Law Firm Mergers and Acquisitions

The UK legal profession has remained largely unchanged for nearly three hundred years, but new legislative changes have compelled it to change its working practices, processes, and traditional structures.

The legal profession has been run in the same way for hundreds of years; the traditional model of “the partnership”, where individual solicitors became personally wealthy but no profits were maintained in the business itself. Nothing, generally speaking, was done to promote branding and generations would pass on the name of their solicitor through word of mouth to promote their services.

In fact, solicitors were not allowed to “market their services” and relied on existing clients to recommend them or visit the busy high street where most practices relied on footfall from passing trade.

Why was the legal profession targeted for change?

There has been talk of legal services reform for many years and the protected market enjoyed by solicitors eventually had to change. The partnership model, where all profits were withdrawn from the business, leaving no funds available for investment in technology and processes, was simply not sustainable.

Back in 1997, we began the process of change with the commencement of the reforms recommended by Lord Woolf, closely followed by the Clementi Review which fundamentally challenged the way the profession was managed and how legal services were being delivered. This naturally led to the Legal Services Act of 2007.

This brought forward the decision that the profession could not be both represented and regulated by the same body, The Law Society. Hence the birth of the Solicitors Regulation Authority (SRA) back in 2007, which slowly began the process of reform.

Prior to 2007, all solicitors firms had to be operated as a professional partnership with all the flaws mentioned above - hence the beginning of the Limited Liability Partnership (LLP) and subsequently the limited liability company.

We also had a male-dominated ownership model and it has taken many years for the glass ceiling to be broken before we saw the rise of the female partner and, subsequently, the female managing partner. When you consider that for the last decade the new trainees joining the profession are 70% female, it was only a matter of time.

However, the legal profession has been slow to adapt to change with older partners still providing legal advice into their seventies and even eighties. ‘Why’, you might ask. The challenges of merging or selling a practice are complicated and unlike most other businesses, where you can walk away, solicitors firms are subject to providing run-off cover on their professional indemnity insurance. This cover is valid for six years after sale or closure but costs are an eye watering average of three times the annual premium and, when you consider that 11% of claims arise after the six year period, the individual owner is personally responsible for meeting these claims.

Traditional Mergers and succession planning

In the past, every young solicitor aspired to be a partner in their firm and as the elder statesman / senior partner was looking to retire. There was always a group of aspiring younger potential partners waiting in the wings to take their place. Over the last decade, this aspiration has changed with both salaried partners and senior associates no longer looking for partnership/ownership roles.

The responsibility of a partner was often not explained; as being an owner of a solicitors’ practice comes with considerable responsibility and risk to the individual, who are liable for other partners’ errors and mistakes. If a practice gets into difficulties, all partners are jointly and severally responsible for professional indemnity claims, bank overdrafts, and loans. Even if they were simply a salaried partner.

Therefore, over the last decade, we have seen a reticence amongst salaried partners and senior associates to become owners of a practice whatever the corporate structure.

There are numerous examples where we have a managing partner syphoning client monies for their personal lifestyles, and the firm then being intervened by the regulator whilst all other partners are held responsible for the breach of trust and fraudulent actions. By the actions of one partner, the remaining partners were held responsible by the all-encompassing “ought to have known”.

Why would a younger aspiring solicitor wish to take such responsibility and risk?

Over the past five years we have seen less and less firms finding their succession and exit route from within the practice. Solicitors no longer aspire to become owners whatever the structure. And who can blame them?

An example of this is a firm that thought that, by incorporating into a limited company with limited liability, their salaried partners and senior associates would jump at the chance of investing in their future under this business model; just as the existing owners had done some thirty years before. In this instance, every potential investor declined the opportunity and wanted to remain as a fee earner and not an owner of a firm - citing that the risk and liabilities are too great.

All they wanted was to use the skills they had learned, and earn a good salary without the responsibility of ownership and the risks that it entailed. Needless to say, that left the existing owners now in their late fifties and early sixties with a succession issue that they thought, maybe naively, had been resolved by incorporation.

These examples highlight the changing crises that the legal profession is facing regarding exit and succession planning. If we extend the example above across the profession, then we are facing a minimum of three thousand firms in that position, with some being even in a worse position.

The Growth of the Consultant Solicitor Model

Various reports are predicting that around 40% of solicitors will be working as self-employed consultants by 2026. The growth of the firms offering such opportunities has been staggering and this has created a real challenge in finding new talent for all sizes of practices. In fact, it has put significant upward pressure on salaries which may or may not be sustainable in the mid-term. 

The growth of remote working has encouraged individuals to make a lifestyle choice about working from home and, as both turnover and profitability has risen for both the individual solicitor consultants and the firms they work for, this trend will continue. This change was accelerated by the pandemic and will be the demise of the traditional practice model.

One of the challenges to the new model is ensuring the consultant solicitor is capable of generating and converting new business. The consultant solicitor may have a following which is a good starting point but, when they have been employed and been fed work from the traditional firm, they sometimes find it difficult to recognise the importance of marketing themselves if the new consultant solicitor firm does not provide them with a steady workflow.

Many find this “eat what you kill” mentality tougher than they first thought, and many of these should arguably be trained in the world of networking, marketing, and converting new business.

What will happen to the High Street Practice?

As mentioned earlier, there are circa 3,000 practices considered at risk. These are a variety of sole practitioners, two, three, and four partner firms, and they all have something in common. The age profile of the owners is in the sixties and seventies, with no succession and exit planning in place. If we accept that younger solicitors no longer aspire to ownership then where will these firms end up?

