emphasized the necessity of managing significant risks associated with such investments. The FRC is particularly vigilant about ensuring that PE involvement does not compromise the rigor and independence of audit processes essential for investor confidence.

Implications for Major Audit Firms

The directive arrives amid heightened activity from private equity groups, notably Permira and EQT, which are reportedly eyeing the UK operations of mid-tier accountant Grant Thornton in a deal potentially valued at up to £1.5 billion. This prospective investment would mark the largest private equity involvement in the UK’s accounting industry to date.

Traditionally, UK accounting firms operate as partnerships owned by their practitioners, which has historically limited their capacity to raise equity capital for expansion or technological investments. The FRC’s stance requires that any audit firm seeking private equity investment must ensure that qualified accountants maintain majority control, assessed based on economic substance rather than merely legal structures.

Current Trends in Private Equity Investments

To date, private equity participation in the UK audit market has been confined to a few smaller firms, contrasting with more extensive involvement in the United States. The FRC's intervention suggests a cautious approach as the sector potentially opens up to larger-scale private equity investments.

Regulatory Concerns and Quality Assurance

The FRC has been proactive in pushing audit firms to enhance audit quality, especially in the wake of high-profile failures such as Carillion in 2018 and BHS in 2016. In its annual sector review released in July, the FRC highlighted risks that private equity investors might lack a deep understanding of audit objectives and the public interest imperative to maintain audit quality.

Additional concerns include the clarity and long-term planning of private equity exit strategies, which could impact the sustained commitment to audit quality and public interest motives over time.

FRC’s Open Stance and Future Engagement

In his letter, Moriarty extended an invitation to private equity firms and other potential investors to engage with the FRC. The goal is to provide clarity on the regulatory framework and the expectations for maintaining audit standards. Moriarty stated, “The FRC is not in principle against a greater participation of external private capital in the UK audit market. We recognize that access to external private capital could, in the right circumstances, have potential benefits for the UK audit market.”

He further noted that additional investment could bolster audit quality within firms that might otherwise struggle to fund such enhancements.

The FRC’s directive underscores the delicate balance between facilitating investment and safeguarding the foundational principles of audit independence and quality. As private equity firms like Permira and EQT explore significant investments in the UK accounting sector, the regulatory framework established by the FRC will play a crucial role in shaping the future landscape of audit practices in the UK.