DSW Capital (LON:DSW) - Call with Co-Founder James Dow
Notes from my call with James Dow 3rd of May 2023
Here are my notes from the call with James Dow, a meeting which I had recorded but silly me, did so without sound. Nonetheless for the lip readers out there, you can watch a silent recording here.
Questions
Before we get into the microeconomics, taking a top-down view of the potential tailwinds for the business, it is no secret that the Big 4 for example have had countless audit failures to their name whilst in the presence of consulting arms. As such there is substantial pressure to restructure, with examples such as Accenture splitting from Arthur Anderson a few decades ago, EY deliberating the idea of an IPO of the consulting arm and the global Deloitte CEO doubling down on the multi-disciplinary model in a public video back in March. With over 2/3 of DSW’s employees having an Ex-Big 4 background, what are the primary things that excite you, and what are the primary things that concern you about these and other developments.
Excited about the restructuring of Big 4 creating turbulence in the employee base and thinks it will be a push factor into having employees reconsider where they currently are.
Values the Big 4 training highly and would like to employ those with training from the Big 4.
Follow up question by me on halo effect potentially applying on EY IPO.
Said that they are already established so perhaps not the same effect but interesting question. Alluded to perhaps better equity across the organisation instead of just partner.
It’s clear the group has substantial exposure to the whims of the M&A market, and has an intention to diversify from this, although from my perspective it looks to be that the corporate finance related divisions are experiencing the best recruitment drive. Is it difficult to hire in other areas or does DSW have a perceived preferred employer status in the M&A related areas, what do you think about this?
Correct Observation – James views the corporate finance division as having strong momentum and having a strong market position Moreso than smaller divisions having difficulty hiring.
From my understanding of the business model, because you aren’t exposed to the costs of the various businesses paying DSW a license fee, from my understanding it is crucially important for the business to have a lean corporate entity. At the current size of the business, even a single hire at the parent entity has a large impact on the cost base, and I have noticed several recruitment and marketing staff hires in recent times pushing up centralised administration costs in a time where reduced activity is pushing revenue per fee earner down. From my understanding, with ~200-220k in Revenue per Fee earner and a mid-teens license fee you see roughly 30k in license fees per Fee earner and have commented in a recent presentation that admin costs per fee earner were 11k or so, resulting in a low 60s sort of margin. In light of the trading update I am gauging that the former will come down and the latter will come up, resulting in the margin crunch alluded to in the announcement. Could you comment broadly on this development and what sort of margin the parent can get over the long term.
Another Correct Observation – James gave a rule of thumb that their operational ratio target is a 10:1 ratio and that margins on that ratio will be very good generally.
Commented that as a small business with a lack of scale that also agreed with my comment that at a small size the cost base is relatively fixed and as they scale it releases.
I am aware that we aren’t far away from the year end results, but perhaps more broadly you did make a comment in the January trading update about being extremely frustrated about a confluence of events which has stuttered growth. Can you perhaps comment on activity levels across the various service lines in the business?
Could not comment on activity levels but did say that the mini budget last year impacted the ability to close deals (after I asked him about it).
Market update expected to come out on the 17th of May 2023.
I have a premium LinkedIn subscription which lets me see company insights, including hiring trends. I keep a close eye on all the companies I’m most interested in and couldn’t help but notice that last month there was a sharp drop of 6 employees. Could you please comment on this, and perhaps more broadly on the past 6-12 months of employee recruitment and retention for the business?
James is unaware of this and based on their figures the data doesn’t seem to match and they haven’t seemed to have any noticeable churn based on James’ demeanor.
The group has mentioned that contrary to popular consultant lawyer models which focus on the sole proprietor, DSW’s model is focused on building businesses. But there is a major flaw in the model in my view which in my view, is a primary reason why DSW has an extremely low 1:1 partner/employee ratio. That is, the license fee is set on a % of revenue, but as you would know professional services businesses are set up to recover time, and the more employees you hire the more the firms margin approaches the margin of an average employee which may well be anywhere from 40-60% typically. When you apply a license fee to total revenues as a result, it seems counterintuitive to hire additional employees as the equity owner as a 22% license fee for example could drift towards more like 40-50% of their net revenue if they hire too much staff. How do you address this, is it perhaps more ideal to have juniors at the parent level like Keystone Law do for example, or do you apply license fees to net revenues instead of total revenue?
