Private equity houses set sights on LPOs and higher investment returns

Ever since it was announced that outside investors would be able to buy a stake in law firms, debate has raged about the potential impact of the Legal Services Act.

But with just months to go until the new rules come into force, ­private equity houses appear to be more interested in the upstart legal process outsourcing (LPO) ­industry - in which they can already invest - than ­conventional firms. Could the legal industry’s Big Bang be about to go off with a whimper?

Lyceum Capital was the first private equity house to announce, back in 2008, that it would ­actively target the legal sector. Now ­managing partner Jeremy Hand says new business models, such as those of outsourcing vendors, are more attractive to investors than law firms.

“You need management, clear strategy, capital and sound ­execution. I’m not sure how many traditional firms offer this ­combination,” he argues.
To prove the point, Lyceum bought a £25m stake in outsourcing provider ­Laureate Legal ­Services in ­November 2009.

Other investors point out that the recession has taken the shine off the law firm model, at least when it comes to providing the sort of explosive growth venture capitalists crave.

“Eighteen months ago there was significant discussion about ­private equity investing directly into law firms, but growth in this sector has been impacted by the credit crunch,” says Intermediate Capital Group’s (ICG) head of minority partners Piers Millar. “Private equity firms are more ­likely to target investments in legal outsourcing rather than investing directly into law firms.”

ICG has been at the forefront of a flood of investment in the LPO industry, the timing of which does not bode well for conventional firms looking for backers.

In January the fund paid £440m for a significant minority stake in patent filing specialist CPA Global, part of the £500m of new private equity investment in LPO so far this in 2010, according to ­figures compiled by investment bank Marks Baughan & Co and Integreon. This compares with a total of £54m for the previous decade.

But can law firms expect a ­similar influx of cash next year? Taylor Wessing managing partner Tim Eyles thinks probably not. The firm formed a ­committee to examine the ­possibilities arising from the Legal Services Act in July 2009, and Eyles says it has had approaches from private equity firms who are “sniffing the ­market”.

But he believes that law firms are unlikely to receive direct ­funding from private equity for several reasons, including the fact that partners would likely find it unacceptable to relinquish ­managerial control and the ­difficulty in finding a suitable exit for such an investment.

Eyles also points out that ­private equity funding is much more expensive than bank loans or ­tapping up partners, adding: “I imagine most leading law firms will be able to fund their ­ambitions with a combination of partner ­capital and bank debt so won’t need access to private equity in any event.”
Of course, LPO is not yet the goldmine its backers hope it will eventually become. The market is fragmented and, as The Lawyer’s story about Integreon’s losses in its Bristol operation show (19 July), margins are thin.

“Overall the sector has, from an investment perspective, not ­delivered private equity returns to date,” explains Exigent director David Holme, whose outsourcing ­company has so far resisted the lure of the buyout firms.

But there is clearly room for growth. Integreon is majority-owned by the private equity arm of Philippines conglomerate Ayala Corporation. The company is now thought to be worth between $250m (£159.67m) and $400m, according to industry analysts, meaning Ayala’s reported initial investment of $20m in 2006 could now be worth between six and 10 times that sum. Investors will struggle to find a law firm offering those sort of returns.

Former Cravath private equity lawyer Larry Graev is now ­chairman and chief executive of Glenrock, a New York-based investment group. He says that while ­corporations continue to demand that low-end legal work is done at the lowest possible price, the ­outsourcers will thrive.

Glenrock bought up a stake in LPO provider Pangea3 four years ago and Graev sits on the board. He recalls a defining moment for the new company following a meeting with a major financial institution that had just started using Pangea3’s operations in India.

“They called us in with five of their law firms,” says Graev. “There was nothing subtle about the meeting. It was their view that a lot of work could be done in India and that it would be in the best ­interests of the law firms if they worked with us. All five firms understood that message.”

It is a message that potential investors also understand all too well.