UK lawyers may see a ‘Brexit Bonanza’ surge in demand as clients seek advice on changes to legal and regulatory environments. At the same time, law firms have started forming ‘Alternative Business Structures’ and take on outside investors.
This confluence might push lawyers and investors to explore new marriages. There have been early successes but also cultural clashes.
Part 1: The post referendum legal market
Pre-referendum, a lot of noise was generated about the impact of Brexit on the legal sector. Much of it was negative: “Law firms will bear the brunt of Brexit, lawyers warn” declared a column in The Telegraph. Two factors dominated the pro-remain argument:
- A predicted decline in UK economic activity and more specifically, in major drivers of legal services such M&A and FDI transactions.
- The potential loss of being able to practice law across the EU as allowed for under the lawyers’ directives (the solicitors equivalent of the financial services ‘passport’).
In the immediate aftermath of the vote many law firms feared a violent sector shock and some publicly considered actions such as staff pay freezes. On the face of it, the environment did not look conducive to attracting investment.
Three months post referendum, a more detailed look by investors may be warranted.
Whilst there is still justified uncertainty about the general economic drivers of legal services, there has been no obvious boom or bust in either UK economic activity or ‘deal flow’. GDP forecasts were slashed and then re-adjusted upwards. Predictions of a major crash in deal flow seemed premature as major deal announcements continued, probably most notably UK chipmaker ARM being acquired by Japan’s SoftBank for £24bn. SME deal flow has also held up according to the Cass/Lyceum Capital UK Growth Buyout Dashboard.
The ‘loss of passporting’ is less of an issue for investors as it is for lawyers. It is indeed a possibility that lawyers could lose the right to practice across the EU should the UK leave the single market, and lawyers’ adverse reactions to this risk is understandable. However, from an investors perspective only, does it really matter if a lawyer is registered and based in Dublin instead of London to deal with EU specific legal issues if he or she still works for the same firm?
Investors should also be considering an additional market force that has subsequently gained prominence – a Brexit driven demand for legal services. Post referendum, major law firms have set up Brexit hotlines, teams and departments and are now actively marketing these services to advise clients on the inevitable changes to legal and regulatory environments. International trade, corporate restructuring, commercial, contractual, employment and immigration law are only some of the obvious areas that will require a boost in legal advice. Joseph Andrew, global chairman of Dentons, was quoted as saying “It’s an unfortunate truth that it is bad for business and a bonanza for lawyers”. Speaking on CNBC, Pippa Malmgren (@DrPippaM) jokingly described Brexit as the “solicitors full employment bill” (or words to that effect). She went on to build on this comment in a later article, predicting “that many fortunes will be made in the British legal profession“.
Part 2: Demand for outside investment
Demand is real but law firms are proceeding with caution.
In 2012, law firms were granted the regulatory flexibility of setting up an “Alternative Business Structure’ or ABS. This allowed firms to have non-lawyers at manager level as well as non-lawyer investors.
Of the 10,000+ law firms in the UK, to date 540* have set up ABS’s , with take-up spread across large and small firms. ABS registrations continue to show steady growth as 2016 exceeds 2015 by 20% on a year to date basis*. According to research by both the Solicitors Regulatory Authority and the Legal Services Board, about one third of ‘ABS firms’ have or intend to change the way their firm is financed. The LSB survey showed the main focus of lawyers’ intended spend of new external investment as being in technology, delivery channels and marketing followed by developing non-legal services, adding on new legal services and recruiting staff with new skills. Clearly this segment of just under 200 law firms have seen an opportunity to invest in growth and are not continuing on a business-as-usual basis.
How many of the remaining 10,000 law firms will convert to an ABS structure and seek external investment remains to be seen but the trend is favourable.
There are already tangible examples of successful external investments in law firms but not without some problems:
- James Caan’s private equity vehicle Hamilton Bradshaw took a stake in Knights solicitors in 2012. Although transaction details have not been publicly disclosed, the firm grew turnover from £9m to £16m and profit from £600k to £3m** during the approximate period of his shareholding (HB exited in 2015). Mr Caan was however quite candid in disclosing that the investment journey was not all plain sailing as he encountered resistance to investor ideas such as significant spend in IT and working practices refer this link.
- In 2015, Gately became the first commercial law firm in the UK to adopt an ABS and list on AIM, investing £5m of its listing proceeds on growth initiatives. The firm sees its ABS and listing as providing structural advantages for both organic and acquisitive growth, including an enhanced ability to attract and retain talent; additional financing and deal structuring options; and enhancing the visibility of the firm. Investor returns are 20%+ since the Nov 2015 listing (as at Sep 2016).
Linking the legal market and investment environments:
Gately also provides an interesting and relevant link back to the ‘Brexit Bonanza’ argument. Being publicly listed, more financial, performance and outlook metrics as well as investor reactions are available. It is however, only a single data point and we flag the caution required in drawing conclusions from Gately data in isolation.
As a national UK focussed, mid-market law firm with a mix of corporate, banking, business services, pension and property work, Gately would be expected to be on the receiving end of a Brexit induced slowdown. The firm, investors and the only analyst covering the firm are sanguine on the point:
- Gately states with the release of its annual results on 19 July 2016 “No EU referendum impact immediately visible in our business … Our clients currently telling us the same … Encouraging start to FY17 but challenging environment remains … Management expect to deliver in line with expectations for the full year … Economic volatility promotes a need for legal advice (contract redrafting, changes in workforce, asset disposals, balance sheet restructuring etc) and promotes litigation ***“.
- Investors currently assign a respectable PE ratio of around 13 to the firm which is growing revenue at 10% and profits at 12%. Shares sold off by around 10% in the immediate aftermath of the referendum but have added 20-25% since then, clearly supported by the release of good full year results and a positive outlook commentary.
- Cantor Fitzgerald who, in a research note sent out following the results release, maintained a ‘buy’ rating on Gately, increased its price target for the shares and described the firm as “well positioned to grow across the economic cycle”. It also noted that its forecast of 8% annual organic growth did not allow for the “likely positive impact of Brexit as companies review their contractual arrangements”.
The legal services sector could present interesting individual opportunities for investors and consolidators, given the overlap of a very unique set of market conditions with the additional investment flexibility now available to the legal sector.
* Solicitors Regulatory Authority, Aug 2016
** Companies House Filings
*** Gately results presentation July 2016