Law firms' profitability is proven, but third-party ownership of them is still relatively unchartered territory, says Sovereign Capital's Nick Miller

The Legal Services Act is a catalyst for change in a traditionally conservative profession. It is not often that such an exceptionally large (about 2% of UK GDP) and broad sector is opened to investment, and this has attracted a significant amount of interest from investors.

While there will be winners and losers from the market changes, it is not a zero sum game between incumbents and new entrants.

Increasing competition and investment should allow for more valuable legal businesses providing a more valuable service to clients. But this will not happen overnight.While change is certainly coming, how quickly it will emerge is open for debate.

Alternative Business Structures (ABS) have been more than a decade in the making, starting in March 2001 when the Office of Fair Trading recommended that unjustified restriction on competition in professional services should be removed.

It then took two years for the Government to appoint Sir David Clementi to carry out a review of the regulation of legal services, a further two years for his report to be accepted, and another two years for the Legal Services Act to be passed. That was almost five years ago.

The Solicitors Regulation Authority (SRA) then began approving structures allowing non-lawyers to own businesses delivering reserved legal services at the end of March. As of June, of the 230 stage one applications, only a handful have been approved.

The market is pointing blame at the SRA for a lacklustre response to the approval of ABS. However, considering the timeframe in which the opening-up of the legal market has been coming, the action over the past few months has been at a significant pace.

Slow change
The pace of the introduction of ABSs is reflective of how the legal sector has historically been slow to change. This is not necessarily a bad thing when dealing with something as historic, far-reaching and steeped in precedent as English law.

But when a market is opened up to competition from incoming corporates, entrepreneurs pushing new business models, and interested financiers – all looking to modernise and improve aspects of the legal market – the incumbents increasingly recognise that the rate of change will continue to increase.

New entrants and investors are attracted to the sector because it is large, highly fragmented, high margined and cash generative with customer loyalty and a history of secular growth.

Despite already seeing a handful of announced investments, to expect a flurry of cash flowing into the sector as the regulatory gates creep open may be optimistic.

There are many types of investors, but they generally look to invest in successfully tested business models. The profitability of legal services is proven. However, the sustainability of partnership structures under third-party ownership is not.

Not all areas of law are looking for, or will be attractive to, investors. Large magic circle firms, for example, are unlikely to be seeking significant investment beyond that which is available to them from their bankers.

One key characteristic of the partnership model that may hinder investment is governance. The outcomes of consensus votes for strategic (or investment) decisions is likely to be influenced by individual partner circumstance rather than what is wholly best for the firm (ie, a partner close to retirement would, acting rationally, not wish to reinvest his drawings into the firm where he will not be a beneficiary).

There is need to have a longer-term focus towards a common goal among those making decisions, and a number of positive changes are starting to emerge:

• The increasing shift towards the hiring of CEOs for law firms (so long as the CEO has the authority needed for him to do his job and lead the firm with vision), and

• The introduction of ABS to allow non-lawyer leadership and the incentivisation of non-lawyer management as well as the flexibility to equity incentivise below partnership level.

Slater & Gordon is an example of a law firm that has thrived by altering its business model and attracting third-party investment. Over the past three years, its earnings have more than doubled by pursuing a market consolidation strategy.

It is perhaps the reason for a number of high-profile applications for ABSs by investment companies within the personal injury market.

A key factor for Slater & Gordon's success in attracting capital is that its governance and organisational structure is akin to a FTSE 100 company. Law firms looking for investment will, in all likelihood, need to change their organisational structure to one that resembles a limited company rather than a partnership.

Splitting tasks
Putting governance aside, the most attractive areas of law for investors will most likely be those where the service to a client can be broken down into discrete processes, and administration-led tasks can be separated in to those that require the expertise of qualified solicitors. Splitting the two tasks allows for more efficiency, a lower cost base and more profitability, without a decline in customer service.

It also allows for qualified solicitors to focus on the job for which they were trained (complex legal reasoning) and should therefore increase overall job satisfaction. This is not a new concept and many firms are putting this into practice.

Generally, firms that specialise in particular niches (ie, personal injury, employment law) will benefit the most from adopting this process-driven approach.

Investors understand that the legal services sector is much broader than the 10,500 law firms within the UK. Services into law firms (ie, IT and software, legal publishing, outsourcing), services to in-house legal (which has been a focus of new market entrants) and a number of niche markets that have evolved within the legal system (ie, costs draftsmen, litigation funding) have all had the spotlight cast upon them despite never having had restrictions over third-party investment.

Indeed, many of these businesses may be more attractive to investors than the law firms that they service.

Financial investors can bring a significant amount of value to existing firms and businesses, as well as to entrepreneurs looking to create valuable sustainable businesses within the new legal landscape.

The benefit of incoming financiers is restricted not just to the cash they invest, but also the extensive commercial intelligence they bring from investing in businesses and supporting growth in other sectors. A partnership approach is required between investors and investees in order to map the opportunities and execute a strategy.

There are extensive opportunities emerging from the current changes in the legal sector. Increasing interest from entrepreneurs, corporates and investment companies will likely result in a more competitive market, enabling clients to benefit from improved service and value for money.

While the winners and losers from this change may not emerge for a number of years, it is clear that all organisations operating in the sector need to assess their strategic options and the opportunities available to them.

Nick Miller is investment manager at Sovereign Capital.