Partners need to become less risk averse in the law firms of tomorrow

Are the law firms of tomorrow going to be owned by a smaller group of entrepreneurial lawyers prepared to risk more capital for the rewards that were taken for granted a few years ago?

This seems increasingly likely in a legal market where law firms continue to de-equitise equity partners (owners) as a response to lower profits. Although this maintains PEP, it increases the amount of capital that each remaining owner has to inject into the business to replace that of the leaving partners and generally increases the risk of the remaining owners. 

Most lawyers are naturally risk averse because of the nature of our work. When being an owner was a one-way bet, this didn’t matter. However, in the new environment where law firm failures seem more commonplace, ownership may increasingly appeal only to more risk-taking entrepreneurial lawyers, with others happy to accept the greater certainty of a fixed remuneration package and bonus. 

If it was just the recession that had caused the risk profile of ownership to change, we might expect things to revert to normal once growth returns. New entrants to the legal market are, however, likely to put further pressure on revenues and margins in law firms. 

This is already apparent in the volume PI market, where new entrants are using technology and business processes to reduce the cost of claims. Consolidation in this fragmented sector is likely to be rapid and will be driven by a relatively small number of risk-taking entrepreneurial partners who will become the management teams of the new businesses and expect to be highly rewarded with a capital gain on exit. The same is likely to happen in the retail market. 

Similar pressures are likely to be encountered by all top-200 law firms as we see the unbundling of work. For example, as LPO providers continue to invest in technology and other processes to deal with disclosure and due diligence more cheaply, the revenue and profits associated with this work will migrate from law firms to the new entrants and will not be easy to replace in a crowded market. This is likely to drive consolidation and further de-equitisation to maintain PEP. 

As owner numbers reduce and the partnership becomes more entrepreneurial, the firm’s approach should be more innovative and businesslike. Some of the emotion that prevents deals from happening may disappear and these firms may start to behave like other companies in a fragmented market and seek to consolidate it quickly. 

These partners may also start to think like entrepreneurs in other ways. With income taxed at 52 per cent, their focus may shift from PEP to shareholder value and converting income into capital gains (currently taxed at ten per cent). This could be achieved through incorporation, the creation of an internal market and the issue of share options. 

There are risks attached to this approach that generally make it unattractive to most partners now, as they are focused on their profit share. A more risk-taking group of owners focused on consolidation and growth may, however, favour this approach. It might also mean an easier and more rewarding exit to a consolidator with external capital. 

Is this change in culture and approach likely to be the most important impact of liberalisation? Only time will tell, but there is plenty to play for if partners are ready to take the risk.