No free lunch – Will law firm IPOs be the next big thing?

For years it could, just about, be ignored. But no longer. The UK’s largest practices are being forced to consider a seductive, provocative, explosive question that strikes right to the heart of a law firm and what it means to be a professional: have they considered an initial public offering (IPO)?

By now, of course, at some level they all have, if only to construct a stock (no pun) rebuttal of the case for capital. But despite public dismissal by the leadership of the majority of top-25 UK firms, under the surface there is far more curiosity in this year’s string of legal floats.

‘You could publish articles about those that have considered it on 70% of the top 30, and that’s fine,’ observes Arden Partners’ John Llewellyn-Lloyd, the financial adviser to listed firm Gordon Dadds and a leading figure in the emerging field of law firm IPOs. ‘But the real question is: “Where are you in that process of assessing external capital?”’

The turnover of the top 100 UK law firms alone was more than £24bn last year. These firms generate a lot of cash, usually at high margins, and are resilient to downturns. At the same time, the world is awash with money looking for a lucrative home. Investors see a legal market rife with opportunity, whether for consolidation, New Law offerings, or just different ways of working.

But only five UK law firms have gone all the way to IPO since regulations were relaxed more than a decade ago, raising a meagre £158m between them. Four of those, however, have come in the past 15 months. Market observers believe only a third of those that have seriously considered coming to market so far have done so and that the time is ripe for a top-30 firm to go public.

‘You could publish articles about those that have considered floating on 70% of the top 30, but the real question is: “Where are you in that process of assessing external capital?”’
John Llewellyn-Lloyd, Arden Partners

Enter DWF and a touted £1bn listing early next year. Add to that expansive New Law players Axiom and UnitedLex positioning themselves for multibillion-dollar public listings in the coming years. Throw in substantive changes to the law firm model – evident even at industry leaders such as Allen & Overy and Freshfields Bruckhaus Deringer – favouring scalable platforms and process over simple reliance on individual legal brilliance.

Such calculations could overcome one obvious objection to going public: large firms have historically generated plenty of capital compared to their investments, but some believe that the demands for new models will change that. It is becoming much harder to dismiss law firm floats as a game for hustling high-street players.

‘For the right firm now, the planets of external understanding and interest are beginning to line up,’ argues RSM senior tax partner George Bull. ‘That gravitational pull will prove very useful for firms that undertake successful IPOs.’

Many law firm leaders can see reasons to float, but the problem remains the fundamental issue of how a law firm – as a people business with prime assets that can leave at any time – can reconcile the conflicting interests of partners with outside investors without bringing the whole enterprise crashing down.

If the firms lining up show the tension can be profitably managed, the momentum behind publicly-listed law businesses will be huge. As such, Legal Business spent weeks analysing those legal service providers that have listed, as well as speaking to dozens of bankers and financial advisers, to assess if this is a potentially radical force reshaping global law, or the latest in a long line of over-hyped detours.

‘We went viral’

It is early 2015. The legal press is full of speculation about a firm coming to market. UK firms are yet to follow Slater and Gordon’s pioneering float in Australia, but Irwin Mitchell, the first major player to convert to an alternative business structure, is the early favourite.

Out of nowhere, a Sunday newspaper publishes a story that a Birmingham-based law firm – Gateley – is to float. It is the day before the firm’s staff are due to find out, but more than a year since wheels started turning on the idea.

‘For the right firm now, the planets of external understanding and interest are beginning to line up.’
George Bull, RSM

In that year, most of the time has been spent convincing the firm’s relatively small partnership that an IPO is the right move. Michael Ward, Gateley’s now-chief executive, needs to get 75% of those 81 equity partners over the line: one partner, one vote – an abstention counts as a no.

Ward sees an opportunity to differentiate the firm as entrepreneurially-minded, as well as raise capital for acquisitions and incentivise staff in a different way. Partners, of course, care about what it will mean for their pockets.

If the first thought that comes to mind of floating a law firm is investors injecting money, in reality the trade-off Ward is facing is less enticing. Every partner, irrespective of seniority, is told they need to agree to a substantial salary sacrifice to about £120,000. LLP profits are paid to partners, but a listed firm needs to turn a profit after partners have been paid. This reflects the fact that what is commonly known as a law firm’s profit pool is, to most industries, an accounting sleight of hand.

The equation initially means Gateley partners will earn less in a listed company. They are told they all need to agree to a lock-in for five years post float and will only be able to sell up to 10% of their interest in any 12-month period after the first anniversary of admission. Easy money starts to look a lot less, well, easy.

It is not unanimous, but Ward gets there. Local Bar rules mean the Scots arm, HBJ Gateley, will not be able to be part of the float either. Now the firm needs to convince financial institutions to invest. That involves three intense weeks of one-hour presentations – at five a day – all across the City. The roadshow is exhausting.

‘We’ve increased our opportunities as a result of the float.’
Michael Ward, Gateley

‘It’s not a straightforward process,’ Ward ruefully reflects. ‘The physicality is not the most difficult bit; mentally, it’s tougher. You’re presenting your wares 61 times and you don’t know if anyone’s interested.’