Confirmed that this is a problem they are dealing with. I probed him about the license fee being a barrier to growth and he alluded to the profit share as a mechanism to substitute the license fee and alleviate this.
Noted that they do pay for recruitment which is in lieu of recruitment costs, so that for example is usually set as a certain amount of an employee’s wage. So, if you think that basically covers the first year of an employee then perhaps there is issues in justifying dilution of partner margins from year 2 onwards of an employee’s tenure.
I want to touch on the cross-referral scheme for a moment. With 10% of a referred job going back to the referrer, I am interested in how you enforce this as the licensee, is it just a handshake between partners? Furthermore, I am of the same view that a tax service line would have extreme cross-referral potential and would not be surprised to see that be a potential avenue for much of the raised capital.
It is literally just a handshake. James has never had a problem with gratuity surprisingly.
The service line incentive interests me quite a lot, but I am not too sure how this is administered, having 5% of new license revenue coming back to existing service lines, could you please explain this for me?
How this works is that it is meant to foster emotional teamwork in addition to economic teamwork. Culturally significant.
My concern was that if across the same service line isn’t this inviting competition? Or looking in another way perhaps it could be exploited to directly steal competitor margin. But that is critiquing it a lot.
Gave an example that if their corporate finance team refers in another team then 5% of their fee goes into a pool for existing partners.
A smaller part of the business receives revenue in the form of a profit share rather than license fee. My intuition tells me that this relates to the boutique deals business that existed prior to the inception of the license fee model a decade or so ago. Could you perhaps identify which businesses the group receives this from?
Couldn’t share as not public info but profit share relates to “older business”.
It is apparent that license fees are billed on a quarterly basis, and I can clearly see these in the accounts, although receivables are split out into 3 categories, trade receivables being the license fees, accrued income being profit share and other receivables being licensee loans. Specifically, the profit share seems to of accrued but not paid soon thereafter, is there a reason for retaining capital within the partially owned partnerships?
Profit share is paid when the other partners get paid. In some situations, it is retained yes.
Lastly, to touch on ‘acquisitions’, where you pay business owners a fair valuation for their business upfront in return for a license fee. To what extent is the capital payment tax deductible for the parent seeing as it’s not goodwill but rather more of an acquisition cost?
He stopped to say the quality of questions has been brilliant.
This question depends on whether the structure is an LLP or LLC, in most cases it’s best to offer partners consideration in the form of a capital payment because CGT rules are more favourable currently.
Stressed that sometimes transaction structures can be complex.
Have you thought of ways where you could entice existing businesses without the upfront capital contribution, is there examples of this in the past?
He basically said they also want a capital payment. Oh well, thought perhaps he might have a bright idea anyway. On the flip side, he is open to ideas!
In reference to the initiation note by Shore Capital at the time of floatation, they walk through the Camlee deal in detail and the flexibility of a license fee in comparison to a merger of asset purchase is obvious. In saying this, there is substantial risk associated with purchasing like this due to a lack of equity ownership. How do you ensure you protect your payback period, is it using retention payments, contractual obligations, or something else?
Main way to combat this is heavy use of deferred compensation. This allows lock in to perform and as I rightly brought up allows DSW to show value within that window too.
Are you modelling DSW off any other business?
Brought up Buffett and Michael Porter. Also brought up Mcdonalds.
After discussing Kelly Partners with him he said there is an ‘identical’ business replicating them in the UK he found after discussing with a tax advisory target they were looking at. Was another party of those discussiuons.
Speaking of the exposure to the M&A market, how do you intend to diversify away from these revenue streams and where have you seen the most opportunity to do so in terms of deal flow etc.?
2 most obvious areas are business recovery and tax.
Has becoming a publicly traded company changed the way you operate the business or added extra pressure to you or your team?
Higher degree of professionalism across what they do.