Is external investment the future for law firms?

So far, relatively few law firms have opened themselves up to private equity investment (PEI). Are law firms culturally prepared to face the challenges of raising capital in the current economic situation? Globalisation has placed pressure on international firms to consolidate as their corporate clients merge and margins are squeezed. US law firms and their professional bodies appear to be against non-lawyer ownership of firms. However, in the UK, mid-tier firms may have little choice but to move away from the traditional partnership model in finding capital for their operations.

It is inevitable that law firms will find it increasingly difficult to find commercial loans to invest in smarter IT and other capital intensive projects. There is increased capital adequacy pressure on banks, due to the requirements of Basel II and Basel III, and so they are not in a position to extend loans on generous terms. There are imminent problems in the eurozone which also will make bank lending tight.

Incoming equity partners in traditional firms and members of LLPs will find it more and more challenging to find commercial banks willing to fund their equity. In these circumstances, PEI is inevitably going to become something of the norm.

The profession had hoped to see a return to the prosperous conditions law firms enjoyed from the 1980s until the 2007 financial crisis. However, for the foreseeable future firms of all sizes will remain under pressure. Many City firms are reducing their corporate teams, the Jackson reforms will adversely impact the fees PI lawyers can recover and legal aid firms will see further reductions in their income. Law firms will, therefore, have to look to new ways of funding themselves.

Inevitably, if PEI is the route taken, investors may wish to see far more commercial and dynamic approaches to decision making and maximising the return on capital. As more firms are compelled to convert to alternative business structures (ABS), those sticking to traditional partnership models may be forced to make changes to the way they charge for services in order to remain competitive.

We have seen in the financial services industry that the FSA has taken a robust approach to the mutual sector. The FSA does not appear to understand the basis friendly societies have access to capital through members who have life assurance policies. Project Chrysalis assumes that the life assurances market is in terminal decline and is putting pressure on friendly societies to demutualise. It is quite likely that a similar effect will be seen in the legal services sector, as traditional firms turn to ABS structures. In the legal market, the regulators will not need to take action as financial pressures and the lack of ready capital from commercial banks are likely to bring an end to all but a few traditional firms in the next five years or so.

Firms contemplating PEI should be aware that the SRA has required an independent firm of advisers to vet the bona fides of investors at considerable cost to the firms involved.

ABS potential

ABS is potentially a good model to entice young people fed up with the traditional model of partnership. Many young lawyers do not want the pressure of unlimited liability, lockstep partnership returns and the conservative approach to business inherent in the collective decision making of partnerships. How often are partners trapped in a firm because they cannot get their money out? LLPs suffer from many of the same issues, and consequently many firms do not see their brightest lawyers become owners of the business.

Perhaps ABS will enable business models to be devised that enthuse bright young things to invest in ownership. An ABS may be much more fluid in terms of buying and selling shares. Shares that have a realisable value, perhaps? ABS has the potential to create new career opportunities for those involved in the legal sector by providing alternative options to the traditional partnership route. Non-lawyer talent can also be rewarded through bonus shares rather than cash, which has significant attractions.

Of course, there will be reluctance from partners who are not prepared to sacrifice control and profit per equity partner (PEP) (at least for the short-term) to enable investors to see required significant returns on their investments. A word of caution to all those firms that think their firm may be a very attractive investment opportunity because of published healthy PEP: investors will want to see a healthy return on their capital in hard cash. Profits available for distribution are not synonymous with PEP. ABS entities are to be expected to be run as tight ships to ensure that there is a healthy return for investors.

Impact on medium-sized firms

Large firms are yet to show much of an interest in PEI because for now, at least, they have had an eye to how conversion to ABS might be seen by US clients, who might otherwise be driven into the arms of US firms. It is likely to be medium-sized law firms that will be taking up external investment opportunities, principally to merge and consolidate to enjoy economies of scale. As a result, the top 100 law firms might begin to look quite different in just a few years time.

As we are beginning to see, where there is external investment, there will inevitably be an impact on the way that medium-sized firms provide services to clients. In particular, in the future, increased competition from ABSs offering more consumer-friendly approaches to billing will put pressure on other firms to review the way in which services are charged.

Firms will have to ensure that they have a strong brand and a sophisticated website to attract and retain clients. If a firm raises capital for expansion through private equity investment, it is likely that the investor will want to see marketing budgets used primarily on areas that will give a good rate of return.

Investment in robust IT and alternative ways of delivering services to clients will require partners of members of firms to dig deep into their own resources or obtain external funding. ABS offers a realistic opportunity to many medium-sized firms to grow their business at a time when access to capital is otherwise restricted.

Taking the plunge

Although there has not yet been the 'big bang' moment in terms of PEI into the profession, economic conditions dictate that firms will have to start looking into alternative ways of raising capital. Given that the legal profession is generally considered to be quite conservative, it may be that a number of firms are quietly waiting in the wings, willing to let a few brave firms take the plunge, and, once the advantages of external investment become clear, many will follow. Law firms are an attractive investment opportunity as most are well established, well run, with a clear strategic direction and require only moderate capital to provide services ?to clients.

The three recent PEI deals in the UK (Parabis by Duke Street, Silverbeck Rymer by Quindell Portfolio and Russell Jones & Walker by Slater & Gordon) all involved law firms specialising in large volume insurance and personal injury claims: areas likely to be subject to significant consolidation in the coming years thanks to civil litigation reforms. So, initially at least, it might be some time before firms specialising in other areas with smaller volumes open up to external investment. However, as firms struggle to retain their margins in the unrelenting credit crisis, partners may find they have to embrace private equity investment.

Where firms are willing to welcome PEI, the future should be quite exciting. As with any investment, however, the parties will have to have clear strategies about why the investment is needed and how it will return the capital on the investor's exit. If there is any notion that investors are happy to put money into a firm to subsidise the lifestyles of the partners, this will be rapidly dispelled. For firms with vision and drive, using PEI wisely could make the difference between survival and success