March 23, 2012 6:00 AM
Continental Breakfast: The Dark Art of Law Firm Valuation
Posted by Chris Johnson
We at The American Lawyer have been reporting on law firm financials for more than 15 years. Through our annual Am Law 100 survey, the next installment of which comes out in May, we utilize a slew of metrics to provide a detailed economic health-check of North America’s 100 largest firms by revenue. Profit margins, revenue per lawyer, net income, profit per partner. . . . It’s enough to make you never want to see an Excel spreadsheet again.
But one area we haven’t tackled—thus far, at least—is how much each firm is worth. Indeed, law firm valuation is a relatively new phenomenon. In the past, the industry has largely been geared toward delivering short-term profit gains and maximizing partner compensation. Little thought was given to the inherent value of law firms as businesses.
Following the introduction last December of radical legislation that permits U.K. law firms to accept external equity investment for the first time, however, that mindset is beginning to change. The law for so-called "Alternative Business Structures" (ABS) is expected to result in a glut of transactions within the sector, and has brought into sharp focus the need to determine value.
London-based corporate finance advisory firm Europa Partners thinks it has the answer, having recently released the first independent study looking at valuation within the sector. Covering the 30 largest U.K. firms by revenue, the results make for fascinating reading.
Allen & Overy emerges as the country’s most valuable law firm—ahead of Magic Circle rivals Freshfields Bruckhaus Deringer and Linklaters—with an estimated worth of £2.6 billion ($4.12 billion). The stakes held by Slaughter and May’s 122 equity partners, meanwhile, are each valued at a jaw-dropping average of £8.09 million ($12.8 million). (Click here for full details of the United Kingdom’s ten most valuable firms.)
"Investors tend to look at everything through the prism of value—that’s our stock in trade," says Europa’s financial services expert Robert Colthorpe, a former accountant and investment banker. "Law firms have never really been subject to that form of analysis before, but they’re starting to become more sophisticated and strategic in the ways they are seeking to quantify business value."
But actually calculating the pounds-and-pence worth of a top-end practice is no easy task. Their premises aside, legal businesses have little in the way of tangible assets. A law firm’s chief revenue generators can quit the organization at any time, potentially taking clients—and revenue—with them. (This is also true of other professional services businesses, however—many of which are publicly listed and have been valued and traded successfully for years.)
The issue is further complicated by how a firm's owners—its equity partners—are compensated. The way that most partnerships are structured means that they are effectively unable to retain any earnings at the end of each fiscal year. Save for any planned investments, all remaining profit is distributed among the equity partners in full.
Compared to companies in other industries, this gives law firms an artificially high profit margin, since from an accounting perspective, equity partners receive no above-the-line salary and therefore represent no cost to the business. This arrangement also precludes the calculation of EBITDA—earnings before interest, taxes, depreciation, and amortization—which is the favored tool for private equity valuation.
"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," says legal consultant and former Clifford Chance managing partner Tony Williams. "Firms have never really looked at it that way before, but that's exactly what [external investors] would do."
Part of the problem in appraising law firms is the lack of any existing investment deals to use as a benchmark. In two recent acquisitions of U.K. law firms by professional investors, for example, the apparent valuations differed wildly. This January, technology and outsourcing company Quindell Portfolio acquired Liverpool-based personal injury law firm Silverbeck Rymer for £19.3 million ($30.7 million)—a multiple of less than four times the profit that firm accrues each year. Then, just a few days later, Australia's Slater & Gordon—which in 2007 became the world’s first publicly listed law firm—bought another U.K. personal injury specialist, Russell Jones & Walker. Slater paid £53.8 million ($85 million) for RJW—more than 11 times the target firm's annual pretax profits.
(The details of a third deal, which saw private equity house Duke Street take a majority stake in Parabis Group, the parent company of insurance litigation firms Plexus Law and Cogent Law, were not disclosed. It has been reported that the acquisition cost £50 million ($79 million), and Duke Street support services head Iain Kennedy, who led the transaction team, told me that Parabis generates annual revenues of around £160 million ($253 million). But because Parabis is not an LLP, it does not have to file public accounts with Companies House. Its profit levels are therefore unknown, as is the exact size of the stake sold to Duke Street.)
Colthorpe says the methodology behind Europa’s analysis is actually relatively simple. Europa merely treats each law firm as if it was a corporate business and then applies a common private equity technique of calculating value based on multiples of posttax earnings.
The tricky equity partner compensation issue I described above was resolved by assigning notional salaries based on those seen at comparable professional services companies. This equated to a basic wage of £150,000 for each equity partner, and a bonus pool set at 25 percent of each firm’s pro forma pretax profits. The profit remaining after those additional costs were deducted was then subject to a standard corporation tax of 28 percent, leaving each firm’s "true" posttax profit. Europa finally applied an earnings multiple of 13.5—a midpoint in the 12-15 range that Colthorpe says is typical of other publicly traded professional services businesses—to produce its valuation.
Colthorpe insists that feedback from managing partners and CFOs at each of the featured firms has been positive, but some of the results are surprising.
Valuing A&O above Freshfields and Linklaters, which both generate more revenue at considerably higher levels of profitability, seems questionable to me. The survey also treats verein firms as one entity, resulting in prominent showings for both Hogan Lovells and DLA Piper, but the top ten doesn’t include Norton Rose, which having combined with practices in Australia, South Africa and two in Canada, has become one of the world’s largest firms. (Europa says Norton Rose’s position may change next year based on its recent expansion.)
This report actually represents the second time that Europa has carried out its study. Last year’s results were not published, but after agreeing to withhold certain details, Colthorpe allowed me to see a copy during our meeting.
Most immediately apparent was that, a few minor positional shuffles aside—Freshfields headed the list in 2011, ahead of A&O, for example—very little had changed. The top ten firms today are the same as they were last year and the valuations almost identical, highlighting both the consistency of the methodology and—considering the choppy market conditions of the past 12 months—the financial resilience of the sector overall.
But perhaps the main point to take from the report is just how valuable leading law firms really are. Six of the firms featured in the survey would be large enough to make the FTSE 100, should they decide to list—an option that is now open to them under the new ABS legislation. It's little wonder that external investors are eyeing law firms so hungrily.
Colthorpe says he has already spoken to a number of Am Law 100 managers about producing a valuation report for the U.S. market. Unlike in the U.K., where LLPs are obliged to file publicly available accounts each year, some of the detailed financial information Europa needs for its calculation—specifically those relating to costs and debt levels—would be harder to come by.
But some quick back-of-the-napkin math by this reporter suggests that Skadden, Arps, Slate, Meagher & Flom could achieve a valuation of more than $5 billion. That’s bigger than toymaker Hasbro, Inc., and stock market operator The Nasdaq OMX Group, Inc., and would be enough for Skadden to comfortably make the Fortune 500. Now that’s very Big Law indeed.
Chris Johnson is The American Lawyer's chief European correspondent. Reach him at email@example.com. Follow him on Twitter at @chris_t_johnson.
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