First published by The Lawyer on 9 July 2012
Capital value. When was the last time that was top of the agenda at your partnership meeting? Never? Is that surprising? Not if you consider that law firms are all about profit, and capital only gets a look in when, Dewey & LeBoeuf-style, partners start asking for theirs back.
For James Caan, erstwhile star of BBC reality show Dragons’ Den and an entrepreneur who likes to talk about his “25 years in business”, this makes no sense. Having just committed to a long-term investment in Newcastle-under-Lyme’s Knights solicitors via his investment vehicle Hamilton Bradshaw, Caan is a big believer in capital value.
“Ultimately, law firms sacrifice capital value for income, but income is one times earnings while capital value is up to seven times earnings,” he muses. “I could draw out a £1m profit share or leave it in there to create seven times ebit [earnings before interest and tax]. If I compare the legal industry to the HR industry, they’re both people businesses: they’re fee-based, they’ve got the same financial dynamics.
“[Recruitment businesses] are sold in the market for five to six times earnings. The market will pay that. The reason it wouldn’t pay that for a law firm is that each year the profit is taken out.”
Original synergies
The law is hardly an attractive proposition for a man who has famously made a fortune out of his recruitment empire, you may think. But it is precisely his experience of the recruitment and HR markets that has led Caan to look at the legal sector, even if it can’t see the ROC for the PEP.
“I come to this from the point of view that I’ve spent the past 25 years investing in people businesses,” he explains. “When I look at the concept of financial services, advertising, headhunting, recruitment and HR, most businesses have the same dynamics. If you run an accounting business you have two primary costs: facilities and people. If you look at a law firm, it’s precisely the same. The commercial model is how productive the workforce is against the cost base.
“If a law firm bills, say, £300,000 a year, you’d like fixed costs to be £100,000, people costs to be £100,000 and a third as profit. I understand the financial dynamics of the business model pretty well. Having been in business for 25 years I get the concept of scalability of a professional services firm. That’s clearly an opportunity.”
But it is not an opportunity many are willing to take advantage of. For the handful of private equity investors that have expressed an interest in the post-Legal Services Act market, the traditional partnership model has so far proved too great an entry barrier to overcome. Consequently, Duke Street Capital has gone down the commoditised route, with its investment in personal injury business Parabis – the parent of claimant brand Cogent Law and defendant brand Plexus Law – awaiting SRA sign-off.
Similarly, Bowmark Capital is preparing to strike a deal with specialist insurance firm Keoghs, while Lyceum Capital is eyeing opportunities in legal services generally rather than law firms per se.
For Lyceum co-founder Jeremy Hand, who in 2009 committed £25m to business process outsourcer Laureate Legal Services, it is law firms’ devotion to partnership and all its trappings that is proving something of a turn-off.
“When I look at a law firm I ask myself whether the strategy and USPs, partnership model, decision-making process, IT infrastructure and method of delivery combine to make a future winner or a legacy player.” Hand ponders. “Some other business models are more compelling – legal verticals with newer platforms are more exciting, for example.”
Perhaps, then, Caan’s investment is about trying to stand out from the small crowd, driven by his father’s mantra that to be successful in business you should “observe the masses and do the opposite”. Either that or he has found the perfect partner in Knights – or, more precisely, in managing partner David Beech.
Buy and buy
Having run North West firm Heatons for 12 years, Beech has a deep understanding of the private equity model. Not only did he break Allen & Overy’s exclusive relationship with now-defunct Icelandic investment group Baugur, advising it on a string of multimillion-pound deals such as the £110m acquisition of UK retailer Goldsmiths and £152m buy-out of high street clothing chain Oasis, but he also raised and managed a private equity fund.
On leaving Heatons in 2005 Beech joined private equity house Arev, where he managed a fund alongside former Baugur international operations chief Jon Scheving Thorsteinsson and former KPMG partner Andrew Manders, investing in retail brands such as Jones Bootmaker and Mountain Warehouse. Heatons’ Stoke office, meanwhile, was spun out by partner Stephen Myers to become Myers & Co just months after Beech’s departure.
For Caan, this background, and the fact that Beech has been a full-time CEO-style manager since joining Knights in 2011, has been key.
“David’s role is as close to a chief executive in a private company as you can get,” says Caan. “A chief executive has to be a decision-maker. To run a business in which it takes eight people three months to make a decision is not the way to create efficiencies. One thing the industry needs to take on board is the principle of having someone run the business who’s not a fee-earner. What I’d consider to be operational decisions in a firm often appear at partner meetings. If you compare that to a private firm it wouldn’t happen; an individual would make the decision in a day. That’s how you create efficiencies but also speed up execution.
“You can’t grow a firm unless you unleash the talent in the business – you’ve got to let the genie out of the bottle.”
