External capital and law firms – the future

Chris Marston, Head of Professional Practices at Lloyds TSB Commercial, a Legal Futures Associate, offers some thoughts on the opportunities and the threats posed by the next stages of the Legal Services Act

Unattractive prospect? law firms are under-capitalised because they do not retain profits

In recent months, a number of important changes have taken place in the regulatory and competitive environments for law firms. The Solicitors Regulation Authority has introduced entity-based regulation, and legal disciplinary practices (LDPs) are now possible, allowing up to 25% of the equity in a firm to be owned by non-solicitors for the first time.

There hasn’t exactly been a stampede towards LDPs, but there are a number of reasons for this. Economic conditions have no doubt ensured that many firms have more pressing priorities, and some firms may regard LDPs as merely a half-way house towards the ‘real deal’ of alternative business structures (ABSs) and see no need for action at this stage. And, of course, a firm needs to have (and keep) three partners in order to allow a fourth, non-legally qualified person to come in and own no more than 25%. That excludes maybe 70% of firms.

What are ABSs and when will they come into play?

Let’s start with the definition, taken from the Solicitors Regulation Authority website: “New types of law firm which will be permitted from about 2012, such as a firm with more than 25% non-lawyer managers, or a company taken over by a non-lawyer enterprise, or a company floated on the stock exchange, or a firm which provides both solicitor services and non-legal services; an alternative business structure will need to be licensed by a licensing authority as a licensed body; note that the Clementi report classified LDPs as a type of ABS, but we tend to use the term to exclude LDPs.”

The Legal Services Board seems to be showing a determination to deliver more quickly, and recently its chairman David Edmonds said: “Opening the market to ABS will help to transform the way in which legal services are delivered. It offers benefits to consumers of legal services, be they private individuals, small businesses or large companies.

“More competition will be good for the legal services sector as it is has been in other sectors. I hope that lawyers, law firms, and their representative bodies will embrace change because ABS offers great opportunities to them too. But all firms will need to respond to the changing market, whether they adopt ABS or not.

“The case for ABS has been well made by others over a number of years so I am glad we are now in a position to make it happen. It is a top priority for the LSB and we are driving the agenda forward. We are today making clear our commitment to the first ABS licences being granted in 2011.

“We want to see the removal of regulations that act as unnecessary burdens on legal practices or as anti-competitive barriers to entry. Regulation should instead focus on addressing identified risks to consumers such as conflicts of interest.”

So how will this affect the financing of law firms?

The key difference is that external capital will be available.

Currently most law firms are financed by such capital as the partners/members are able or willing to provide, plus debt, whether provided by banks, other specialist lenders or sometimes LLP members. My own observation is that the majority of high street law firms we deal with are under-capitalised for the level of business they transact, and the reasons are largely to do with the partnership model, which does nothing to encourage the retention of profits. It’s bad for tax and bad for succession planning, so by and large partners are advised by their accountants to draw profits fully. Growth can be inhibited by the scarcity of additional capital and the understandable reluctance of lenders to have more at risk in a law firm than the owners do.

What does an external capital provider want?

A venture capitalist will be prepared to invest if he can see opportunities to make a significant return on his investment. The timescale would typically be fairly short – maybe three to four years, and the expectation would be that the investment would be at least doubled in that timescale. To achieve the return requires a clear exit plan, either a sale or a float.

So, given the range of investment opportunities available to an equity investor, why would he choose to invest in a law firm? As they are currently structured, it is difficult to see the attraction. Unless there is a considerable upside to be gained by changing the way the business operates, or its scale, or the nature of the work it does, an investor might choose to invest elsewhere.

Whether a venture capitalist or a corporate entity that sees the provision of legal services as a sensible bolt-on to its core business (Co-operative Legal Services, for example), the provider of external capital will want to have the right structure in place. This means economies of scale, robust processes and management information systems and the optimum combination of lawyers and non-lawyers to undertake and supervise the work. Larger players with membership or affinity strengths (eg, AA, Saga) will see legal services as an additional offering to sell to customers who already trust their brand.

The areas of law most likely to be attractive to external capital are those that can readily be commoditised, and/or which are process-driven. The application of scale and the use of paralegals fundamentally change the profit opportunity.

