September 30, 2010 2:19 PM
LETTER FROM LONDON: U.K. Law Firm Investment Countdown Enters Final Year
Posted by Chris Johnson
The long wait for the onset of Alternative Business Structures (ABS) is almost over. Just 12 months remain until the third and final stage of the Legal Services Act comes into force, permitting U.K. law firms to accept outside equity investment for the first time. Firms are already preparing themselves for a change that many experts believe will fundamentally reshape the profession.
"The legal market faces an interesting future," says Matthew Hudson, who formerly led the London offices of both O'Melveny & Myers and Proskauer Rose. "I look at ABS as similar to the financial services big bang," Hudson says. "In the 1980s, investment banks were partnerships and charged by the hour. Now, all investment banks are companies with external capital and they charge transactionally. The same structural issues are present in the law. To have associates all trying to be partners is antiquated, unfair, and drives firms to make the wrong decisions. Something has to give."
In July, Hudson launched his own boutique law firm, MJ Hudson, using seed funding from several private equity backers--debt he anticipates will be converted to "minor stakes" when the ABS legislation takes effect next October.
Hudson is right to wait--the Solicitors Regulation Authority has already shown it will not tolerate firms attempting to jump the gun.
In May 2007, DLA Piper's former volume business, Optima Legal, which had been spun off from the global firm a year earlier, faced SRA censure after a two-year investigation found that its relationship with U.K. outsourcing company Capita "went further than was allowed by the rules." Optima was ordered to repay a $55 million (£35m) loan, tear up a share-option agreement, and rehire 234 back-office staff that had been outsourced to Capita.
When the LSA was introduced in October 2007, it was primarily designed to drive reform in the U.K.'s fragmented and poorly serviced consumer-legal market. It is perhaps unsurprising, then, that the greatest impact of the changes is likely to be found at the retail-focused end of the industry.
High street lawyers across the country, for instance, are bracing themselves for the advent of 'Tesco Law', named after grocery retail giant Tesco, which is just one conglomerate likely to exploit one of the LSA's other key elements: the potential for corporations and businesses owned by nonlawyers to provide legal services.
But while the seemingly inevitable influx of big brands into the legal market represents a major concern for those smaller provincial firms, the extent to which the effects are felt elsewhere in the industry is a matter of some debate.
Certain areas of the market seem ripe for outside investment. High-volume, commoditized practices such as those focused on personal injury and debt recovery represent scalable, process-driven businesses in which private equity investors could utilize their expertise in outsourcing and technology to increase efficiency and reduce costs.
Irwin Mitchell, a national 520-lawyer personal injury firm with revenues of $244 million (£157m), is just one possible candidate for external investment. Indeed, when Legal Disciplinary Partnerships (LDPs), which allow nonlawyers to hold equity within law firms, became permitted under an earlier stage of the LSA in March 2009, Irwin Mitchell was among the first to convert to this new status.
When it comes to assessing the probability of major corporate law firms turning to external capital, on the other hand, the picture is less clear. First and foremost is whether these firms actually want--or require--such funding.
The most likely uses of any investment would be to help launch a new business, as with MJ Hudson; for potential consolidation through merger; or as a war chest for significant development and expansion--three areas that managing partners would argue have been successfully completed by firms for years without help. But with banks still reluctant to lend, and firms having trimmed their equity partner numbers throughout the downturn, the prospect of easily raising new capital is diminished.
The recent plight of U.K. top-50-firm Halliwells, which went into administration in July after spiraling arrears left it unable to meet its loan repayments or rent, offers a stark reminder of the potential difficulties law firms face when saddling their balance sheets with debt. More senior partners in the U.S. may also recall Finley, Kumble, Wagner, Underberg, Manley, Myerson & Casey, which went bust under similar circumstances in 1987 after bankrolling sustained expansion that saw it go from an eight-lawyer practice to America’s second-largest firm, behind Baker & McKenzie.
