Gold nuggets: acquiring troubled law firms

The legal profession has been beset recently with stories of high profile law firm failures. However, for every firm that makes the headlines, many more quietly cease to practice. This is unsurprising in a sector which is faced by huge challenges and massive structural change.

A combination of recession, low interest rates, increased and new competition, heightened regulation, legal aid and costs reforms, high debt levels, and latterly professional indemnity insurance increases, has proved lethal for many. Though the number of law firms that cease to trade for all reasons is perhaps only 500 or so each year, many more are teetering on the edge of insolvency.

It has been reported that just fewer than 200 firms were unable to get PII cover for the 2013/4 year and will be forced to shut their doors. Many observers, including me, think that the underlying position could be worse. The hikes in premium this year will have knock-on effects. Many firms will be unable to afford these premiums and will fail as a result. This will reduce funding levels available for next year as traditional secondary lenders take losses on instalment finance. The hard PII market will combine with tighter funding and create near-impossible conditions for many in 2014.

The SRA believes that perhaps only 2,000 of the c 10,000 authorised firms in England and Wales face potential financial difficulties.

While certainly many firms enjoy robust health, the anecdotal evidence suggests that problems may in fact run far deeper. Cassandra like, many have long predicted a consolidation of the ?sector to perhaps 5,000 firms. Economic, technological and regulatory forces seem certain to push the profession into a smaller number of larger firms, particularly those dealing with 'consumer' specialisms.

Consolidation opportunities

However the process of consolidation '“ much of it in reality driven by insolvency and commercial failure '“ gives well managed and financially stable firms the opportunity to acquire businesses, clients and some excellent people. Acquisitions of the whole or part of troubled firms usually are accompanied by a significant discount and other advantages compared to a standard merger or bolt-on situation. But while there are undoubtedly opportunities, there are also potential pitfalls.

A good starting point is to state that merger or acquisition is not a strategy but a means to an end. Indeed I have come across a surprising large number of firms whose strategic goal of merging is in fact predicated on the fact that their business is in a mess and needs someone else to sort it out.

When researching this article I found a KMPG study which looked at a series of major PLC acquisitions between 1990 and 2000. Only 17 per cent successfully created value, a third appeared to 'break even' and a half were unsuccessful and caused losses. This study mirrors many in that acquisition appears a quick and easy way of developing a business but all too often it seems the opposite occurs. When thinking about acquiring troubled law firms, these lessons need to be considered.

Forced sale

When looking at acquiring a problem firm (in whole or in part) it is necessary to have some understanding of why it is in fact failing. The reason is clear '“ whereas an acquirer hopes to lift out the golden nuggets from the detritus of a failing firm, they may in fact also be picking up problems. The risk of dealing with 'fools' gold' is increased given the short cuts and timeframes that are usually present in these types of distressed situations.

Though bad luck can be a root cause of failure, most often it is bad management that leads to firms finding themselves in a forced sale situation. This can be historical in nature and often there are deep seated problems with staff, culture, PII and risk management, leases, retired partners, regulation and financial discipline.

Further issues arise with shortened timeframe. Often a firm is sold within a very short space of time. A break up or whole firm merger rarely takes longer than a month, and often is occurs within 10 to 14 days. In these situations it is almost impossible to do the sort of due diligence that one would normally expect and this necessarily increases risk.

Join the queue

None of the aspects I have discussed above are particularly unknown to acquisitive law firms '“ and there is usually a long queue of firms seeking to buy up bits of failed businesses. The question therefore is why do firms seek to acquire distressed firms knowing all the risks?

The answer of course is that they see a bargain. Typically a firm can acquire live matters at between 25 per cent and 50 per cent of recoverable WIP. They usually have to part with cash for this but '“ in this market '“ cash is king. This is particularly the case in popular areas such as personal injury and probate work.

Beyond the simple acquisitions of files, a firm can also take over an on-going business stream and its people at virtually no cost. There are no agency or introducer fees. Unlike a normal situation where a team is 'poached', the seller assists the acquirer with client consents, information provision, waiver of restrictive covenants and access to files and people. A distressed firm which is closing cannot be left with live client matters and must transfer everything - the best price it can obtain though in a very short timeframe. So whereas an acquirer accepts risk, they avoid a full costs indemnity and the problems that often arise when trying to acquire people and clients from another firm which may be understandably hostile to that notion.

Ready cash

To successfully acquire troubled firms, an acquirer needs access to cash or pre-approved funding. There are plenty of firms who have the financial firepower to make these deals and a 'earn out' offer will normally be insufficient. Successful acquirers have their PII position worked out as far as possible. Many deals have collapsed at the eleventh hour because insurers have vetoed an acquisition. A successful bidder will typically ?have a management team that is focused and streamlined and is empowered to act quickly ?and decisively.

TUPE problems exist in all these situations. ?In my view an acquisitive firm needs to consider the full downside risk, but also then to adopt ?a pragmatic, hard-nosed and commercial approach. I often find myself in the position of having to explain to staff in a firm which has days left to live that - if someone is prepared to offer them a job - it may not be the best idea to immediately try to take their new employer to an industrial tribunal.

There are a small but growing number of well managed and well financed law firms who are successfully acquiring (hopefully) the gold nuggets that can be dug out of a landscape littered with the barely breathing bodies of their failed and distressed competitors. The predicted consolidation and on-going problems of the legal sector will mean that these opportunities will ?only increase over the next few years. SJ