The Legal Services Act 2007 (‘LSA’), taking effect in 2011, enabled new forms of legal practices with the introduction of the Alternative Business Structure (‘ABS’). This change in legislation permitted the external equity ownership of legal businesses and disrupted the British legal market with new entrants benefiting from this liberalisation. Law firms have increasingly benefited from the LSA through innovative business models facilitating the diversification of their client offerings.
The emergence of ABS firms prompted external capital investment which is driving innovation in operating models, streamlining client service delivery and developing competitive practices. Arden Partners believe that this development will result in consolidation in the UK legal services market with the potential for over £3 billion of revenue changing control.
Competition
The legal services market is representative of stark competition and traditionalism. In order to differentiate, firm’s must diversify their business models and seek increased profitability through alternative means. Accordingly, the legal sector is consolidating to deal with increasing globalisation and pressure from new entrants. Altman Weil’s 2017 “Law Firms in Transition” survey found that 79.3% of leading law firms in America believed that competition from non-traditional service providers is a permanent change to the legal market.
Competition from Legal Process Outsourcing, artificial intelligence software, in-house legal teams, specialist boutique firms and accounting groups is increasing, with the legal industry being far from consolidated. Corporate clients are progressively dealing with fewer law firms whose upsurge in output to a smaller selection of firms facilitates a lower price point.
Failings of the traditional model
In a bid to expand, traditional partnership law firms consolidate their specialisms enabling a stronger hold on a competitive marketplace. However, these mergers carry cultural and financial risks. In 2013, King & Wood Mallesons utilised a swiss verein structure to create a new breed of international law firm, allowing for three distinct firms in Australia, China and the UK to retain their existing forms and finances while benefiting from an anticipated lucrative branding opportunity. However, 2016 saw the UK arm of SJ Berwin fall. The European arm had long been tainted by the failure of management, defective governance practices, lack of strategic development, individual partner greed and partner capital deficiency. The firm remained undercapitalised and profit distributions were deferred, with the firm taking cash from tax reserves and profits in an attempt to bolster capital. Sizeable debt and issues over partner pay distributions plagued the firm which led to its recent administration in January 2017.
Johnson and Walker’s report argued that the fall of SJ Berwin was led by manipulation of the firm’s compensation structure. Partners were driven by individual performance where the remuneration committee awarded credit to the invoicing partner. This discouraged the retention of work within the firm and encouraged partners to forward work to other firms, invoice the clients and thus benefit from the credit. SJ Berwin exemplifies what Jonathan Molot calls “law firm short-termism”. Historically, most mid and top-tier law firms value current revenue generation through the annually published profits-per-partner figures (‘PEP’), relinquishing long-term value and overall growth.
Future development is not in the annual PEP figures or the pursuit of illusory growth with no material aim. The abiding doctrine of ‘eating what you kill’ is the prominent stance of many equity partners, with the impenetrable chest of clients and billings shaping a partner’s annual compensation. Future development rests in accepting the liberalisation of the legal services industry and striving to incentivise the law firm structure to further long-term institutional maturity.
Gateley Plc (“Gateley”)
Overview
The start of 2015 saw Gateley as a mid-market UK commercial outfit, but in June 8th 2015 Gateley become the first UK law firm to float on the London Stock Exchange’s Alternative Investment Market (‘AIM’). Selling 30% equity to external investors as 31,589,93 ordinary shares of 10p each at an offer price of 95p, Gateley raised £30 million in its Initial Public Offering (‘IPO’).
Opportunities
The UK legal services market exhibits growth and was valued at £32.1 billion in 2015. In switching from the traditional partnership model to a corporate structure enabling public equity financing, Gateley capitalised on increasing its size, reputation and output. Money raised from the markets allowed for selective acquisitions of legal and non-legal firms, complementing their client offering, increasing opportunities to organically grow the firm, aiding retention of key personnel through share participation and enhancing Gateley’s visibility and global outlook. The IPO constituted a valuable vehicle for the stakeholders.
The admission belies the traditional partnership structure, where budding lawyers accumulate long-term returns after an arduous trail to partnership level. The placing provided a gateway to ownership in the firm, offering partners the opportunity to monetize their sweat equity investment. The model is greatly incentivised, with the commercial objective being personnel retention. Gateley created share incentives, enabling a wider set of employees to gain equity ownership, develop flexible career structures and ensure retention through long-term capital value.
Strategy
Organic growth
After gaining an ABS licence in January 2014 and becoming AIM-listed in June 2015, Gateley gained the title of “first mover in the market.” With a definitive advantage over competitors, Gateley expanded organically through increased employee retention, attracting new talent, increasing cross-selling opportunities, expanding specialist areas, growing regional teams and developing project litigation offerings.
Acquisitive growth
Gateley forefronted the anticipated consolidation of the UK legal services market, representing a more liberalised national system. Gateley aimed to acquire legal teams offering niche services and specialisms to increase output, aid client growth and develop substantial client propositions offering expanded business and regulatory services.
