Traditionally law firms have relied on internal funding to drive ambitions of growth, but since the Legal Services Act 2012 partners can access external finance through public share offerings or private equity investors
By Matt Jackson, corporate development manager, Slater & Gordon
With the recent introduction of Alternative Business Structures (ABS) under the Legal Services Act allowing for external ownership of law firms, the funding alternatives for firms have been greatly enhanced. Since its implementation in January 2012, there have been more than 130 ABS licences issued, 86 of which went to UK law firms that can now access external investment.
The key issues to address when assessing funding options, however, are to ensure the strategic objectives of the firm are clear and to understand how the relevant funding options can help them.
Funding from existing or new internal owners
The traditional form of funding for law firms is the injection of funds from partners and/or the retention of profits to assist growth. This works best where there are low capital requirements and the growth forecast for the firm is achievable within the cash generation capacity of the firm.
Internal funding has natural limitations, however, as the capacity (and desire) of existing owners to continue to fund growth may be different. Further, continued investment in the firm results in a greater individual risk profile for the individual partners as an increasing amount of their wealth is tied up in the firm.
From a firm’s perspective, internal funding may limit the capacity to take advantage of opportunities that arise and could exclude the potential for the firm to grow through acquisition if that is the strategic direction of the firm.
The other traditional route for owners of law firms is to utilise debt finance. Introducing debt finance is an effective way to obtain additional funding for growth and in the process increase the returns to the owners of the firm, whether they are partners or shareholders.
Most firms have a level of bank debt already, which may consist of short-term working capital funding or longer term facilities to enable growth opportunities. Bank debt is familiar and relatively low-cost, thereby providing an easy option for many firms to access growth funding.
Taking on additional debt has a downside, though. As the debt levels grow, generally banks will place more and more onerous conditions on the bank debt. Gradually the bank may become the key stakeholder in the firm and threaten the firm’s autonomy. Bank debt is always senior to the funds invested by the owners, and as such bank debt will always increase the owners’ level of risk. This is not always a bad thing, as risk is the counterpart to reward in investment.
What the owners need to determine as part of their strategy is the level of risk they are comfortable with as a group, and whether that level of debt will enable the achievement of the strategic goals of the owners and
Subject to the risk profile of the owners and the strategic objectives of the firm, it may not be a viable option for the existing owners of the firm to contribute additional capital (in the form of cash or reduced drawings). Additionally, the partners/owners may not be comfortable with raising the level of debt on the business.
This is where the benefits of an ABS kick in. This puts law firms on an even footing with most other businesses in being able to access external funding from non-lawyers. Funding can take the form of either private or public, although to date there has only been a handful of law firms willing to go down the public ownership path via an IPO.
Any external investment, however, will naturally dilute the existing owners’ interests and influence, with increased reporting and governance requirements subject to the form and size of the funding obtained. It does provide an effective means with which to achieve the firm’s growth objectives though, assuming the interests of the existing owners are aligned with the incoming investors.
Private equity (PE) may be as simple as raising sufficient funds from ‘family and friends’ as many small and medium size businesses do each year, or can stretch to the introduction of PE firms, which can invest anywhere from £1m to £100m.
PE investment not only provides cash but other skills, such as deal-making expertise, should the firm wish to pursue an acquisition growth strategy for example. PE investment, though, brings a greater degree of transparency regarding the firm’s operations. Prior to making an investment, PE firms scrutinise the depth of management, quality or practice management and IT systems and the capacity to achieve growth. Generally, PE firms will seek to have a representative on the firm’s board of directors, and may even request veto rights on certain decisions within the firm, for example the hiring and firing of senior staff.
PE firms are not altruistic in nature, and the purpose of their investment is to achieve a sizable return. The owners of a law firm need to understand what this will mean in the future and that it will most likely leave them as minority shareholders of their firm in the longer term. This may, of course, be a key objective in terms of succession planning so would naturally align with the objectives of the exiting owners.
When investigating the potential to utilise PE, the existing owners should put themselves in the shoes of the PE firm and ask, ‘how will I exit this investment in the future?’ and ‘what is going to drive the return on my investment?’. It should not be looked on as an easy way to create ‘cash out’ as it is likely the PE firm will be looking to lock in the owners (subject to their importance to the business) for up to five years.
Initial public offering
Depending on the size and managerial capacity of the firm, the owners may wish to look directly at an IPO. For an IPO to be successful both in raising capital and post-raising market support, there must be a clearly articulated need for capital and a quality management team to drive that growth. This may require a firm to bulk up its support areas such as finance, IT, marketing and human resources and develop a more corporate structure in terms of its management. This will in turn lead to a centralisation of decision-making and a dilution of the traditional partners’ influence.
This has been the path of Slater & Gordon and Shine in Australia, firms with revenues of approximately £175m and £60m respectively. From an investor’s perspective, both of these firms had a use for the external investment that could be well articulated (funding growth in new jurisdictions and consolidation of the markets they were in) and a corporatised management structure in place.
IPO vs PE
The key advantages of an IPO over PE are:
- The potential for existing owners to crystallise some of their investment on day one;
- A higher valuation when compared with PE;
- Once listed, easier access to debt and further equity;
- Enhanced ability to offer shares as consideration for future mergers;
- The ability to offer incremental, differential equity to employees as a retention mechanism.
Conversely, an IPO opens up the firm to greater transparency, with annual reporting requirements and increased compliance regulations and costs.
In the UK, there are two main markets where firms can seek external public markets: the London Stock Exchange, which caters for larger, more established firms; and the Alternative Investment Market (AIM) allowing for smaller, growing firms to access many of the benefits of a stock exchange listing.
Strategy is key
The key consideration when evaluating the most appropriate form of investment remains the firm’s strategy.
If the growth strategy calls for aggressive growth that will require funds greater than the capacity of the existing owners or debt allows for, then external equity becomes a viable option for law firms under the new ABS provisions. However, owners should not see external equity as a quick means to crystallise the value held within the goodwill of the firm, as usually the external investors will require significant commitments for the owners to see out the identified growth strategy. However, as long as there is an alignment of interests between the incoming investors and the exiting owners, and there is a clear strategy for growth, external investment provides a mechanism for value creation that until recently was not available.
The future of law firm funding
Surprisingly for many, there has not been a rush of firms to list in either the UK or Australian markets, the only jurisdictions where external ownership of law firms is allowed. In reality this has been a function of need (many firms strategically do not need the quantum of funding an IPO provides) or strategy (many law firm owners are looking at funding for an exit rather than growth).
It has also not been the most conducive of capital markets in the UK over the past few years.
Even so, it is unlikely that there will be a flood of firms listing on the LSE in the near future. The majority of firms will continue to fund their operations through exiting cash flow and debt facilities as they have done for the past century, and as do most commercial enterprises in the UK.
A number will seek out both the capital and expertise of PE firms as a bridging mechanism to an eventual listing on the LSE.
As consolidation gains pace in the legal services market, especially in the consumer legal services market, a number of large firms are likely to list and the capital they raise will then provide an exit mechanism for many small and medium sized firms.
The opportunities are now there for those firms that wish to take advantage of the opening up of the more flexible funding options available. These funding options are, however, the mechanisms to achieve strategic objectives rather than an end in themselves.