Structural shift

With the advent of LLPs, the Legal Services Bill and the additional option of an alternative business structure, the legal profession should be prepared for a dramatic period of change. By Colin Ives

By the end of this year, more than 50 per cent of the top 100 UK law firms will have become limited-liability partnerships (LLPs). This represents a major development within the legal sector. However, the Legal Services Bill takes things up a gear or two, as it allows firms to be licensed as alternative business structures (ABSs) with external (non-lawyer) shareholders or stakeholders. This opens the way for such firms to seek public listings, either on AIM or on the full market. Whether the Legal Services Bill will herald a revolution is hard to say, but the legal sector is undoubtedly set to change dramatically during the next 10 years. But why should firms opt for change when the traditional partnership model has existed very successfully for more than a century?

What is the alternative?

LLPs, partnerships and limited-liability companies can all opt for ABS status. Becoming an ABS firm brings flexibility above all, but it also marks a departure from tradition, as it enables law firms to have non-lawyers as partners or owners. While this could facilitate the promotion of a talented finance director, for example, it also paves the way for broad multidisciplinary practices. So how will the legal market change during the next few years?
As a general rule, law firms are people businesses without an inherent ongoing need to accumulate funds within the entity, assuming they can fund capital expenses such as IT developments and expansion. The ability to build up funds within the business tax efficiently is very helpful for the average incorporated company, but tends to be less important for professional practices. But if firms want to broaden their service offerings or attract external investors, incorporation and a public listing are options that many will consider.

Professional practices have not been accustomed to attributing value to goodwill built up by their businesses and this has prevented partners from accumulating capital wealth. As a result, generating income has been the priority. The possibility of having external investors on board automatically gives an inherent value to goodwill, which could result in a sea change in attitude. This process could even create a ‘golden generation’, where partners who have previously enjoyed substantial income seek to convert this into capital value for which there will be a market from both incoming partners and external investors.

While there are potential financial gains to be made from such changes, not all firms will be rushing to take advantage. This should favour the few firms that do pursue this route, though, as they may be able to strike a better deal with investors.

Learn by example

There are lessons to be learnt from other professions where it has been possible to separate external investors from capital ownership for some time. The ‘consolidators’ within the accounting profession attracted their share of attention, but this remains a relatively immature market and it should be noted that firms within the accountancy profession to have sought a listing do not yet include any of the major players.

This contrasts with the property market and, in particular, the surveying profession, which are both more mature in terms of the structures they choose to operate from. Within these sectors, some firms continue as traditional partnerships, some have adopted LLP status, a few have floated on the UK stock market and others have fallen prey to US ownership. Interestingly, these different entities coexist well, but each structure can reflect a different culture and have its own particular issues.

Within the surveying market, traditional partnerships are typically UK-focused, but they have had to adapt to remain competitive. Their underlying core business remains strong providing they have the financial strength to retain and reward good people. However, I anticipate that most remaining traditional partnerships in this sector will have become LLPs within the next few years.

LLP attraction

So what is the attraction of the LLP model? Quite simply, it provides some protection from liability for partners while maintaining the flexibility of a partnership. In addition, both LLPs and partnerships can combine income shares and capital ownership as one asset, or if desired they can be separated. This is important, as it enables these firms to reward short-term performance differently from long-term commitment without suffering the tax hit that would apply to a limited company.

For large partnerships and LLPs, the cost of distributing profits to the owners/employees is cheaper than it is for a limited company. So professional practices that do not need to retain significant profits might be better off financially by not incorporating.

Limited companies tend to have a different attitude towards distributing profits, as capital ownership and staff rewards remain separate. This makes it easier for external investors to participate in a business as they take the role of owner, which is distinct from that of employee. However, external investors seek rewards for their investments, which should not be underestimated. There has been speculation that some firms will look for private equity finance, but these organisations can be focused sharply on their payback and expect to have their say in how the business is run. Law practices must therefore consider how much external intervention they can accept.

The listing option

An alternative to private equity finance would be to seek a listing of the firm’s shares through a flotation on AIM or on the full market. Any firm taking this route will need to step up its level of corporate governance, which will mean appointing non-executive directors at board level.

However, the main difference is that any firm that lists would have to use part of its profit to provide a return to investors who own shares in the business. This can represent a significant drain on profit so it is important to incentivise staff to help make up this shortfall – not least as competitors may not have to deal with this issue. Attributing capital value to goodwill can be very helpful. Once created, share options and share incentive schemes, for example, can be used as part of remuneration packages. However, the success of this approach can be heavily influenced by the firm’s share value, so share options are not always rated highly by staff. Some listed firms of surveyors have suffered from a poorly performing share price, while large multinational practices have generally been the most successful.

So what will the legal environment look like in 10 years’ time? I believe it will have changed significantly, although we will only be at the beginning of a long period of transition. ABS firms will be in business. The high street law firm will have changed dramatically due to the impact of the Legal Services Bill, increased regulation and the review of Legal Aid. Today’s small, independent law firms will have been under considerable pressure to merge and consolidate (this process is already underway, with the recent announcement by the Co-operative Group that it intends to build a network of small firms). At the top end of the market, the big firms will be looking at the advantages they may gain from external capital.

Will this enable one of the magic circle firms to raise the funds to acquire a major US law firm? The shift in transatlantic mergers may yet enable UK law firms to dominate. In the mid-market there will still be a place for the partnership structure, but within 10 years LLPs will be the most common vehicle.

Colin Ives is a director at Smith & Williamson