Equity partners would also have to come to terms with the fact that significant external investment would likely come at a price: they would make less money, at least initially. Private equity houses would want a return on their investment, after all--typically 20 percent within three to five years. The long-term opportunities for cashing-in could be considerable, however. When Goldman Sachs, which prides itself on its partnership ethos, floated in 1999, the partners' stakes received during its conversion to a corporate structure were worth billions.
Though we may not have seen a U.K. law firm IPO yet, the precedent has already been set by Australian personal injury specialist Slater and Gordon, which in May 2007 became the world’s first law firm to float its stock. Its debut listing on the Australian Stock Exchange raised $25 million (A$35m), netting each of the firm’s seven partners up to $3.6 million (A$7m).
And while the noises emanating from larger firms suggest that they are entirely dismissive of the need for external investment, doubters should recall that even Magic Circle heavyweight Clifford Chance tapped the debt markets in 2002, raising $150 million through a dual-tranche bond issue.
For the investor, too, there are a number of potentially serious issues to overcome. Most fundamental is how you would actually go about valuing a law firm. While the reported profit margin, which treats the total net income distributed among the equity partners at the end of the financial year as the absolute bottom line, may look good, it actually presents an overly positive perspective by ignoring any fixed salary that these managers might receive. This also precludes the calculation of EBITDA--the favored tool for private equity valuation.
"Law firm valuation is both an art and a science," explains legal consultant and former Clifford Chance managing partner Tony Williams, who was recently instructed by midmarket investor Lyceum Capital to advise on their possible activities within the sector. "Law firm profit margins are only notional, as they’re on the basis that none of the senior managers are paid a salary—they’re not even getting a brass farthing above the line. Partner remuneration is reported as one figure, but really it’s two things--it's a payment for a day job and it's payment for putting capital into the business as a proprietor. Firms have never really looked at it that way before, but that's exactly what [private equity investors] would do."
The scope for external investors to generate value by cutting costs has also been reduced by the significant efficiency drives that most firms have been forced to undergo over the last 18 months in response to falling demand. Without radical structural change, it will be harder to trim much further from what are now far leaner organizations.
Even if values are agreed upon and deals proceed, parties on either side of any transaction will also have to deal with the potential minefield of merging these two clashing cultures.
Although it would of course depend on the size and nature of the investment, private equity houses are unlikely to be comfortable stumping up cash to merely sit as a silent partner. The likelihood is that they would at least want representation on the board in the form of nonexecutive directors, and would probably push for the instatement of a new CEO and CFO--a change that Tim Eyles, managing partner of European technology and IP-focused firm Taylor Wessing, admits would be a "massive culture shock for most partners."
Recent experience in the U.K. with nonpracticing CEOs has already shown us that partners have a hard time taking orders from nonlawyers—although there would be nothing to stop investors from hiring current or former lawyers as managers in an attempt to counter this--while the radical approaches likely to be adopted by these professional sponsors may not sit well with notoriously conservative and risk-averse law firm partnerships.
"I'm not sure that some of the partners at law firms actually understand what investors would want out of the relationship," says Stephen Mayson, director of independent policy think tank the Legal Services Institute. "When people hold the purse strings they can exert a rather difficult sway. It would be a real difference to what partners are used to and is potentially quite a heady mix. It might mean some degrees of initial discomfort or even casualties along the way."
Despite this, as the October 2011 D-day draws near, private equity firms are already circling. In addition to Lyceum, Lloyds Development Capital, and South African private bank Investec have also made clear statements of intent.
There had been fears that the Reducing Regulation Committee, launched in June by the new coalition government to tackle unnecessary reform and excess regulation, would delay the LSA, but everything appears to be on track.
"Give it 25 years and all law firms will be incorporated," adds Hudson, who previously spent six years working in private equity for Credit Suisse and specialist secondaries investor Coller Capital. "[The change] may start with the consumer firms, but it will transform law at the highest levels and will also travel across the Atlantic."
In less than a year, the U.K.'s legal landscape will change forever. U.S. managing partners and institutional investors will surely be looking on with interest.Make a comment