“Weak competition” and legal culture behind lack of external investment through ABS, says LSB report

Buckley: investors see opportunities for investment

The low level of external investment in law firms since alternative business structures (ABSs) were allowed more than five years ago “may be a symptom of weak competition in the market overall”, a Legal Services Board (LSB) report has suggested.

There are also cultural and management factors – many law firms are concerned about losing control of the business, while they have “a weak grasp of the value of their businesses”.

However, it found “encouraging evidence” that the Legal Services Act reforms were delivering greater scale and diversity of law firm ownership.

The LSB’s evaluation of ABSs and investment in legal services – which cited Legal Futures‘ articles and last year’s innovation conference extensively – argued that “the dynamics of competition create incentives for suppliers to increase productivity through innovation, which lowers costs and hence prices through time”.

It continued: “This is likely to involve taking a different approach to delivering a service, or developing new services completely. In the absence of strong competition, there is insufficient impetus for law firms to take the greater risks (and rewards) involved with using external capital.

“Until these incentives change we may not see significant growth in the use of external capital by ABS firms.”

Since licensing began in September 2011, there have been 950 ABS licences issued by four licensing authorities, and as of March 2017 – when the research was completed – there were 892 active licences. Some 204 of them responded to an LSB survey, which was augmented by workshops and desk research.

Most were existing firms converting to ABS status, with enabling non-lawyer ownership to some degree the single biggest reason. Just under one in five were wholly owned by non-lawyers. Only 4% became an ABS mainly to enable access to external investment.

Some 23% of respondents indicated that they also provided non-legal services, with accountancy, tax and financial services the most common.

The report noted the “statistically significant links” between higher levels of non-lawyer ownership and the likelihood of having made an investment in the business; only a small proportion had difficulties in accessing finance.

However, only 12% of ABSs surveyed had used any form of external finance. Instead, the most frequent source of funding for investments was business profits or cash reserves, followed by bank loans and overdraft facilities.

The LSB tried to identify what was preventing investment. Legal services regulation was not a “significant barrier”, although wider changes to business regulations and governmental activity – such as personal injury reforms – were having an effect.

“Instead, non-regulatory factors appear to be the main barriers to external investment. While the overall size of the sector and large number of small law firms may limit opportunities for some investors, cultural and management factors seem to be the main factors.

“Investors report that law firms are reluctant to seek external investment, and a large proportion of firms are concerned about losing control of the business. There is also a view that many firms do not present financial information in the ways investors expect and/or have a weak grasp of the value of their businesses.”

Participants at a workshop suggested that investment would have a stigma – “generated in part by press coverage and high-profile negative experiences… External investment is not considered to be consistent with the ‘brand’ of solicitor in some quarters”.

An investment adviser told the LSB that what was also holding back private equity was the possibility of a clear exit from the investment.

“There aren’t many consolidators in the legal industry who would buy out the investors. There just aren’t many classic trade buyers, and most law firms are reluctant to give a realistic exit price.”

The LSB said that, in the context of ongoing levels of significant unmet legal need, “it would concern us if the potential added benefits of external investment are not being realised due to issues relating to the overall functioning of the market”.

These benefits included greater scale of investment and the injection of new ideas and business disciplines that could enable more transformative change in the sector.

At the same time, the LSB saw “some potential signs” of greater demand for external investment in the future.

“These trends include a growth in the proportion of all firms adopting a more corporate structure, and the current trend for market consolidation.

“However, stimulating increased competition in the market – including through the combination of demand and supply-side changes recommended by the Competition and Markets Authority – is likely to make the most difference to opening the sector up to greater levels of external investment.”

LSB chief executive Neil Buckley said: “The investors we spoke to told us that they see opportunities for investment in the legal services market to improve efficiency, to fund innovation and to increase productivity. External capital is, however, not yet used as much in the legal services sector as might have been expected.

“A significant majority of ABS firms (66%) either have already invested or are planning to do so, since they gained their ABS licence. This is positive evidence of the increased scale that allowing non-lawyer ownership was designed to enable. There is also evidence to link higher levels of non-lawyer ownership and the likelihood of having made an investment.

“The research shows that there are no significant regulatory barriers to investment in the legal services market. Nor does the cost of legal services regulation seem to be a barrier. Instead the key challenges are cultural – lawyers are reluctant to cede control of their businesses, preferring instead to rely on profits and reserves, or bank lending.”

    Readers Comments

  • Chris Marston says:

    External capital is not good. Nor is it bad. It is an option for businesses that wish to grow more quickly than they could using their own money. By definition, most SME businesses do not avail themselves of external capital – they prefer to own and control the direction of their businesses. It is naïve of regulators or anyone else to suppose that SME law firms should behave any differently to SMEs in any other sector.

    There are only three sources of money to run your business.

    1. Your own money -whether as an individual or a group of owners – costs you nothing (except opportunity cost) and leaves you beholden to nobody. The decisions and the profits are yours alone.
    2. You can rent money from a bank (interest is rent) and accept a degree of disclosure and influence from the lender as a result, until the day you give them their money (you were only renting it) back. You’re still pretty much in charge of your business though, and you’re not sharing your profit with the bank. Getting their money back is as good as it gets for them.
    3. You can invite some external party to put money in. An investor will be taking a share of the business and therefore a share of the profits. Their money might enable you to achieve things that you could not achieve without their cash, either at all or as quickly. Few external investors are willing to invest a minority stake – most want majority and the control that goes with it. And they need to realise a gain on their investment; for most VCs that means an ‘exit’ achieved through a trade sale or even a flotation. Very few are prepared to take steady but unexciting ‘dividends’ over a long term. Rather, because some of their investments inevitably will fail, they tend to look for situations where, if all goes to plan, they can achieve a 2 or 3x multiple of their investment within a 3-4 year period.

    Readers will have their own view on the success or otherwise of external capital so far in the legal sector. Some pioneers have taken a battering, but that is the role of pioneers in a military context. At some point somebody may make a success of it, but meanwhile there is no evidence that external capital at play in the legal sector would do anything to improve the experience of ‘consumers’.

    To describe the legal sector as being in some way culturally deficient because it has not embraced external capital is misguided because it assumes that law firms would have a different view towards it than all other SME businesses in all other sectors. It also assumes that external capital behaves in the consumer’s interests. In this connection one needs only to compare the employee-owned John Lewis with British Home Stores.

  • Eve Jarrett says:

    Well said, Chris. You have hit the nail on the head!

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