PE Investors Have the Legal Profession in Their Sights—But Only Those That Get the Right Talent Can Make it Work

Paul Hodkinson's thought-provoking recent article (Big Law has heard it all before) suggested the time may finally have arrived where private equity disrupts the traditional law firm model in a meaningful way. As someone who has been heavily involved in disrupting the traditional model previously in setting up and building London offices for U.S. law firms, I believe the time is ripe for disruption of the type he contemplates.

I encounter many market players who believe the existing model is fundamentally broken. Rates cannot continue to rise inexorably. The rewards on offer to lawyers seem increasingly out of kilter with the value they bring.

The most prestigious law firms in London register profit margins of around 40%. Yet look at the growing band of ‘platform’ law firms and litigation boutiques and you’ll frequently find margins in excess of 70%. Those margins are delivered through working on a fixed fee basis and within a leaner, lower-cost model. Private equity should want to understand why that discrepancy exists.

Private equity is attracted to industries where it sees inefficiency and an opportunity to out- compete incumbents by lowering costs. The traditional law firm hourly rate model positively encourages inefficiency. What’s more, it goes directly against what clients increasingly want from their law firms—certainty around fees.

In return for providing the client with the certainty of a fixed fee, a firm could demand more certainty over its workflow and effectively ‘bulk buy’ client work it can deliver profitably.

Building that reliable pipeline of revenue is a key element of making the model work for a PE investor.

A private equity-backed firm need not undertake the type of work most often undertaken by platform firms—high-volume, low-cost work. With a combination of rigorous cost control, injecting better quality management and incentivising the leadership team appropriately, a firm should be able to generate returns that work for both the investor and the clients. Is this not the classic win-win?

The platform model would also allow for PE to create multiple 'silos' or sectors within an overall framework. Each could in time be developed and then 'sold off' to management, allowing for the exit PE wants and the freedom the partners will want to run their own show.

It is worth noting here that it is not only PE that is looking at the model I am describing. Litigation funders are also thinking along the same lines, and they operate without a fixed timescale for an exit. The ‘five to seven years’ PE lifespan certainly need not be a barrier to investment.

When it comes to the talent to build a firm, a model with a few high-quality equity partners and a group of talented junior partners and senior associates is one that PE funds may explore. Those lawyers could be supported by a pool of interim talent that would be scaled up or down as demand required. Interim talent pools are a fast-growing part of the profession and this model would provide an excellent use case.

Paul's article flags some potential stumbling blocks and hints at a possible way forward for potential PE investors. Conflicts were an issue for the Big 4's legal ambitions and are increasingly so in Big Law generally. The right incentives and equity model would need to be developed to attract the best talent whilst giving the PE house their return. Any firm that is created needs to be seen as 'neutral' and not simply a vehicle of one particular PE house. How can naturally risk-averse partners be persuaded to accept a ‘jam tomorrow’ compensation model, and can a PE house commit to holding a longer-term investment?

No one is saying it will be easy but the building blocks are there. The ‘star’ lawyers are looking for a way to create a legacy and truly monetise the businesses they create. In a sense that is what we are seeing with the eye-watering incentives being offered to the PE and leveraged finance partners who have moved to the top U.S. firms over the last few years.

It is not only private equity that sense their day has come. Users of legal services may feel they can use their muscle as clients to create a more affordable law firm offering. Intermediaries like the Big 4 previously are also sensing the opportunity and setting up their own vehicles. Disruption is not only on the horizon. It has been with us since large U.S. firms decided to enter the U.K. legal market in the late 1990s. True third-party ownership of law firms is simply a logical extension of what is already there and proven to be successful. The only surprise is that it has taken so long for the idea to have come to the forefront.