Financing change

Sound financial management should be a strategic priority for any business as the unpredictable economic climate continues. For any law firm planning to attract external investment, however, the bar may well need to be raised much further.

By Jonathan Haley and James Thorne, Farrer & Co LLP

The Legal Services Act 2007 (the Act) is set to bring about sweeping changes to the legal-services market. Although predominantly a regulatory act, most excitement from within the sector is understandably focussed on Legal Disciplinary Practices (LDPs)
and Alternative Business Structures (ABSs). In this article we examine the likely impact of the LDP and ABS regimes on the financial-management strategies of law firms, focusing particularly on the possibility of private equity (PE) investment.

Legal Disciplinary Practices (LDPs)

LDPs are an interim model of business structure introduced by the Act. Under its provisions, the class of lawyers who can be admitted to partnership in a firm of solicitors is widened from practising solicitors to include, for example, patent attorneys, barristers, legal executives
and licensed conveyancers, as well as “non-lawyer managers”.

Farrer & Co became an LDP in April 2009, shortly after the regulations permitted, with the promotion of its chief financial officer to partnership − CFOs and CEOs are perhaps the most likely non-lawyers to benefit from the LDP provisions. However, by 18 May 2009 only 34 firms had taken advantage of the new rules. Of these, just two have more than 25 equity partners, suggesting an unwillingness among larger firms to lead the charge. This should probably come as no surprise, and we need only look to the previous example of LLPs for a comparison. In that instance, very few law firms jumped in on day one, leaving a select number to lead the way, and with a steady stream of conversions in the following years. Of course, this time around we have the additional factors of the credit crunch and the worldwide economic slump to take into account, which also seem to have affected lawyers’ enthusiasm for change.

So, if LDPs permit non-lawyers to join law firms as members, does that mean they will have a significant impact on financial management or strategy? Probably not. First, non-lawyers can only account for up to 25 per cent of the partners in the LDP. Second, and more importantly, they must be “active managers”, i.e. involved in the management of the firm, meaning that true outside participation in an LDP is not possible. Those additional partners introduced to an LDP (lawyers and non-lawyers) might be required to make a capital contribution to the firm, but given the finance models of most modern law firms, any such contribution is likely to be nominal, and almost certainly insignificant compared to the capital of the firm as a whole.

Alternative business structures (ABSs)

The truly seismic shift facilitated by the Act is the ABS regime. ABSs open the door for genuine multidisciplinary practices (able to offer non-legal services alongside legal ones) and for firms to be owned by non-lawyers, although the extent of the level of external ownership that will be permitted is yet to be determined. Although we are unlikely to see their advent until 2011, firms are already considering the opportunities that ABSs will present. Investors and outside participants in ABSs holding more than 10 per cent of equity will need to meet the relevant “fit and proper person” test set down by the regulator (and we also await details of that) but there seems little doubt that large corporates, insurance companies and PE firms will all be looking for a piece of the ABS action.

Opportunities available

From time to time every firm will require capital expenditure. But the implementation of the Act (bringing about, as it does, the likelihood of new entrants to the market, commoditisation and pressure on fees) means that capital requirements are likely to be greater now than ever. The next few years will witness a shake-up of the legal sector never before seen and there is no doubt that, without capital investment enabling them to swim, some firms risk sinking. Commonly-cited examples of capital needs post-implementation include investment in IT (to enable commoditisation of certain businesses and efficiencies in other areas), the acquisition of other firms or teams, the recruitment of non-lawyers to offer additional professional services and the replacement of funding from other sources.

There are, of course, other existing avenues available to firms looking to raise capital – most commonly, bank debt. This, even today, remains relatively cheap, and the banks still see many law firms (comparatively speaking) as a good bet. So for such time as it remains available, firms will continue to rely on it. What the Act does, however, is open up new opportunities and the possibility of external finance, in particular, in the form of PE investments and listing. And while such investments are likely to be rare, there are a number of reasons why firms might look to investors, rather than banks, for funding. These include, of course, the availability of money (which in the current climate may be more readily available from funds than increasingly cautious banks), but more importantly, these sources of funds would bring with them the mindset of the investor − PE investors approach all investments with the view that they can be the catalyst for beneficial change. They will work to a fixed exit timetable (generally three to five years) during which they will wish to make transformational changes in order to achieve ambitious goals. They believe they have the knowledge and skills required to bring about and manage those very significant changes that will be required to keep the firms not just afloat, but ahead of the competition, in the new de-regulated market.

Clearly there will need to be good reason for a firm to take such significant steps. Any change would indeed need to be transformational in order for the equity give away to be justifiable to the partners.

Despite our assertion that PE investments and listings will be few and far between, there is no doubt
there is appetite for them in some quarters. Lyceum Capital is the oft-quoted example of a fund with
cash (something in the region of £50m) already raised for investment, and they are not the only players intending to be in the game.

The most likely beneficiaries of PE cash are smaller mid-market firms, with potential to increase efficiencies and grow rapidly. But, as they (most probably) say, there is no such thing as a ‘free multi-million pound investment’. Firms with growth ambitions, and considering an approach from investors, will need to consider whether the proposed investment will suit its requirements, and importantly, what will be required in return.