Sadly, many of these practices no longer have a value with their clients ageing along with the owners, and it is unlikely that a buyer will come along to acquire the firms. That may not be true of all firms, particularly if they have a significant will bank. However, many will banks have remained untouched for many years and have never been approached about upgrading wills and adding value added services, such as Lasting Power of Attorney, Trusts etc. Many high street practices have relied on residential conveyancing to provide a relatively quick cash flow but, as we have seen, it is fraught with risk. Many of these firms had not invested into robust I.T. systems, making it much harder to allow remote working and therefore insisted that staff came into the office. These are the staff that are being approached by other practices that can offer remote and more flexible working.

The lack of investment in technology and the lack of succession planning can only mean that these firms are on a downward spiral and it can only be a matter of time before reality sets in. It will be very difficult for these firms to find another firm to merge with, as no one will want to become a successor practice. The only way many of these firms will be able to exit is to go through an administrative process and all the financial and personal pain that involves. The “pre-pack” administration is when a buyer will purchase the assets of the practice but not take on the liability which might include bank debt and other loans.

This may become the only solution for these firms when a potential purchaser will only wish to acquire the assets but not the liability.

The Trend in Professional Indemnity Premiums

The closure of the Solicitors Indemnity Fund (SIF) back in 2000 encouraged new entrants to enter the professional indemnity market and, because of this increased competition, drove premiums downwards. In fact, for the best part of twenty years, the legal profession enjoyed a very soft market in professional indemnity premiums. Since 2019, this trend has changed with fewer insurers wishing to be in the market. Therefore, a gradual rise in premiums began before the pandemic really got started. 

Without a robust IT platform and with home working becoming the norm, the insurance market anticipated higher claims for some firms. By bringing in the stamp duty holiday, coupled with the drive for the public to leave town and city centres, looking for more space meant that every conveyancing solicitor was working extremely hard to keep up with demand. The PI insurers saw this as a greater risk and thus began the substantial rise in premiums. A rise in premiums of 30% year on year was not uncommon and this greater pressure on firms to meet the premiums further exacerbated any financial issues they might be experiencing. 

Some insurers would not even provide a quote if more that 25% of turnover came from conveyancing. We have seen premiums rise in one instance from £7,000 in 2019 to £56,000 in 2021 and this is not uncommon.

For the time being, there is no indication that premiums will fall as there is no new capacity in the market so the trend will be for premiums to rise.

Therefore, if a firm is facing these rises in premiums and as the economy slows and income drops, what options do these firms have?

What’s my Law Firm Worth?

The simple answer is what someone is prepared to pay. The term “goodwill” seems to have disappeared from the lexicon of law firm mergers. Historically, a merger between two firms of equal size could easily be carrying a large amount of goodwill in the balance sheet – the goodwill is in the people, the partners, owners, and senior staff. When a partner retired, the goodwill would retire with them, therefore creating an overstated value on the balance sheet. 

Solicitors coming towards retirement would traditionally expect their salaried partners and senior associates to take out a partner capital loan, often secured against property which would be paid off over a long period. The number of firms I have seen who simply expected that their juniors would willingly wish to do this just as they had some thirty years before! When we consider that the intake into the profession each year has been around 70% female for several years, why would they burden themselves with huge debt just to pay the capital accounts of the retiring partners?

Finding internal buyers would be the ideal solution, but planning for succession should begin at least 10 years before the planned exit, but many firms have left it far too late. Training younger members of staff to run a business is an essential part of the process – they need to know all the intricacies of running a solicitor practice.

As we previously covered, external buyers are looking for no risk transactions and some firms may be forced into the pre-pack route.

Is there such a thing as a true merger in today’s market? Probably not, there will usually be a buyer and seller.

The Growth of Private Equity

As part of the planning process review, the availability of private equity partners as an external source of funds – there are a plethora of consolidators who are acquiring smaller and mid-sized practices. There is rarely a pot of gold on the table, but an earnout over a period of years, encouraging the existing owners to continue running their business.

The advantage of the consolidator is to avoid the duplication of support in each firm. By centralising certain functions such as finance, I.T, and marketing in one central location, economies of scale can substantially improve the bottom line.

There is no shortage of consolidators, but they are careful in their choice of firm – geography, size, profitability, and a youthful management.

There is no doubt that the legal landscape will look very different in the coming years, with larger PE-backed consolidators and very niche practices alongside the process driven volume factories in conveyancing, will bank cleansing etc. 

Conclusions

The legal profession will change beyond recognition over the next decade with new business models arriving and some failing. Anything that can be processed will be, and this means that there will be little room for the generalist solicitor practice.

The Consolidators will continue and floatation on the various stock markets will, too. I suspect the consultant solicitor model will not grow as predicted for the reasons outlined above.

The merger and consolidation of smaller and mid-sized practices will continue and as succession and exit strategies evolve we will see greater consolidation.

There will be niche practices such as family law that will create their own models.

Technology will drive the change in the profession - ignore it at your peril. If a law firm is to survive, embracing apps and technology will be a must.

How will legal services be purchased in the future? Will it be technology-led and will all processed legal services, the mainstay of the high street, be in the hands of a few?

We are not the last profession to face significant change, but we must adapt to the demands of our customers (I suppose we should stop calling them clients, or should we?)

Viv Williams