Law firms outside the top 50 are the new ‘squeezed middle’. The burden of regulation is increasing, key practice areas are being commoditised, and closing is complicated and expensive. That’s where consolidators can come in. Mark Briegal and Nigel Haddon explain
The legal market is changing – and the pace of change will only quicken. The traditional model is proving harder to sustain. Renowned strategy guru Professor Michael Porter of Harvard Business School said that there are only three generic strategies for business: focus, differentiation and cost leadership. That model leaves the traditional high street firm in an unsustainable situation.
Life is becoming harder for high street firms
The top end of law sits in the differentiation part of Porter’s model, and there are a number of specialist or niche practices which follow the focus approach. And any part of the legal sector which can be commoditised – such as conveyancing, personal injury and probate – will be. That is the cost leadership part of Porter’s model.
That leaves the high street firms. There is still a need for them. Some clients like the personal touch, and certain practice areas, such as family, crime and employment, will continue to work well with a personal interaction between the client and a local lawyer. But life is becoming harder for these firms, as some services are creamed off by the commoditisers, profitability is squeezed, and younger solicitors are becoming less interested in the traditional partnership model and don’t want to take on the hassle and risk of running a law firm.
For these firms – neither sole practitioners nor part of the top 50 – consolidators are starting to play a key role. In this article, we take a high-level look at how consolidation works, the pros and cons for firms approached by consolidators, and the practicalities of making a deal.
The consolidation model
In the year to June 2018, 345 law firms closed and 154 merged or amalgamated. In September 2018, there were 10,456 law firms in England and Wales. Of these, 2,392 are sole practitioners, and the distribution by turnover has a long tail – to get into the top-200 firms list, you need a turnover of over £10m. In fact, over half of the 10,000 firms are either sole practitioners or have no more than three partners, with an average equity partner age of about 67 (in this article, we use the terms “partner” and “partnership”, but our comments apply equally to LLPs and incorporated law firms). Many of these are ripe for merger or acquisition.
This is when consolidators can step in. From the consolidator’s perspective, there are a large number of good firms with ageing partners who can’t see an easy way out. Closing a law firm is both difficult and expensive – there’s run-off cover, lease break costs, redundancy payouts and file storage to pay for. The consolidator can come in, potentially acquire the firm for a low figure, and then consolidate the back office with systems and controls and run it more efficiently.
There are a number of consolidators currently active in the market, including Cubism Law, Gordon Dadds, Metamorph, HCB, Echelon Law and Star Legal. A few years ago, we would have added Slater and Gordon to the list, as it was indeed a consolidator. Knights, now floated, is also pursuing a growth-by-acquisition model.
It is interesting to note that some of the earlier models did not work as well as expected. Slater and Gordon appeared to be working well until its disastrous acquisition of Quindell. This may show the need for consolidators to conduct their due diligence very carefully, rather than pointing to a fundamental weakness in the model.
By way of aside, it is worth considering the QualitySolicitors (QS) model, which aimed to give law firms a similar set of outcomes to becoming part of a consolidator, but without giving up their independence, which is a common fear among owner-managers. Our personal view is that QS was primarily a shared marketing tool with some common branding and access to help, but with no centralisation and therefore no economies of scope or scale. It worked well for firms with no marketing function which wanted to improve. It now seems to have lost much of its initial drive.
The pros and cons for law firms
Law firm partners may be wary of the loss of control: most, if not all, of the consolidators active in the sector are only interested in acquiring the entirety of a selling firm, which means no equity stake for the current partners.
However, there are a number of significant benefits to the consolidation route. Consolidators assume liability for your debts and your professional indemnity insurance (PII) cover, and, in many cases, help secure your release from personal guarantees to your firm’s bankers (a particular boon to those approaching retirement).
For those not yet looking at retirement, there are other compensations, such as repayment of your capital; a salary that matches or exceeds your existing drawings; and someone to take over the management of external relationships with the Solicitors Regulation Authority, insurers, landlords, and so on.
Firms at real risk of closure will also be attracted to the opportunity to ensure the firm and its legacy lives on, and that there are jobs for its staff.
Consolidators have the money to invest in new systems, which a firm may need but not be able to afford, as the consolidator has the ability to spread the costs across a larger cost base. Consolidators also have a larger central staff who can look at the use of technology in the business as a whole. All of this cuts costs.
And for many – tiring of the burdens of regulation, and the countless tasks that take them away from their professional work and looking after their clients – being free to return to the practice of law while leaving the business to others is a compelling attraction.
Making the deal
The key question asked by most partners selling to consolidators is “how much?” Consolidators tend to be fairly ruthless businesses. The final agreed price will depend on the selling firm’s bargaining power compared to the consolidator’s. Any business has a different value to a range of buyers depending on how it fits into their existing businesses, and the current state of the selling firm – how strong are its financials, its clients, its systems and its staff? If those are strong and it occupies a niche, either geographically or service-wise that the consolidator wants or needs, then a better deal can be negotiated. A ‘fire sale’ always gets a low price.
Consolidators have the money to invest in new systems … [and] a larger central staff who can look at the use of technology in the business as a whole. All of this cuts costs
While this is not an article on how to value a law firm, price is often a multiple of maintainable earnings. The consolidator will want to see that a firm either has good earnings or can achieve them quickly with some simple changes.
If the firm is incorporated as a limited company, the selling ‘partners’ will want to sell their shares, as it is neater and more tax-efficient, and the whole business passes to the buyer. The consolidator may well, however, prefer an asset sale, as it will not then acquire any of the liabilities of the company that it does not specifically agree to acquire. There may be some tax advantages to this approach for the consolidator, too.
One key issue to discuss is whether the consolidator will become a successor practice (generally the case), or whether it will require the target firm to purchase run-off cover, which costs on average two and a half to three times a firm’s annual PII premium. This will affect the price.
Other issues that can affect the deal are whether the sellers get cash or shares in the buyer, or a combination; and whether it is all paid in one lump sum on completion, or whether there is some form of earn-out. This all affects the price and the negotiations. Cash now is usually better than cash in the future, but an earn-out (which usually means that the sellers get more money if the firm generates certain levels of profits after the sale) will usually produce a higher price.
Another consideration is the ability to share cases across firms within the consolidator’s group and retain a fee share. If, for example, one firm cannot handle a complex piece of commercial litigation but another in the group can, that can be kept within the group. One of the consolidators pays a fee of 20% of fees earned for such a referral.
The demographics that we looked at earlier in this article show, it seems to us, that there has long been a huge number of small to medium-sized firms ripe for consolidation. The surprise to us isn’t that we are now seeing this consolidation gather momentum, but that it has taken so long for it to happen.
That can partly perhaps be explained by the years of austerity following the financial crisis, with a concomitant impact on some investors’ appetite for investment. Partly, we suspect it was down to the inherent conservatism of the solicitors’ profession (“We’re not going to talk to a business like that, are we? No one else is, that we’re aware of!”). And partly, no doubt, it was due to some high-profile failures (such as Slater and Gordon / Quindell and Cobbetts), some of which saw either investors or consolidators get their fingers burned.
Though it is too early for any sweeping pronouncements to be made, it would seem to us that most of the consolidators at work in the sector now have business models that are reasonably robust. Back-office costs are centralised. Local management remains in the hands of the sellers, and systems are rolled out location by location. PII costs are reduced by the power of bulk-buying, as are, for example, training costs.
The consolidators aren’t just coming, they’re here. Expect to see a lot more activity involving them over the coming years.