Investors will wish to see capital judiciously applied. They will expect funds to be invested in the infrastructure of the firm − and definitely not just acting as a cash bung for continuing partners, or a pay-off for retirees. In particular, heavy investment in IT will, in many places, be key. Huge leaps can be made in efficiency without requiring great pressure on staff to increase productivity (something that could lead to significant cultural change and resistance from those members of staff who feel they have not benefited directly from the investment). Firms may be allowed to go on the acquisition trail too. Funding could allow them to purchase other businesses for cash rather than by way of merger − something which, to date, has rarely been seen in the market.

Reporting revamp

They say that if you dance with the devil, it is always to his tune. While the comparison is of course unduly harsh on PE firms and institutional investors, it must be accepted that they will expect a different approach, particularly when it comes to financial management and reporting. What are the most likely changes that they will require?

Prior to investment

Even before an investment is made in a firm, the business may need to make some significant changes. PE investors make no secret of the fact that they are looking for firms with potential for growth. While the investor will need to be able to identify areas for improvement, it would be naïve to think that they would be willing to take on a poorly-organised or uncompetitive firm; the PE investor is looking to boost a firm going in the right direction rather than to rescue a failing business. The potential for development will be found in businesses with a need for cash to pursue a clear vision, coupled with a partnership commitment to chasing that goal. Those firms will already have a strong brand, durable client relationships and sensible financial strategies. Those without will not be appealing prospects.

What will they want?

PE firms seem to believe law firms are unsophisticated when it comes to financial management. Indeed, the White Paper on which the Act is based seemed to share that belief. The view is, however, outdated. Certainly, in respect of any of the top-100 firms in the UK, financial management has improved exponentially in recent decades. Nevertheless, any external investor, particularly one not directly involved with the practice management, is likely to require unfettered access to management accounts and financial figures in order to ensure its investment is being properly protected.

The financial discipline imposed by a PE firm will be stringent. There will be tight controls on cash flow and a push towards whatever exit the investor is focusing on. PE measures and goals are almost exclusively financial, and there will inevitably be a focus on concepts previously unfamiliar to many law firms such as return on capital employed (ROCE). The imposition of these tighter measures and altered goals could be a shock to the system of smaller firms.

Listing and market demands

No law firm has ever listed in the UK, but the example of Slater & Gordon in Australia serves as a comparison of sorts. Ignoring the general economic climate that firm, which listed in May 2007, has performed impressively. Perhaps inspired by that example, prior to the credit crunch a number of firms in the UK were making noises about listing as soon as the Act permitted. The cynic might question the attractiveness of some of those firms even in a bull market, but they have been rather quieter of late, and there are few firms seriously promoting the prospect. Whether a bounce in the market might renew earlier enthusiasms remains to be seen.

In addition to any professional regulations, a firm seeking a listing would of course be subject to the strict reporting requirements of the market, and business owners will need to be happy that they can meet those requirements. The discipline required for a listing (which is likely to be on AIM, the less regulated market) will be quite a burden. Any lawyer who has advised a client through the process will be fully aware of the requirements for information and absolute accuracy, not to mention hefty professional fees.

Nor is a successful listing the end of the matter, and the continuing appetite of the market for financial information, coupled with the expense of reporting to shareholders (and the requirement of those shareholders for an income stream by way of dividend), will be enough to deter many. In any event, the recent exodus of businesses from AIM suggests it would be a bold step to be first mover in this particular new market.

Control and stakeholder expectations

The switch to an ABS structure will almost inevitably lead to a more centralised management structure, coupled with wider financial reporting to investors and partners. While centralisation of power might, at first, be anathema to partners, in many professional partnerships it has, in fact, been seen as a liberating experience. Partners devolve power and control to a corporate-style management, allowing them to concentrate on their practice development and core professional skills. The consensual and collegiate approach that exists within traditional partnerships can be beneficial in many respects, but a mechanism for fast decision making it is not. An ABS structure, coupled with an external investment, can streamline the process.

Furthermore, the ABS model can revolutionise the incentivisation of stakeholders by way of shareholdings and the production of capital gains − something of a holy grail to partners currently facing an income tax rate of 50 per cent. A move away from the system we once heard described as “come in with nothing, earn well, leave with nothing” towards (the admittedly less snappy) “come in with a modest investment, earn reasonably well and leave with a tax-efficient lump sum reflecting your contribution to the goodwill of the business” is bound to be welcomed by partners.

External influences

We have generally focussed on the factors that a law firm choosing to take advantage of the ABS regime would need to consider. But it is worth noting that the regime itself will inevitably impact on all firms, regardless of whether or not they are taking on third-party investment. As mentioned, the sweeping changes brought about by the Act will force firms to consider their productivity and competitiveness, particularly if they find themselves in competition with the new breed of legal business that the Act will bring into being − those with wholly-commoditised practices, high volumes and low margins. Firms will find themselves in a position where cost savings, streamlining and efficiency of financial management become key to survival.

The Legal Services Act and the ABS regime will impact significantly on law firms. Those businesses opting to involve third-party investors will inevitably face pressures to improve, or at least, alter their financial strategies to suit the aims of their investors. It should be remembered that PE and institutional investors focus on numbers and targets, and that any investment will be coupled with an exit strategy towards which the firm will be required to work. Firms considering taking advantage of the ABS regime may well find that it provides the capital they need in order to reposition themselves in the market ahead of competitors. But careful consideration needs to be given to the source of that funding, the likely needs of the investor and the consequences of such a move.

Jonathan Haley and James Thorne are members of the partnerships group at Farrer & Co LL, and contributors to The Butterworths Guide to the Legal Services Act 2007. James Thorne is also a general editor of the Guide, which was published in June 2009.