Before that genie can be let loose, though, there’s an elephant in the law-firm-investing room that needs to be addressed – the simple fact is that most law firm partners would argue that their firm does not need capital.
It is for this reason that Caan is targeting firms of a certain size – the nine he is talking to have a turnover of between £2.5m and £15m. Knights turned over a little over £9m in 2010-11, the most recent financial year for which LLP accounts are available.
Profitability is a key consideration too. Regardless of a firm’s turnover, if its profit margin and PEP are high, partners will be reluctant to swap profit shares for salaries even if a capital injection could transform the business.
With the highest-earning of Knights’ nine equity partners receiving a share of just under £200,000 in 2009-10, it was still possible to offer partners an attractive salary without them feeling short-changed. For a firm with PEP of £500,000 it would be a much harder sell. Which is not to say it was an easy decision for Knights, or its partners, to make.
Appetite for growth
“It’s a really emotional decision as well as a business decision,” says Beech, adding that ultimately “the partners saw the benefits to the firm and therefore to themselves.”
What swung it was the firm’s voracious appetite for growth and the recognition that to achieve that in any meaningful way it was going to need – that’s right – capital.
Although the firm markets itself as an outpost for City firms looking to offer lower-cost solutions to their clients – most notably as part of Hogan Lovells’ ‘Mexican Wave’ – to scale this up it needs to pour some serious investment into people and branding – two things Caan has built his entire career around.
“In the modern economy, brands have overtaken the way we do business,” explains Caan. “You have to define what your brand is – what it stands for. People associate brands with specialisms so I’d say a firm should be a specialist. If you’re going to do M&A you should have an M&A brand. You could have a firm that sub-brands all its specialisms – let’s have a litigation brand, let’s have a property brand. Customers want to feel they are getting an elite service from people who are specialists; it’s easier to attract talent when you’ve got a strong practice.”
Knights’ experience with the Mexican Wave is a key starting point, yet also one that, for Caan, highlights the disparity between the way law firms and entrepreneurial corporates are run.
“If I’d developed a new concept [like the Mexican Wave] I’d have gone out and done 10 of those by now,” he says. “One of the key challenges is how to replicate that model across 10 clients.”
And while many businesses have embraced Mexican Wave-style models of working for the cost savings they bring, Caan aims to go one step further with Knights, marketing the firm not just as a go-to adviser, but as an in-house adviser too.
“I like the concept of going to organisations and getting them to outsource legal work,” he says. “I’d like to go to corporates and get them to outsource their entire legal function to Knights.”
Build it and they will come
So far, so ambitious, although there is only so much a 140-person firm can do. But at a time when larger firms are cutting staff to maintain or boost profits, the move away from the traditional partnership model has freed Knights up to take on more capacity in preparation for the uptick in work.
“We’ve taken on 10 lawyers in the past two weeks, which has created some nice extra capacity,” says Beech. “We’ve sought to get the capacity first, then we’ll get the work in – we’re now in a position where we can afford to do that. Firms are often under pressure to utilise as they go, but we’ve got plenty of utilisation.”
That may seem like an odd business decision, especially as there is no guarantee that corporates or other law firms, which have a vast regional market to choose from, would want to punt work Knights’ way.
But Caan has big plans for his move into legal services and, given that one of the firms he is talking to at the moment has just one partner, he believes there is scope to leverage off one portfolio firm to benefit another, whether that be through wholesale consolidation or piecemeal sharing of systems.
Ambitious minds
“There’s no question that the concept of identifying firms that have the same ambitions of scale, size and capital value is something we’re committed to,” he says. “But we’re aware that in law firms, culture plays an important role. Only where we feel there’s the ability to do a real merger would we consider that.”
For Beech, it makes sense to use an investment in one portfolio firm to benefit others.
“We’ll be open to all opportunities,” says Caan. “We’ve got a strong back office as it is and we’ll strengthen that with IT investment. There’s no reason why we couldn’t be using that back office to supply other law firms, whether they’re integrated with our people or not.”
Now all Caan has to do is build his law firm portfolio and watch the empire grow, but that could be the hard bit.
Recognising the differences between investing in a conventional private company and a partnership, Caan acknowledges that the pool of firms he can pick from is limited.
“It comes down to ambition, drive, retention, market share and capital value,” he states. “If a firm doesn’t have those attributes, it doesn’t work. There’s no point trying to make it work because you’d be trying to force a square peg into a round hole.”
For now, that is.
“Financial services was turned on its head when it was deregulated by Margaret Thatcher’s government,” says Caan. “If you look at the commercial scale and size of that industry pre- and post-Thatcher, it’s 10 times bigger today.
“Change takes a long time to implement and you need a change of mindset. Eighty per cent of the market may wait to see what happens, and that’s okay because you never have a tsunami of change. Change takes time and the tsunami comes at the end, but change is coming – the Government has let the genie out of the bottle.”
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