Less than a year remains until the final stage of the Legal Services Act comes into effect. This law will permit U.K. law firms to accept outside equity investment for the first time. Of course, law firms have been preparing for the change many feel will radically alter the vocation.
As referenced in September 30th edition of The AmLaw Litigation Daily, Matthew Hudson, former leader of the London offices of O’Melveny & Myers and Proskauer & Rose, feels “The legal market faces an interesting future. I look at ABS as similar to the financial services big bang. ”In the 1980s, investment banks were partnerships and charged by the hour. Now, all investment banks are companies with external capital and they charge transactionally. The same structural issues are present in the law. To have associates all trying to be partners is antiquated, unfair, and drives firms to make the wrong decisions. Something has to give.”
In July, Hudson started his own law firm, MJ Hudson, using seed funding from several private equity investors–debt he believes will be converted to “minor stakes” when the ABS legislation takes effect in October.
Big Law lawyers across the country are gearing up for the advent of ‘Tesco Law’, named after grocery retail giant Tesco, which is just one conglomerate likely to exploit one of the LSA’s other key elements: the potential for corporations and businesses owned by non-lawyers to provide legal services.
But while the seemingly inevitable influx of big brands into the legal market represents a major concern for those smaller firms, the extent to which the effects are felt elsewhere in the industry is a matter of debate.
Equity partners would also have to come to terms with the fact that significant outside investment would likely come at a price: they would make less money, at least initially. Private equity houses would want a return on their investment–typically 20 percent within three to five years. The long-term opportunities for cashing-in could be considerable. When Goldman Sachs floated in 1999, the partners’ stakes received during its transformation to a corporate entity were worth billions.
And while the sounds coming from larger firms suggest that they are entirely dismissive of the need for external investment, doubters should recall that even Magic Circle heavyweight Clifford Chance tapped the debt markets in 2002, raising $150 million through a dual-tranche bond issue.
For the investor, too, there are a number of potentially serious issues to deal with. Most essential is how you would actually go about valuing a law firm. While the reported profit margin, which treats the total net income distributed among the equity partners at the end of the financial year as the absolute bottom line, may look good, it actually presents an overly positive perspective by ignoring any fixed salary that these managers might receive. This also precludes the calculation of EBITDA–the favored tool for private equity valuation.
Explains legal consultant and former Clifford Chance managing partner Tony Williams, who was recently instructed by midmarket investor Lyceum Capital to advise on their possible activities within the sector, ”Law firm valuation is both an art and a science. Law firm profit margins are only notional, as they’re on the basis that none of the senior managers are paid a salary—they’re not even getting a brass farthing above the line. Partner remuneration is reported as one figure, but really it’s two things–it’s a payment for a day job and it’s payment for putting capital into the business as a proprietor. Firms have never really looked at it that way before, but that’s exactly what [private equity investors] would do.”
Many believe this is the wave of the future. “Give it 25 years and all law firms will be incorporated,” adds Hudson, who previously spent six years working in private equity for Credit Suisse and specialist secondaries investor Coller Capital. “[The change] may start with the consumer firms, but it will transform law at the highest levels and will also travel across the Atlantic.”