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Succeeding in the era of external investment


Marston: successful firms understand clearly what their market is

Posted by Chris Marston, head of professional practices, SME banking at Legal Futures Associate Lloyds TSB Commercial Banking

External equity has been allowed in law firms since the start of last year, and there’s still plenty of talk about investing in law firms. The Law Society law management section’s annual financial benchmarking survey, published in January, revealed that one in five respondents were likely to seek external investment for expansion.

At a recent conference, a number of speakers representing equity providers expressed views ranging from “external investment is the best way to ensure the future for firms” to “law firms will continue to be unattractive to private equity investors until they improve how they present their financial situation and partners invest their own cash”. Interestingly, both of these quotes came from the same speaker!

So how much activity has there really been, and what is the outlook for traditional firms? Of course we’ve seen corporate capital involved in growing Co-operative Legal Services, as well as the legal services offered by Saga and the AA. We’ve seen Slater & Gordon’s acquisition of Russell Jones & Walker financed via the Australian stock market. And there’s been some modest personal capital invested by a handful of non-solicitor individuals, such as chartered legal executives and practice managers. A large number of the 170 licensed ABS entities as I write fall into this category.

There seem to be some clear trends emerging in what we might refer to as the traditional investors’ arena. Personal injury is a clear theme – Slater & Gordon grew its business in Australia with PI work at the forefront of its strategy, and when the conditions were right to enter the UK market, it targeted a leading UK personal injury firm.

Any mention of personal injury is generally followed by insurance, and that seems to be the second thread of this theme. The prime example here is Quindell, an AIM-listed company which has been busily growing an end-to-end solution for the insurance claims industry with a series of strategic acquisitions.  On the other side of the claim we have seen Keoghs, the only top 100 firm to focus exclusively on defendant insurance work, receive investment from LDC.

There have been some more generalist investments, and an example can be found in Brilliant Law, founded by Betfair creator Bert Black, who is reported to have made a seven-figure investment into a firm which is offering fixed-price legal services to SMEs.

There have been ABSs involving links with independent financial advisers, and this does seem logical for firms doing private client work, especially those which service high net-worth individuals.

What do investors want?

Leaving aside for a moment the practice managers and chartered legal executives at law firms who have assumed an ownership role, investors tend to be pretty clear about what they expect when they invest.

They expect a return for the risk they accept, and they want some certainty about that return and how it will be achieved. On stock exchanges, investors will want to see share price growth or dividends – preferably both. Other investors will want to ensure they see significant capital appreciation (at least double) and a clear path to crystallising that gain, typically through a flotation or a sale.

They need to be certain, therefore, about the difference that their money will make and the nature and timing of their exit strategy at the point of making their investment.

It’s worth contrasting this with the approach taken by the traditional law firm investor – the practitioner owner-manager. Here we have an investor who makes an investment upon becoming a partner and expects to take the same sum out again upon departure many years later. Rather than growing value in the firm’s balance sheet and reinvesting for growth, the emphasis in ‘traditional firms’ has been upon maximising drawings to keep wealth outside of the business.

This makes long-term planning and investment in IT problematic, and makes it difficult to compete with the new players.

How to compete against new entrants

So is the game up for traditional law firms? I see no reason why independent firms cannot prosper provided that they are prepared to make some changes and understand the areas where they can compete effectively. There are certain areas of law that lend themselves easily to a process-driven approach, and it will become increasingly difficult to compete in those areas against new entrants who have invested heavily in IT and process management.

However, just as fast-track personal injury cases can be regarded as a commodity, the more complex cases involving catastrophic injury or clinical negligence may be better suited to the more bespoke legal service and skill set that independent firms can offer.

We know that most of our solicitor customers are financed by a combination of owner capital and borrowed money, and the challenge for many is to get the balance between those two in the right order. Too much debt makes firms vulnerable to running out of cash – even if they are profitable. The partnership model does nothing to encourage the retention of profit and the building of a sound balance sheet and as a result many of our law firm customers are thinly capitalised.

Even though there has been a move towards LLP and full incorporation, most balance sheets still reflect solicitors firms’ partnership beginnings.

Despite a flat economy, many of our solicitor customers are performing well. We recently took a look at the characteristics of the more successful firms, because we wanted to understand what set them apart from the rest. Interestingly, we found it was irrelevant whether the firm was an ABS, a limited company, a LLP or a traditional partnership – it was all about behaviours. The key differentiators were these:

Strong management teams take their investor and leadership roles seriously and are also far more likely to seek external advice, whether this is from an accountant, a specialist banker, a membership group or even a non-executive director.

There’s no doubt that external investment can be transformational, but it also involves surrendering independence and adapting to corporate thinking. That won’t suit everyone, but our most successful customers are showing how it is possible to be competitive while still maintaining their independence.