Beyond Duke Street

With the recent investment by Duke Street in the legal services sector has come a flurry of commentary seeking to draw generalised conclusions from a specific set of circumstances. Parabis, in which Duke Street has taken a majority stake, is indeed a law firm, but arguably not as we know it. Another of Duke Street's star investments is the Wagamama chain, a fantastic business and investment opportunity but by no means a traditional food outlet, which is probably not a coincidence.

The point is that the enthusiasm of external investors, or funders, with cash seems to be limited at present to business process outsourcing, legal process outsourcing and the commodity end of the legal services market. If there are funders out there who have a taste to engage with the traditional cut and thrust of transactional or consumer-facing law firms on the subject of direct investment, they are hiding themselves well and my perception is that, as the interest for third-party investment within this category of law firms goes up, the interest of funders seems to be firmly in decline.

Indeed, one funder, who was a strong force in these developments back in 2008, is quite open about the fact that after discussions with more than 100 firms it has found the business proposition much less attractive than originally anticipated and has now effectively withdrawn from the sector. 'There is a fundamental misalignment between law firm partners and what we do,' explained its managing director.

But what of Palamon and its much-heralded stake in QualitySolicitors? Surely, that proves the contrary case? But no. That investment is in a marketing and branding company, replete with fees and subscriptions and excellent cash flows, an investment largely untroubled by the messy business of legal practice. It's looking at the moment as if most of the enthusiasm for direct investment in the traditional law firm model is being expressed by potential recipients of that largesse and by market commentators.

Though law firms can scarcely be accused of making life easy for the funder, one to whom I spoke said that 'very few people are interested in being the first to cross the finishing line and that is traditional in law firms', and while in a survey carried out for ABS Advisory in 2011 56 per cent of respondents indicated that they wished to engage with funders on the principle of direct investment, that statistic was regarded as 'not real' in the context of a private equity firm's usual model according to a funder I spoke to. 'In any event, we need to be welcomed, not just tolerated, as a cash provider,' he continued

Added to this mix is the current lack of any established valuation benchmark reference, though that situation is likely to change over time as the Duke Street/Parabis situation clarifies, and the Slater & Gordon/Russell Jones & Walker and Quindell/Silverbeck Rymer markets settle.

Creating the conditions

The obvious opportunities in this sector will not be missed forever though. The fundamentals present far too good an opportunity for an external investor with deep pockets and considerable patience, and it is easy to envisage a fundamental shift in the thinking and attitude over the next three to five years. But, to achieve this, a number of elements will need to develop and come together.

First, law firms must take the lead, for they have the most to do and most to gain. For them, the focus needs to turn to the three Cs of culture, cash flow and corporate outlook. Culture ought to be a force for good, but so often it appears as a negative aspect in the legal sector, reinforcing stereotypical views of conservative businesses with prima donna partners. As one funder says: 'I think culture is a lazy way of explaining why [firms] are not keen to see change'¦ People talk about culture as a way of explaining why any change would be bad and might damage what we've got.'

Cash flow is the essence of financial management and will be a huge focus for investors. Getting the basics right will increase a firm's attractiveness significantly. An immediate focus on lock up and debtor days and a professional approach to cash and debt could pay huge dividends.

Corporate outlook requires a strategy, a business plan and the professionalisation of management skills and (what horror) an acceptance that not all management skills are simply subsets of being a lawyer. Management is a serious job, not something to be assigned by rotation as an adjunct to the day job of fee earning.

Second, the funders need to do their bit: they can't just flash the cash, they must analyse and explain the added value that their team can bring and, crucially, do some work on the exit model. Firms are very nervous about the likely method of realising the investment in three to five years and, while it is obvious there is no clear route out yet, that shouldn't be the end of the current debate.

And finally, commentators and researchers need to keep on commentating and researching. In order to gather the complete picture there needs to be an understanding of industry norms and standards, and crucially a valuation benchmark should be established.

It's worth the time and effort because the opportunities for all are huge. As one funder commented: 'The legal services sector is fat and very happy and we will have some of that, thank you.'