Will we need as many lawyers?

Law Society statistics show the numbers of solicitors continuing to grow, from 133,378 solicitors on the roll at July 2007 to 139,666 in 2008. However, the story underneath these big numbers is interesting. Over the last ten years:

  • The number of solicitors with practising certificates has grown by almost 50% from 75,072 to 112,433;
  • The number of women solicitors with practising certificates has grown by more than 96% from 25,439 to 49,909;
  • the number of solicitors employed outside of private practice grew by 104% from 14,254 to 29,104. Women are a majority in this group;
  • Women continue to be the majority for new admissions, at just under 60% for each of the past two years. In addition, women comprise more than 63% of those commencing training contracts;
  • Most importantly, the profession continues to be highly fragmented. At one end of the scale, firms which have 81 or more partners employ over a quarter of all solicitors, while sole practices, which account for 44% of all law firms, employ 8% of solicitors.

Can this last? There seems to be a trend among new entrants to the profession towards working as an employed solicitor, either in or outside of private practice without aspiring to equity ownership – at a meeting with a group from the Law Society’s Junior Lawyers’ Division last year, I was surprised that not one of a group of 18 had any ambition to become a partner.

It is clear that there will always be a demand for legal services, but how many of these need to be delivered by solicitors? The Legal Services Act defines those areas of law which are ‘reserved activities’ for solicitors, and there are plenty of work types that are not reserved, and which therefore are open already to competition from non-lawyers, will-writing being an obvious example.

A similarity can be drawn with opticians. Twenty or 30 years ago, who would have dreamt of buying glasses without consulting an optician, getting a prescription and buying the glasses from ‘the professional’? These days, consumers (the very word David Edmonds, chairman of the LSB uses in his quote above) will purchase glasses from a retail outlet with no professional input. There remains a smaller market for optometrists, ophthalmologists and orthoptists, but the vast majority of what people went to an optician for 20 years ago is now dominated by a small number of household names. What are the chances of an advert in a few years with the catchphrase “Should have gone to Will Writers!”

It is generally accepted that while demand for legal services will at least remain constant, the number of solicitors required to meet that demand will reduce.

Implications and practical considerations for law firms

Does all this mean the end of high street law firms? Probably not, though firms wishing to remain independent will need to make decisions about their own structure, financing model and the type of work that they will undertake. Generally they will be at a disadvantage in work that can be commoditised, because larger competitors will have access to greater levels of finance and lower unit costs.

  • It will be necessary to build ‘brand loyalty’ based upon any combination of geography, sector specialism, service levels, technical excellence, approachability and flexibility. Competing solely on price won’t be an option. For many firms, this will require a shift of outlook, and maybe a move ‘up market’. The challenge will be to persuade clients of the value of the legal solution that has been delivered, and move away from hourly charging wherever possible.
  • The right level of gearing between solicitors and other fee-earners in firms will be critical. There are only a small number of ‘reserved legal activities’ described in section 12 of the Legal Services Act. If solicitors are doing work that is not reserved, there needs to be an excellent reason and associated profit margin.
  • To compete successfully, firms will also need to re-invest in the business continually and adopt modern business practices. Financial management will be key, to ensure the right balance between borrowed money and the capital invested by the owners. Some corporate thinking will be necessary, with an emphasis on building value in the business rather than regarding it as a vehicle through which a number of individuals can make a very good living.
  • A disciplined approach to managing working capital will be critical to minimise the enormous investment that firms make in their clients and thereby reduce borrowing needs. Some cultural changes may be necessary too, such as promoting an environment where all employees regard themselves as salespeople, and achieve better levels of internal referral of clients between fee-earners in different departments.

Successful firms will be characterised by a value-building philosophy, a client service paradigm and an ability to adapt and change in a competitive market. Owner-managers in such firms will be in a position to shape their future. Others will have it decided for them.

Getting the right advice

As specialist bankers we have a duty to our customers to ensure they are prepared for the changes that are underway, and that they are taking the right steps to become winners in the legal market of the future. The framework and disciplines that the Lexcel standard brings to accredited firms go a long way in that direction, and that is why we have invested in training more than 120 of our relationship managers as Lexcel consultants

This article first appeared in Lexcel Link

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