Taking the threat of alternative business structures seriously

Some UK firms may think that the impending Legal Services Act is of little consequence. But the potentially profound implications posed by external ownership and alternative business structures should not be taken lightly.

The UK government’s proposal to allow law firms to raise capital from outside investors has received somewhat muted response from the legal community. On the one hand there is a small group who are keen to explore this possibility, on the other a much larger group who see it as of little interest to them.

We are not concerned in this commentary whether it is a good or bad thing for the legal profession. The thrust of this editorial is to examine the implications for the legal market in the event that this bill comes to fruition.

There appears to be general agreement that the proposals will be taken up at the commodity end of the legal market – I agree with this. There are two likely consequences at the lower-value end of the market. An investor could purchase a number of high-street firms within a single region and find economies of scale by creating a large ‘local-law’ provider, utilising technology and a central-support function – the ‘Tesco Law’ option, if you like. Likewise, an investor could purchase a number of personal-injury, debt-collection or residential-conveyancing practices, combining them into one large unit with a strong technology base, which would drive down costs and allow the business to compete on a national scale.

While both of these scenarios could arise within a partnership structure, trying to combine the various partner interests in such a combination would prove difficult. In any case, such an operation, once combined, will require fewer partners than a merger of several partnerships is likely to produce.
In addition, the capital cost of the technology required to drive down the costs of such a business would be a deterrent to most partnerships. Outside investment is a means of overcoming both of these issues.

Where opinion is more divided is among the firms who are, essentially, mid-market, full-service business law firms. A recent survey conducted by Hodgart indicates that a large proportion of the biggest top-100 UK firms do not see the issue of outside investment as being of interest to them. The arguments run along the lines that most law firms do not require large amounts of capital, which in any case can be borrowed from banks when a particular need arises, such as a large investment in technology. Current levels of profitability in many firms also make it relatively easy to attract good people, so there is no need for additional funds to assist in this. Finally, there is a concern that the introduction of outside investors would reduce the control that partners have over the business and that this could affect the firm’s ethos and culture.

There is no doubt that these points are generally true today, but not entirely so. A number of firms are finding that even with profitability in excess of £500k per partner they are still not able to attract high-quality fee earners in some strategically important practice areas. The ability to offer ‘signing-on’ bonuses and more attractive remuneration packages that are available under a partnership structure would be one way to overcome this.

The concern that outside investors will affect the ethos and culture of a firm is probable, but this might be a good thing in many firms and could be an inevitable consequence of greater competition whatever the ownership structure. Outside investors will demand a business-like approach and require high levels of accountability in the firm’s performance. But this is occurring anyway and any firm that wishes to succeed in the future, even as a partnership, will need to move in this direction.

The danger of current arguments against outside investment is that they are based on the market context of today. The real context has to be a scenario post-legislation and on the assumption that some well-managed, decisive firms take advantage of the legislation to raise capital.

For those who raise external capital, funds do not go straight into the pockets of partners but will be required to grow the business. Partners will become shareholding directors in a corporate entity (converted from an LLP or partnership) and be paid a salary plus bonuses based on performance. Their shares will either vest over a period (eg, five years) or be given at the outset with a lock-in period (eg, five years). They will receive dividends on their shares and could also be granted share options in the future, based on performance.

The crucial point here is two-fold. The remuneration structure could allow high-level performers to earn significantly more in bonuses than most partnerships allow and this could prove attractive to many people. The real clincher, however, is that ‘partners’ now have an asset in terms of their shares, which has a market value. In the event that a firm’s strategy leads to growth in the value of its shares, partners will have a significant capital sum that could realise on retirement (or earlier). Depending on the firm and its strategy, this amount could be anywhere between £5m and £10m for a firm presently in the market with revenues of £100m plus.

So what strategies are likely to produce this value? The money raised from outside investors could be in the vicinity of £40m if a 25 per cent stake is sold in a firm with £100m revenues and a 35 per cent profit margin. But investors will require a robust growth strategy before they put up money such as this.

The first approach would be to use part of the capital to invest in technology to improve work processes and drive down costs where appropriate. The technology exists today but it is expensive, and there is also partner resistance to its adoption.

The second part of this strategy would be to hire successful partners from other firms, paying between £500k and £1m as a signing-on bonus and offering them an opportunity to participate in a large bonus pool, as well as making shares available. Such a package could far exceed their share of profit in a partnership, even one that that is extremely profitable. There would, of course, be the need to fund this expansion, given that it could take new recruits two years to achieve the required profit in their practices.

Another approach, and one that could be operated in parallel with the lateral hiring approach, would be to acquire other firms and use the funds to pay out some partners in the ‘merger’, thereby creating a more highly-leveraged firm than would be possible in a typical merger of two partnerships. This acquisition route will allow a firm to build a well-focused practice that has significant scale and is capable of competing with anyone in its core service lines and markets.

It’s worth pointing out that a firm does not have to raise all of the funds at once. For example, it might raise funds in two tranches of a ten per cent sale and a third of five per cent, with a year or so between each sale. This would allow the firm to use the funds from each investment to start increasing profitability before the next tranche is raised.

The key point is that there will be some firms who take advantage of this opportunity to raise funds from outside investors. Some of these firms will have a robust strategy and will have the capital required to transform their businesses through the judicious use of technology, lateral hires
and acquisitions.

Firms that do not see the need to take this issue seriously should examine the position from the perspective of the future, not the present. If, in five years’ time, several competitors are able to offer your best people an opportunity to earn as much or more in remuneration, plus the chance to build a significant capital asset, alongside working on quality clients and challenging work, how will you fend off such advances and retain your key people?

I am not saying that firms have no choice but to go down the route of seeking outside investment. My message is two-fold: all firms should be taking this issue seriously and discussing it within their partnership; and second, such discussions should be in the context of several competitors having developed a successful strategy with the aid of outside funds and the likely impact of this on the competitive position of those who have not done so.

Alan Hodgart is founder of management consultancy firm Hodgart. He can be contacted at mail@alanhodgart.com.