Since the IPO Gateley has acquired tax incentive advisory firm Capitus and UK surveyors Hamer Associates. Promoting a broader service of cross-selling opportunities presented a stronger sales proposition and increased revenue by 15% for the financial year ending 30 April 2017 to £77m, prompting an EBITDA increase of 14% to £14.6m.
Why float a law firm?
Differentiation
In departing the traditional partnership model, law firms may alleviate cultural and economic issues that have plagued historic growth, encouraging investment and enforcement of the workforce. PwC’s annual survey acclaimed “increased competition, clients’ changing demands and rapidly evolving technology will require positive responses and significant financial investment”. Catalysts for differentiation to expand a firm’s services and specialisms, distinguish a firm’s brand and encourage growth through attracting high quality lawyers embracing increased incentivisation not offered by competitors. Indeed, with a crowded mid-tier market in the UK, Gateley saw a listing as a continuation of its strategy to foster growth and expand its footprint exponentially.
Diversification
The transition to a public company serves as a platform for diversification. In utilising this, a law firm advances its opportunities to grow organically through headcount growth, development of specialist services, increased work output and client based expansion through enhancing visibility.
The limitations of law firms, with partner greed dictating the distribution of annual profits restricts large investment in infrastructure and technology. Advancement of technology within the legal sphere has prompted large outfits to invest heavily in artificial intelligence software to conduct data tasks, due diligence exercises and property disputes. The adoption of lawtech software excludes the firm’s bottom end to ensure growth at the top end, requiring extensive capital to ensure firms remain at the forefront of these developments. Furthermore, with 73% of firms reporting cyber attacks there is a greater need for heavy investment to protect client monies and confidential information.
The leading beneficial factor arising from a traditional corporate structure is the ability to raise equity capital and gain long-term stability through a permanent equity model. According to research by Arden Partners a move to a permanent equity model over a PEP model will result in a focus on efficiency with £200 million of unrealised profit identified in the Top 200 law firms alone. Benefiting from public equity investment an AIM company can, unlike its competitors, utilise its shares as acquisition currency, gaining fast access to significant capital to enable development of more innovative and diverse business models. Long-term returns can be realised through selective investments in technology, geographical and specialist infrastructures, through to regulatory, advisory and business services entities. Furthermore, if shares maintain a high rating on a stock exchange allows for successful acquisitions of smaller target firms on a low multiple of profits and formulate perceived value as a result of the higher multiple afforded to the trading shares of public limited companies.
Incentivisation
Unlike most business entities, law firms do not provide partners with permanent equity that accumulates in accordance with their input into the growth of the firm. Short-termism is the stark reality as partners aim to increase personal economic reward prior to losing their equity stake at retirement, or upon leaving the firm, leaving a “declining draw that more closely resembles an employee pension than a dividend stream on equity”. Law firm partnerships trail in a commercial age that craves profit and capital growth. An unprofitable outlook in the overriding model, the lack of permanent equity and focus on current profits has led to firms overlooking long-term investment plans, thereby negatively impacting both employees and clients.
While the current lockstep compensation model encourages loyalty within a firm it fails to provide sufficient incentive for a lawyer to commit to the firm’s long-term profitability. Within larger law firms lockstep compensation results in apathy being exerted by partners who may barely impact on the firm’s revenue yet benefit from the annual profit share. The proportional impact is slightly twisted in this regard.
Utilising a permanent equity model balances competing considerations through developing a lawyer’s personal contribution with performance compensation and new equity grants. These may be tempered by a firm when balancing loyalty and personal performance. The long-term principal benefit of permanent equity motivates the lawyer to drive the firm’s success.
As a public limited company staff can be rewarded by issuing shares as part of remuneration and bonus packages. Incentivisation of remuneration in this model is a motivational tool. This will ensure commitment to client services, prompting higher earnings for the company, thus creating higher personal earnings through their equity stakes.
Risk
A prospective law firm IPO must consider the high risks associated with investments in AIM companies. In addition to the price of publicly quoted securities existing in a volatile market, Gateley was the first UK law firm to go public. Investors therefore remain wary of future growth prospects given small capitalisation listings that fail to show impressive growth become illiquid and unstable. If security and industry analysts cease to actively cover public companies and publish unfavourable reports, the trading volume and share price may be impacted as a result of a lesser demand for shares. Global economic conditions are vital to the health of a law firm and to a greater extent when placed into AIM, with downturns impacting the volume of billing and restricting opportunity for profitability. Gateley’s shares offer a strong dividend yield alongside capital growth, however a financial downturn within the firm would result in slashed dividends and a lower share price. Furthermore with low profit margins against fees Gateley and future public firms would show vulnerability in volatile times without stringent cash control.
