Posted by Jeff Zindani, managing director and merger consultant at Legal Futures Associate Acquira Professional Services
When discussing private equity or other external investors in law firms, it’s fair to say that many in the legal sector are sceptical. Partners I speak to often consider these organisations to be ‘ruthless asset strippers’ or question their ability to run law firms when compared to the traditional partnership model.
Perhaps some of this unease is because there remains an opaqueness around private equity. The reality is, however, that they follow a predictable playbook, and more importantly are becoming a real force in the legal sector, one that can’t be ignored.
As the potential of private equity to challenge many conventional law firms becomes clearer, it’s worth taking a closer look at how these firms operate and the impact they are having on the legal sector and the market for mergers and acquisitions.
Growth and exit
In simple terms, private equity is a form of financing where money or capital is invested into a company. Normally, private equity investments are made into well-established, traditional industries in exchange for equity or an ownership stake.
It is similar to venture capital, with private firms using capital raised from limited partners to invest in promising private companies. Unlike venture capital, however, private equity firms often take a majority stake – 50% ownership or more – and usually have majority ownership of multiple companies at once.
To invest in a company, they raise pools of capital from limited partners to form a fund. When they have reached a funding target, they close the fund and invest that capital into target companies.
The objective is to grow the fund, generally with a view to exiting after four to five years. Any profit is then distributed to the limited partners who originally invested. When a private equity firm sells one of its portfolio companies to another company or investor, the firm usually makes a profit and distributes returns to the limited partners that invested in its fund.
A new frontier
The legal sector is seen as a new frontier where solid margins of around 30% are the norm for most well-run law firms. These kinds of profits are well above those typically enjoyed by non-legal businesses.
As one private equity executive told me recently, they like established law firms as they are seen as “eternally profitable businesses”, particularly if they are full-service firms that can ride economic storms by having mixed practice areas.
Private equity investors normally have a strategy around buy-and-build which involves forming a platform company and then aggregating and integrating smaller add-on acquisitions to achieve rapid growth and scale.
On exit, the investment benefits from the arbitrage between the higher EBITDA (earnings before interest, taxes, depreciation and amortisation) multiples that larger enterprises command and the lower multiples paid across for the various smaller acquisitions.
A study commissioned by management consultants, the Boston Consulting Group found that, in lower middle-market type businesses, returns from this strategy are nearly two and a half times greater than standalone investments without M&A. The relative benefit of this strategy appears to decline as deal sizes increase.
There is no reason why this analysis should not apply to the legal sector and we can see already this strategy being used by Lawfront, which has in the past two years acquired Essex practice FJG, North West firm Farleys and Nelsons in the East Midlands, giving the company annual revenues of more than £45m.
The other active private equity backed business in a similar space is MAPD Group (standing for Making A Positive Difference), which most recently acquired Cumbrian firm Thomson Hayton Winkley and Ashton-under-Lyne practice Bromleys.
It appears that consolidation in the legal sector is becoming a coherent and properly funded strategy and, as private equity steps up its investment, is bound to gather more pace, particularly around mid-sized law firms.
Consider the remarkable entry by Sun European Partners into the legal sector two years ago when it acquired leading claimant serious personal injury firm Fletchers for over £40m. This clearly demonstrates not only intent but real firepower.
These developments have taken a lot of law firms by surprise as many observers, including ourselves, never thought private equity would branch out into consumer-facing legal services.
This is perhaps because the history of private equity in the personal injury sector is controversial, with another large personal injury practice Roberts Jackson becoming one of the biggest failures, leaving its private equity investors North Edge Capital with a £22.5m loss back in 2019.
A playbook for the legal sector
Private equity firms are winners because they are globally some of the most sophisticated buyers and investors out there. The likes of Inflexion and Sun European Capital would not be investing unless they could see a return. Interestingly, in 2019, the Financial Times reported that Inflexion was producing returns as much as three times invested capital.
It is also worth pointing out that, although it might be counterintuitive to many in the legal sector, private equity likes to take underperforming businesses and turn them into something special. The rationale behind private equity is to take a business and to make it more valuable.
This will clearly chime with partners in law firms who know that whilst they may be excellent managers, they never came into the law to run a business.
As the Harvard Business Review said in its 2007 piece, The Strategic Secret of Private Equity: “The fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them.
“That strategy, which embodies a combination of business and investment-portfolio management, is at the core of private equity’s success.”
My prediction is that we will see the major players in private equity continuing to use this playbook of making a law firm more valuable by buying platform firms with a clear ‘buy to build’ strategy.
We know from discussions with a number of law firms over the past five years that there is little appetite for private equity, particularly amongst traditional law firms, but this may well change as the success of these outfits becomes more apparent.
If not enamoured by private equity, perhaps law firms can learn something from their playbook. It could potentially benefit some to consider the ‘buy to build’ approach – imitation can be better than innovation.
What is clear, however, is that we are looking at a coming wave of private equity that is set to increase competition and heat up this fluid sector.