The next big thing private equity investments in law firms

June 5, 2008

Three years can be a long time in any business, but it may seem like an especially long time for the many law firms who are eagerly awaiting the coming into force of the provisions of the Legal Services Act 2007. This act will come into force in 2011 and for the first time will permit outside investment in law firms.

Why invest in a law firm?

The prospect of deregulation in the legal sector and the opening up of ownership of law firms to non-lawyers has raised two questions: should private equity investors be gearing up to start investing in law firms? And why would a law firm require private equity investment? The appeal of law firms to private equity houses is fairly clear. Law firms are cash generative, often have defensive or counter-cyclical income streams and the sector has shown solid growth. The risks are also relatively low and the barriers to new entrants fairly high (particularly in terms of obtaining blue-chip clients). The prospects for disruptive technological advances which could kill the business are also far lower than for that other private equity darling, technology companies. An exit for an investor should also be possible, given that other sectors traditionally considered 'people businesses', such as surveyors, engineering consultants, PR firms and recruiters have all successfully listed on the stock exchange. The other key benefit of private equity investment, the introduction to a business of experienced personnel with a keen eye for growth, may reap particularly large dividends in those law firms which have in the past taken a seniority, rather than talent, based approach to management. Surely then, private equity would be mad not to try and get a slice of the law firm pie.

What are the barriers to investment?

One potential issue, the partnership structure of most law firms, is likely to be less of a problem for an investor than it might first appear. Most forward-thinking law firms are now LLP's, which, like companies, are bodies corporate, albeit not ones in which shares are issued. The ubiquity of LLP's is useful for a potential investor since, as with a company, the potential investor is dealing with a single entity, rather than a partnership which fluctuates as a body depending on who the partners are on any given day. In addition, many LLP's already have a board-like structure, which would be able to take decisions on behalf of the firm’s partners and on which a potential investor could sit. In fact, an LLP can be organised in such a way as to retain its unique advantages (flexibility, tax transparency), but enable an investor to have the same kinds of rights it would expect as an investor in a limited liability company. An LLP’s governing document, the members’ agreement, is very similar to a shareholders' agreement, but has even greater flexibility as to internal management. LLP's are also subject to similar reporting obligations as for a company, with which investors are likely to be familiar, and there is always the option of putting a holding company in place above the LLP if the investor has any lingering doubts. The LLP structure then, whilst presenting some additional complexity, should not be an obstacle to a keen investor.

Aside from structural issues there are, however, serious questions as to what a typical law firm would do with a private equity investment. The existing mix of financing options, i.e. capital injections from partners, retained profits and bank debt, have been sufficient to see those law firms which specialise in providing legal services to businesses become some of the largest and most profitable businesses in the world, without the need for private equity investment. The partners at such firms may well be eager to sell some of their equity in the firm to an outside investor as part of an exit strategy, but a private equity investor is unlikely to be keen to give money to the partners, the firm's most valuable revenue-generating assets, so they can drive off into the sunset in a new Ferrari.

There is also a question as to whether established law firms could offer sufficient growth opportunities to an investor. The mature nature of the legal market, its conservatism and the close personal relationships often established with clients can make it difficult for a firm, even one flush with private equity money, to poach clients and grow organically. A well-established but poorly managed law firm may hope that private equity investment will bring in a business partner with substantial management expertise. However, a poorly managed law firm is unlikely to be an attractive investment in the first place and in such circumstances private equity investment would be the tail wagging the dog: management consultants provide management expertise without requiring a stake in the business for doing so.

Potential candidates

None of the above issues are universal. There are likely to be a significant number of firms who have high-quality management, who would view private equity investment as a means of achieving strategic business objectives, not as a retirement package. Equally, there are likely to be many firms which could benefit from capital investment. Some of these firms are probably in the less glamorous end of the legal market: conveyancing, personal injury, bulk debt collection and the like. There is nothing on the face of a nasty personal injury claim which makes it 'easy' and people buying and selling their homes will hardly consider the matter to be 'standard', but some pioneering law firms have found ways in which to commoditise these services and in doing so reduce their cost base when compared to a typical high street firm. These firms operate in a relatively capital intensive environment, employing large numbers of people and using expensive IT systems to deliver their services at a competitive price. Such firms seem likely to be in the first wave of potential investee firms. These firms and others may also wish to go on the acquisition trail, particularly if, say, they are weak in a particular geographic region, or if they need to buy in talent in sectors which are showing growth. Private equity investment may therefore make sense for firms with aggressive expansion plans.

Already, there are reports of investment professionals gearing up to take advantage of the opportunities offered by the Legal Services Act indeed, Lyceum Capital recently hired three advisory board members with such a brief. The indications are that private equity buyers will face stiff competition from trade buyers, with legal expenses insurer DAS already having revealed its intention to acquire a personal injury firm.

Watch this space

It is likely that in three years time the enthusiasm for private equity amongst partners in law firms and potential investors will be just as strong as it is now, but it also seems likely that only those law firms who can show they are well managed and have a compelling need for investment will actually receive private equity investment, at least in the first wave. This may prove to be a relatively small pool of firms. Private equity houses should therefore keep a keen eye on the legal market for potential investee firms and start building relationships with the decision makers at those they judge to be the stars of the future.

Related pages:

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