Law firms lack financial hygiene with insufficient billing and fee collection systems which bears the risk of a firm running out of money to support their overheads. Many law firms value their business based on work-in-progress (‘WIP’), which leads to uncertainty surrounding the likely conversion to solid earnings and cash. In this regard many external investors would be cautious of investing in a model that lags behind in its lockup and positive cash flow in comparison to other professional services firms. Consisting of WIP days and debtor days, many firms collect fees after 3 months and, to aid client satisfaction, discount their invoices at project completions.
The most challenging adjustments relate to equity dilution and loss of management control. Both elements are vital to a senior lawyer. Firstly, public companies face accountability to their institutional investors and non-executive directors. They must consider enhanced reporting requirements and regulatory systems resulting in management’s loss of legal control with conflicting interests between management and the owners, alongside publicly showcasing the inner workings of their firm. Secondly, upon issuing new shares to raise capital there is a dilution of shareholdings.
Finally, conducting an IPO requires enormous amounts of time and capital. A small firm would incur costs of 11% of the total funds raised on top of underwriting, professional, initial listing and indirect fees. Ongoing costs such as trading, regulatory and corporate governance costs further affect the cost of raising public equity capital.
Future outlook
The partnership structure has been tantamount to the historical success of law firms and there has been a great reluctance to depart With a corporate structure this dynamic is tainted. The largest law firms continue to pursue traditional means of securing capital to invest in their growth through ensuring partnership profits are retained, WIP is tightly managed and innovative debt financing techniques are explored to avoid selling valuable equity stakes. These large firms have sufficient capital to utilise recognising a third party requires return on capital, thus impacting the profit shares of the firm’s employees. To this end it has been small and mid-tier firms who have adopted the ABS given their accessibility to external investors through their more refined management structures.
Irwin Mitchell took advantage of the liberalisation of the LSA in 2011 developing a two tier structure to include the limited liability partnership (‘LLP’) and a corporate parent company without a need to go public. The corporate member takes a share of the LLP profits to fund growth plans and retired partners retain shares benefiting from two annual dividends. The speculation of a public listing was dropped following observance of the volatile market and Slater and Gordon’s extensive losses, following its acquisition of Quindell’s professional services business in 2015.
Slater and Gordon was the first law firm to go public in Australia and became the poster child for the industry. The firm aggressively acquired firms, showing growth with highs of $8.00 per share. However, the firm’s market capitalisation has been greatly outweighed by its debt of £492.5 million. As a personal injury specialist there is a risk of placing vulnerable clients in a state of uncertainty following a collapse. Aggressive growth funded through public equity and teamed with a volatile market, presents a risk that may greatly impact clients and investors alike.
Conclusion
The future of law firms will be heavily dependent on capital growth and the pursual of long-term strategic outlooks to promote institutional stability over aggrandising short-term profit metrics. Traditional firms are at risk of disrupting long-term growth where client piles are developed by solicitors to allow partners to exercise the ‘eat what you kill’ doctrine. The impact of this is complete starvation of a firm’s future.
Competition in the legal marketplace from firms offering more economic, effective and innovative services is a high risk factor. To secure future investors, firm’s need to innovate, diversify and present market-challenging pricing tactics to improve efficiency and challenge competitors.
Moving away from reliance on bank debt and partner capital and looking to risk equity capital as a mode of growth development, law firms can seek rapid growth. Converting to an ABS does broaden a law firm’s access to capital and enhances funding flexibility. However, is it therefore commercially savvy to look to a public listing to achieve growth rather than focusing on private equity? Many law firms have benefited in successfully retaining capital for funding, while involving the traditional partnership model. However, Gateley and Slater and Gordon are representative of a public company model that benefits from quick access to financing to fund acquisitions, rather than a need to throw a cash call to partners or explore extended lines of credit. Yet, despite the success of Gateley’s flotation, with shares valued at a third more than listing price, the firm’s market capitalisation sits at £193 million, placing it as a small AIM listing. It is therefore unsurprising that private equity houses are reluctant to foster investment in legal services given the stagnant and limited growth factors. However, accountancy firms and investment banks have successfully converted from partnership to public corporation, despite initial widespread doubts. Goldman Sachs is indicative of a successful conversion and has showcased considerable growth, growing its capital to $1 billion within six years, predominantly through retained earnings with the return on equity topping 80%. But most importantly, Gateley’s maiden results, as the first UK law firm IPO, saw the firm’s revenue increase 10.2% after its first year as a public company and has set a precedent for onlookers.
Volatility in legal services and publicly traded companies, being subject to current performance and market fluctuations, produces an ambiguous collaboration. Nonetheless, there is a greater need for deeper pools of equity to support the challenge of global competitors and technology companies who are beginning to enter the market and invest in more expansive and cost-effective legal service offerings. With a small precedent selection on which to base future opinion, it is unlikely that large commercial outfits will begin to reformulate their businesses. However with a greater need to finance growth in mid-tier firms, which have become hindered by the traditional partnership model creating barriers to future investment in technology and international expansion, the legal sector will continue to observe the potential of a law firm IPO and the benefits of permanent equity to secure the future of both their firms and their lawyers.