How to: attract external investors

In the film Roman Holiday, a journalist played by Gregory Peck realises he has befriended a missing princess (Audrey Hepburn) – a news story that would carry a huge premium for his press agency. Being skint, he needs cash to bring off the scoop and attempts to borrow money from his landlord. ‘I no double my money that way,’ the astute property owner observes.

In the event, Peck shares crucial information withheld from the landlord with a photographer who understands the value of the deal and provides finance. Peck looks to get even more by making a side bet with his editor – but it all unravels when Peck’s morals prevent him from writing the story. Instead of making money, he pays out.

Excuse this fanciful vignette, but it shows that seeking external finance in the hope of making above-average profits is fraught with pitfalls. And the task is complicated for law firms and would-be legal sector investors because, as Jomati Consultants principal Tony Williams observes, this is a ‘fragmented’ market, ‘conservative’ and ‘resistant to change’.

Law firm Gateley got as far as flotation, a groundbreaking move judged to be a success with shares now valued at a third more than listing price. But as Williams observes, the firm’s market value of £40m-£50m is pretty much the minimum size for an AIM listing (and Gateley is still the only standalone law firm to list in the UK). It is perhaps not surprising, then, that private equity, a sector whose major players are more used to £250m targets, has been sniffy about investment opportunities.

Andy Poole, partner at accountants Armstrong Watson, explains: ‘The vast majority of law firms would not be right for external investment and law firm owners would not welcome it.’

General high street practices, he adds, would ‘definitely not tick the box for external investors, unless that investment is provided through the channel of a consolidator’.

Consolidators

A consolidator investor, in this context, is focused on linking multiple firms. By combining operations, can a profit margin be achieved that outperforms that of standalone firms and therefore prove attractive? And can that performance outstrip the returns that could be achieved through conventional mergers?

A high-profile example of an investor-backed law firm with a model that appears to work is Knights. The firm hit the headlines in 2012 when Dragons’ Den entrepreneur James Caan invested an undisclosed amount.

Knights managing partner David Beech is clear about the benefits. ‘It’s enabled us to buy law firms,’ he tells the Gazette. ‘You couldn’t do that with normal working capital.’

Why not merge rather than buy? ‘It means we can drive through cultural integration as an owner, rather than through consensus,’ he replies. ‘You see many mergers with legacy cultural issues which are still there years later. We integrate on day one.’

The most recent acquisition, Oxford firm Darbys, took Knights into the top-100 UK firms.

A firm such as Knights may not just be looking for cash. In a classic private equity deal, the investment target may also be looking for the expertise of the investor – the experience they have of growing a business in size and profitability.

While Beech notes that one of his roles is to be a ‘buffer’ between investor and partners, he views commercial acumen as a benefit that came with the investment: ‘There is no doubt that private equity brings commerciality and professionalism. Commercial acumen [extends to] compliance and ethics. A private equity investor will want to see that these things are being done properly. And “talent” is really important to them. They make sure people are encouraged, supported, educated.’

This is a point echoed by Steve Din of Doorway Capital, which provides funding to law firms including McMillan Williams, Rosenblatt and Seth Lovis.

‘Private equity investors can, very helpfully, impose financial controls, external senior management and other disciplines on the firms they invest in that often quickly generate seriously valuable cost savings,’ Din says. ‘I can accept why, from a cultural perspective and as a matter of human nature, a long-established firm might avoid change, but thereby miss the opportunity to benefit financially from these disciplines.’

Cashflow

Not all law firms that turn to external funders are seeking to grow ‘inorganically’ (Din’s term). For some, their profitability and financial stability would be improved markedly if their cashflow could be evened out and managed better. External funders also have a role here. Din points out that, even though some bank finance is at a historic low, the peculiarities of legal business mean that conventional banks may look unfavourably on some finance requests.

‘A common aspiration for any business is that the underlying tenor of the funding matches the economic life of the asset it finances,’ Din  says. ‘Any law firm that suffers from lock-up and the inherent uncertainty about when work-in-progress will turn into cash should, therefore, look closely at funding their lock-up on suitably flexible repayment terms.’ Such terms ‘plainly don’t apply to a traditional bank overdraft facility or bank loan’.

Martyn Jennings, CEO of niche costs and pricing firm Burcher Jennings, confirms this: ‘Firms have always had cashflow challenges. In the past, these were managed with understanding banks through an overdraft facility, capital contributions and adjustments among equity partners. But with partner revenue diminishing, and in the aftermath of the banking crisis, firms are having to look externally for funding.’

Whatever the purpose of the investment, firms seeking external capital, whether through debt or equity, may first need to make changes. Jomati’s Williams likens this process to ‘preparing a house for sale’.

Viv Williams, a consultant who focuses on small and medium-sized firms, has been working with several practices that are preparing for external investment. He identifies key areas most have had to address. First, he advises: ‘Change the corporate structure and be prepared to change the governance of the firm.’ In this context, ‘the collegiate partnership model is dead’.

Next, unprofitable service lines should be removed – even if they are ‘part of the history of the firm’. Outsourcing ‘anything that can be outsourced’ will create a ‘lean atmosphere’. And ‘careful consideration needs to be given to each relationship, with IFAs, estate agents or accountants and other sources of local and national investment’.

These relationships may be affected by the investment, though he reminds firms: ‘Investment does not have to be into the whole firm, there are now ways under the separate ownership rules that a holding company could be formed and several subsidiaries become ABSs for  specific investment in a department.’

In general, Jennings observes: ‘External funders require a far greater degree of due diligence and information from law firms. This may include very detailed short-, medium- and long-term business plans, with profit-and-loss accounts, WIP forecasts, and case opening, success, failure and billing data.’

That is a good level of discipline to work to whatever a firm’s funding needs, Jennings suggests: ‘With the range of challenges and changes in the legal landscape, firms that aren’t able to operate to these standards of planning and due diligence will struggle to survive.’

Growing pains

The legal market may be fragmented, but paradoxically it is also crowded and highly competitive. Growth and profitability are hard-won in such an atmosphere. It must be noted too that this market has been soured for some investors by high-profile failures connected with external funding – perhaps most notably that of Parabis, one of the first legal entities to attract private equity .

Jomati’s Williams suggests ‘a drive to greater consolidation’ may be a precondition to more intense activity in the legal sector. Meanwhile, changes in public policy affecting personal injury claims have constricted the ability to build classic ‘scalable’ models used by private equity businesses.

Still, there are workable investments being made and external funding has a day-to-day role in a growing number of law firms. The options on offer are not, those contacted by the Gazette stress, always as expensive as perceived.

‘Many firms are still taking on facilities with lenders charging double-digit interest rates,’ Jennings notes. ‘There is no reason any firm needs to be paying these rates.’

The most excitement will always relate to investments that can be transformative. But the bottom line is all, as Din concludes: ‘Law firms looking to attract external equity investment should be under no illusion that, above all else, they are expected to generate, and continue to generate, shareholder value.’

Outside investment does not stand still either, as Beech notes. Caan did ‘exit’, selling his share in Knights, which is now financed by a debt fund provider and looking to acquire further firms. ‘“Exit” can be a refinance with a second investor,’ Beech says. ‘It doesn’t mean you’re “sold”.’