Cash or control: Is PE right for your law firm?

The option for law firms to adopt alternative business structures (ABSs) has made it possible all types of investors to participate in the evolution of the UK legal services sector. Private equity investors are keen to get involved.

The prospect of obtaining PE investment can seem daunting and unfamiliar. This relatively uncharted territory may not be for every law firm, but investigating its potential may be beneficial in other ways. Even if you decide that using a private equity investor is not appropriate, it may lead to the creation of an alternative roadmap. You can be sure that if you’re not doing it, your competitors will be.

Look in the mirror

The first thing to consider is if your firm is an attractive investment proposition. PE investment is only appropriate if the firm has a clear business plan that requires an injection of capital.

A steady old-school legal practice with no ambitions for rapid growth is unlikely to require outside capital or be an attractive investment proposition, although clearly it can still provide a good living for the partnership.

Private equity is more relevant to growing, dynamic firms where capital is necessary either to support organic expansion or acquisitions. Organic means of growth include recruiting new talent, entering new and different practice areas, opening offices in new jurisdictions and improving systems and infrastructure.

For example, PE investment maybe the perfect fit for a cash-strapped, mid-market law firm brimming with great ideas and talented staff. Investment could be used to create a new brand and service that’s separate from the firm’s core business competencies to provide niche legal services as a result of legislation changes.

Acquisitional growth may also be a viable route – to merge and bolster existing practice areas and scale up or add new areas of expertise.

In essence, PE firms are likely to be interested if your business plan can demonstrate a profit improvement and increased returns on capital over a three to five year investment horizon.

Considerable interest is being shown in fast-growing firms in highly scaleable areas, including personal injury claims, conveyancing, wills and probate and other high-volume legal services niches.

Find the right investor

Your PE partner should be a firm with which you are happy to work alongside and share a mutual vision for the future of the business. Consideration should also be given to the suitability of the investor. Questions to ask include:

• What is the size of its fund?

• What is its typical investment horizon?

• What is the life of the fund? (this can indicate exit aspirations)

• Will the investor support you in acquisitions and put further equity to work behind you?

• Does the investor have any expertise in related areas as part of its portfolio that can help to deliver mutual benefits?

It is also important to determine if the investor’s vision is aligned with your firm’s long-term aspirations and strategy. An example of this is Palamon Capital Partners, which took a majority stake in QualitySolicitors (QS) in October 2011.

The premise of the deal was based on a shared vision and tightly-aligned strategy to transform QS into a dominant brand for independent and small to mid-sized law firms in the UK. Palamon’s investment enabled QS to expand its brand nationally, improve its market reach and ultimately attracting a wider customer base.

Most of all, it is fundamental that your firm’s management team can work well with the private equity investors. The journey to creating value will include challenges and it is essential you feel from the very beginning that you can ride them out together.

Crystallise future value

Private equity investment can help to open up options for crystallising value in the future – be it through an ultimate sale, initial public offering (IPO) or refinancing. The fundamental objective of external investment is to create shareholder value for all parties, which requires a change in mindset for most law firms.

Moving from a full distribution model to a focus on a future exit and a potential capital gain requires careful consideration and is likely to affect how partners are remunerated. Remember, this is not guaranteed or underwritten on day one. It will also require careful tax planning.

Manage cultural change

The very concept of external investment constitutes a significant cultural change for the legal sector. To implement it will require the buy-in of all partners.

Operationally, not only will the firm’s structure need to change to incorporate investment via an ABS, but the firm will also need to adapt its systems and processes to incorporate the measurement of new key performance indicators and the production of more regular financial updates for investors.

Partners will need to get their heads around having a third party at their key board meetings who is able to influence the strategic direction of the business. In a firm of 200-plus partners, this may not present too much of a concern compared to a smaller firm of between 10 and 15 partners, where there are likely to be worries over loss of control.

PE firms tend to opt for a light touch and keep a fiscal eye on the business rather than a hand on the tiller. They can, however, provide a fresh pair of eyes and help to identify areas for potential improvement.

Avoid a brain drain

Introducing private equity can have a different effect on different people within the firm. While longstanding and mid-term partners may appear to reap the benefits of a successful growth strategy, what about salaried staff and pipeline partners?

Royston Smith, managing partner at Scott Rees & Co, advises ABS firms to ensure there are opportunities for talented junior staff to enjoy a share of the new growth, such as through profit sharing schemes.

Don’t lose your competitive edge with a brain drain of talented staff who feel there is no place for them at the equity table.

Prepare for due diligence

One key area to highlight in securing PE investment is the often onerous due diligence process. It pays to be well prepared for this time-consuming exercise, as it can prove a significant distraction for management.

The PE firm will conduct a detailed review of the partnership’s finances, appoint external accounting advisers and conduct a comprehensive legal review of the business.

Often, commercial due diligence (on the particular market opportunity) and management due diligence (assessing the existing team’s capabilities) will also be undertaken – don’t take this personally.

 

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Assessing the option of private equity investment

Do

• Fully explore your options – it will not be a waste of time.

• See the bigger picture – equity investment can reap huge benefits.

• Have a shared vision and strategy.

• Be open to change.

• Be aware that an external view of the company can boost competitiveness.

• Appreciate that there will likely be further market consolidation ahead.

Don’t

• Dismiss the idea of external investment out of hand.

• Dive in at the first opportunity for investment.

• Be afraid of dilution – increased capital value can be achieved if an investment is put to good effect.

• Enter into discussions unless you are 100 per cent committed.

• Consider shared control of your business as a bad thing.

• Be afraid of making changes to your firm.

• Be afraid to obtain private equity if it enables your firm to maintain or increase its market share.

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A changing market

While the option of external investment will present more opportunities for law firms, ultimately there is also likely to be greater competition and market consolidation, and the development of new business models as a result.

As competition increases, the agility to react quickly to the changing marketplace will be the key to survival. A crowded market will drive the sector forward, forcing it to become much more streamlined.

Reviewing existing processes to identify areas that can deliver greater efficiency will help to keep your firm competitive on its client offering, levels of customer service and pricing policies. Consider the following:

• Are there any obvious wins from reducing your cost base?

• Can you outsource or perform some processes more efficiently?

• Do you need to adopt a different strategy in the rapidly-changing marketplace and rethink the firm’s mix of partners, fee earners and non-lawyer staff?

Don’t be afraid to look and think creatively.

As with all business decisions, there are advantages and disadvantages and private equity is no different. Bringing in an external investor is a big step and law firms need to think long and hard about what it is they want to achieve and how an external investor can help to deliver that.

The key is to get the right fit. Worries over perceived loss of control are usually forgotten when a good PE partner relationship is established and the benefits are realised.

Going the PE route is not for everyone, however. Explore your options in detail: there is no one-size-fits-all approach.

Simon Lord is the managing director at  international investment bank Altium (simon.lord@altium.co.uk)

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