How Private Equity Investment Might Work in the Legal Profession
In recent times, many articles have been written about private equity investment and its direct entry into the legal world. It would seem like a natural extension, as over the past decade, investors have poured huge sums into legal tech platforms, alternative legal service providers, and workflow-driven professional services.
As law firms confront rising client expectations, margin pressure, and the accelerating pace of technological change, legal operations have emerged as the most likely engine room for modernization in the legal world.
Like any change (particularly in the legal world), there are proponents and opponents. Proponents argue that private equity brings operational expertise, access to capital for technology and geographic expansion, and stronger governance that can improve efficiency and client service. Opponents warn of tensions between profit-maximization and core professional duties: conflicts of interest, threats to lawyer independence, pressure to prioritize billable revenue over client outcomes, and confidentiality risks (a familiar opposition from bar societies to most changes in the legal world).
Each bar society will determine which forms of investment are permissible and how ethical obligations will be preserved. And it is unlikely to be a timely resolution, with an estimate of upwards of 2 years to reach a tentative agreement on what would be allowed to move forward.
The underlying issue appears to be a lack of agreement on what constitutes the practice of law (and thereby subjects it to bar society oversight) and the jurisdiction of management service organizations (MSO).
Clearly, the law partnership itself (at least in Canada for the time being) will remain lawyer-owned.
In the US, one large law firm, McDermott Will & Schulte, has indicated that "it planned to invite private equity funding into the house and divide itself into two: a law firm operation run by members of the bar, and a private equity-funded management services organization to handle back-office matters."
However, late last year, the firm's Chair advised that any talks with potential funding sources were preliminary and that they had no updates to share.
The Private Equity Legal Alliance, founded by a group of consultants, investors, and law firms, has a mission to provide a comprehensive roadmap that enables innovation without compromising the legal profession's core responsibilities.[1]
With the above background in mind, let's explore how a scenario involving an actual private equity firm might work. While the following is based on a real situation, we have strived to respect the firm's privacy by avoiding direct reference.
LAW PRACTICE
A founding law firm offers to purchase another law firm. The owners are lawyers, and the lawyers in the acquired firm will be partners in the acquiring firm. Thus, the law firm is owned only by lawyers with private equity holding no ownership.
The purchase price is normally EBITDA (Net Income plus interest plus taxes plus depreciation plus amortization) times a multiplier.
The multiplier is the result of the acquiring firm weighing such factors as the following (not all inclusive nor in any particular order):
1. Financial Performance
2. Growth Potential
3. Management & Personnel
4. Brand Identity
5. Size of Practice
6. Repetitive Client Revenues
7. Practice Structure and Owner Involvement
8. Client Satisfaction
9. Practice Area
10. Client Diversity
11. Geographic Location
The key lawyers at the acquired firm typically sign a 3- to 5-year commitment contract (thus avoiding the "pig in a poke" scenario).
In the future, the acquired firm's partners participate in the acquiring firm's compensation arrangement.
There is no fixed demographic of the acquired law firms; some large firms, as well as smaller firms, are currently in discussions, but to date, the ones that have actually closed have had revenue in the $5-$15 million range and a couple of primary partners. While a number of the firms approached to date are personal injury firms, a cross-section of other practice-area firms have also been contacted.
The MSO Challenge
As part of the purchase, the acquired law firms roll their historical "back offices" into the shared MSO. Obviously, the shared MSO intends to leverage its staff and expenses.
Obviously, to maximize the MSO's profits, which private equity participates in, the goal is to maximize the expenses/costs handled and charged back to the law firm (with a fee attached).
AI (the purchase, financing, and support) is one expense that private equity brings the financial wherewithal to handle. Pretty straightforward that it's an MSO expense. A second potential benefit of private equity's involvement is the development of a comprehensive business development plan that leverages external expertise, an action many firms would not undertake for various historical reasons.
However, there are some expenses that, while historically viewed as law firm expenses, can appear under the MSO menu, such as paralegals (jurisdictional), litigation financing, disbursement financing, software development (which can impact how lawyers practice law), and recruiting, to name a few.
The contract between the law firm and the MSO is subject to obvious scrutiny by the bar societies.
While MSO will price its services in line with current law-firm rates for similar services, the financial power of private equity can directly affect its profitability. A potential concern for the MSO is CRA's formal–informal guidance on a maximum 15% markup.
What is the Underlying Difference
Banks provide cheaper, simpler debt without ownership change; private equity provides growth capital and strategic partnership at the cost of equity dilution.
The real decision for law firms is your partners' appetite for outside governance. Given the costs associated with running a law firm today, I expect deeper pockets with less personal liability will have increasing appeal (particularly if no one is telling them how to practice law).
Who Is Stephen Mabey?
He is the Managing Director of Applied Strategies, Inc. His credentials include:
· Fellow of the College of Law Practice Management (one of 19 Canadians – 276 Fellows);
· Author of Leading and Managing a Sustainable Law Firm: Tactics and Strategies for a Rapidly Changing Profession and Key Performance Indicators: An Introductory Guide (Amazon);
· Co-founder of East Coast Legal Ops, focused on bringing together the people who support the business of law. We deliver this support via conferences, private presentations, and insightful articles.
· More than 25 years in a senior management role with Stewart McKelvey, a 220-lawyer, six-office Atlantic Canadian law firm;
· Over 16 years of providing advice and counsel to small to mid-size law firms on a broad range of issues;
· A past panelist and facilitator of the Managing Partner Information Exchange ("MPIE") at the annual Managing Partner Forum Leadership Conference held in Atlanta, Georgia, each May;
· A group mailing list that circulates articles, directly and indirectly, impacts law firms and offers free mini-benchmarking surveys.
He has been advising law firms for over 16 years on a wide range of issues, including - strategic action planning, leadership, understudy (succession) planning, compensation - both Partner and Associate, organizational / governance structures, partnership arrangements, business development, capitalization of partnerships, partnership agreements, lawyer & staff engagement, marketing, key performance indicators, competitive intelligence, finance, mergers, and practice transitions.
Applied Strategies Inc.'s website contains references from clients describing the value of the services rendered:
https://www.appliedstrategies.ca/client-testimonials
Steve can be reached by:
Email smabey@appliedstrategies.ca
Phone 902.499.3895
[1] The Alliance has published a guide focused on personal injury firms titled : Building Ethical, Value-Focused Partnerships: How Personal Injury Law Firms Can Engage Private Equity to Unlock Capital, Fuel Growth and Create Rewarding Exits