Readies waiting?

Whether law firms want to become LLPs is one issue but who are these potential investors and what do they get out of it? Simon Prideaux reports

The proposals in the draft Legal Services Bill open up a wide spectrum of new funding opportunities for law firms. These range from allowing key non-lawyer employees to acquire a partial equity interest to full ownership by external parties whose interests are traded freely (and valued) like any other shareholding.

While the contention by Sir David Clementi, as reflected in the draft bill, that third-party investment in the legal ‘industry’ will benefit consumer choice, the appetite of both investors and legal businesses themselves remains to be seen. While seminars on the topic tend to be well attended, expressions of firm intent have so far been few. The mood seems to one of ‘wait and see’. While there is general acceptance that the traditional funding mould will be broken, there are also mixed views on the desirability of being the first firm to do so.

Involving external investors may appeal for a variety of motives, but these seem likely to fall into the two broad categories: putting money in and getting value out.

Legal practices differ widely in their funding needs – a function both of the nature of the work undertaken and of their rates of growth. New or expanding firms in fields such as personal injury or debt recovery can consume working capital to a degree that places some strain on the owning partners if prudent levels of gearing are to be maintained. The support of a third-party investor would enable that burden to be shared.

That does, of course, also imply some sharing of the rewards, but that may be particularly appropriate if the investor’s role goes beyond pure financing. It is conceivable that a corporate investor could also bring something else to the party – perhaps internal systems, logistical support or the potential to introduce new clients.

The legal market is ever-changing. Growing, multidisciplinary firms will keep their ‘business mix’ and investment priorities under regular review. Practice areas absorbing disproportionate levels of lock-up funding may become candidates for a buyout by the lawyers engaged in those areas. However, the required financing may be beyond their personal means, especially if the price includes a goodwill component. The introduction of private equity investors may be a practicable solution, provided there is a clear exit route in due course.

Equally, an existing firm may plan a quantum leap of an investment in terms of new premises or IT infrastructure, or an acquisition beyond the size realistically affordable from cumulative profit retentions alone. Sale of a partial, non-controlling stake to a supportive investor could turn big dreams into reality.

Demographics may also play a part in triggering sharp upturns in a firm’s cash needs – perhaps to fund return of capital to retiring baby boom partners or to address pension fund shortfalls. External support may be the only option for slimmed-down firms keen to retain their independence.

At the other end of the spectrum there are successful, mature businesses, often with equally mature partners, who over the span of their careers have seen their businesses grow beyond all recognition. That growth is not just about size, but also about reputation and that hard-to-define concept of brand value. However, under the historic funding model a retiring partner will receive nothing more than the ‘pound for pound’ return of their capital. Even those partners not approaching retirement may find the prospect of realising the true value of their investment, through some form of IPO, hard to resist.

The risks involved
But this is not without its dangers. Brand value in a professional services business is heavily dependent on its people, their continued involvement and their professionalism.

Investors must be aware that what goes up can come down. By the same token, they can become impatient if financial returns dip and, with people costs being the principal overhead, partners may not find their positions quite as secure as they may have been used to.

It is sometimes argued that a market-driven share price can act as an effective performance indicator and so help to focus management’s priorities. It remains to be seen if the market will take a long-term view in its pricing of law firms.

Another consequence of a floating share price should be borne in mind. Where those working in the business wish, or are required, to hold shares and seek bank finance for that purpose, lending terms may not be as straightforward as previously, when capital has had a predictable redemption value.

Of course, younger ‘rising star’ partners may be less enthused by the thought of brand value being realised before they have built up a worthwhile stake in it. There is even the unnerving prospect of partners jumping between potential IPO candidate firms in the hope of becoming serial beneficiaries, much as some depositors did with building societies.

Having said all that, the ‘human capital’ of a successful law firm does not reside solely with the partners. Many large corporate employers have recognised this through profit-sharing and share ownership schemes open to employees at all levels. In an era of accelerating staff turnover, the motivational benefits could be considerable. Yet among law firms profit-sharing schemes are a rarity and wider share ownership is not currently possible. The new approaches envisaged in the Legal Services Bill would give firms the opportunity to broaden the ownership of their businesses from within, without necessarily involving any investment from external sources.

The potential cultural barriers of inviting external capital into an established business should not be underestimated. While some will see it as a breath of fresh air and a fount of new ideas, others may resent the end of a relatively cosy self-sufficiency and the inevitable financial disclosure obligations. Indeed, it has been suggested that, by not being an equity partner, a law firm finance director (or any specialist member of the executive) is able to offer more unbiased, evenhanded advice to the firm’s managing partners. However, there is no real evidence from the corporate sector that ‘shareholder’ status compromises finance directors’ effectiveness.

For others, the need to share profits with parties whose only contribution is a passive financing role may be hard to take. There may be a need for different strands of risk to be segregated and rewarded individually so that each stakeholder is rewarded fairly for their particular input.

Simon Prideaux is in the professional practices group at the Royal Bank of Scotland