One fund manager initially says they would never invest in a people business due to the risk of key talent leaving. The response is to point out that their fund’s largest shareholding is in a technology company, where arguably all the intellectual property and value lies with one person, the chief technology officer. It gets the point across.

From marketing, ten institutions invest in Gateley. It raises £30m at a £100m valuation, with £25m going to partners and £5m to the company. On 8 June 2015, Gateley becomes the UK’s first listed law firm. The pay-off is almost immediate.

‘We went viral,’ Ward comments. ‘We had piles of clippings all over the place. We went from being the Gateley that nobody had heard of, to one that almost everybody had heard of. That doesn’t lead to success on day one, but there is a recognition and then you build on that.’

Three years on, Gateley is widely considered a success. Its market cap has nearly doubled, with revenue for the year to 30 April 2018 up 11% to £86.1m. It has made four acquisitions – although only one other law business – diversifying into areas such as tax advisory and property consultancy. It has made 30 lateral hires post-IPO – its batting average beforehand was no more than three a year. Interest was piqued by the listing and a recruitment consultant once asked a candidate to interview at Gateley just so they could report back on its model.

More than 60% of the firm’s employees are now enrolled in one or more of three share participation schemes targeted at differing levels of seniority. Ward believes listing helps on the client side too, in differentiating the firm.

In floating, and convincing partners to take a pay cut, revenue growth assumptions were made alongside how the share price, profits and dividends would react. If revenue grew by a certain percentage, partners would be better paid. This incentivised partners to improve performance, while also delivering to investors. ‘It’s a meeting of the minds,’ says Cantor Fitzgerald corporate finance director David Foreman, who advised Gateley.

Just three partners have left since listing – none to other law firms (the lock-ins allow for people to leave, but equity partners who do so during the period forfeit their entitlement to quoted shares and have repayment obligations relating to the cash proceeds received at IPO).

The big test will come when the lock-ins expire in 2020. Notes one adviser: ‘You wouldn’t want a prisoner’s dilemma situation where all these partners are looking at each other, thinking, “Who’s the first out the door?” They may want to sell first to get the best price.’

But nonetheless, Ward is pleased with how the float has gone (or a very good actor). The increased disclosure requirements means he cannot use as much ‘flowery language’ as others when talking about the outlook, but this suits his understated manner: ‘That’s the life of a listed law firm: you don’t want to disappoint investors, but you don’t want to overhype your position either.’

Going corporate

The four firms that have followed Gateley all bring different propositions. It took more than two years for the second, Gordon Dadds, to float, before Keystone Law, Rosenblatt and Knights followed.

A rough rule of thumb for the roadshow process is a firm needs to present to at least 40 institutions to raise between £20m and £40m, ultimately landing about a quarter of those, including two or three core shareholders. Keystone chief executive James Knight comments on selling to 50 institutions: ‘It’s very, very intense. It’s seven hours of seven different places and buildings you’ve never been to, day in, day out, for two weeks.’

A big difference with these four, however, has been in bringing a ‘corporatised’ model to market. Getting large partnerships to agree to sacrifice profit share to create a profit, in exchange for shares, gets more difficult the more partners you need to convince. Take Knights, the largest IPO to date after raising £50m in June. Chief executive David Beech, who has a legal and private equity background, acquired the then £8m firm in mid-2012 for a ‘low seven-figure’ sum alongside high-profile investor James Caan. Knights’ four selling shareholders got £20m in the IPO, including commercial operations director Mark Beech, facilities director Joanne Beech, Newcastle-under-Lyme office head Karl Bamford and non-executive chair Bal Johal. David Beech retained a shareholding of about 45% and has a three-year lock-in. Bamford, Johal and Mark Beech have a one-year lock-in.

The firm moved from a partnership – with seven equity partners – to a plc in 2012. It has a board of five and moved partners away from owners to employees. Its financial accounts changed and the argument is this private equity discipline improved performance. Beech comments: ‘The word profit gets confused. With our business for the last six years, profit is what profit says in the accounts – it’s been calculated after paying partner salaries.’

Stuart Skinner, managing director of the corporate broking and advisory division at Numis Securities, Knights’ financial adviser, says it was a well-received IPO. Numis has led on 57 in the last six years, with £3.4bn raised in 2017 from both IPOs and secondary fundraisings. There was almost £100m of demand for Knights’ £50m fundraising.

‘It’s intense. It’s seven hours of seven different places you’ve never been to, day in, day out, for two weeks.’
James Knight, Keystone

Many have been impressed by Beech. The firm has ambitiously stated it wants to acquire three law firms in the next two years (it announced an £8.5m deal for Leicester-based Spearing Waite in early October). However, cautions one large bank’s head of professional services: ‘You’ve got big pockets now and that money is sitting around the place needing to be deployed. If it’s sitting in a current account earning 0.5% you’re destroying value for the equity, but acquisitions might not be optimal if you do it just for the sake of telling the market.’

Keystone similarly had private equity ownership pre-IPO, when Root Capital bought out co-founder Charlie Stringer in late 2014, investing £3.15m. Its 297 fee-earners are effectively sole traders, with each keeping about 75% of the fees they generate. Its London reception proudly displays a photograph taken on the day it listed.

Keystone has the advantage in that what is being floated is effectively a platform as much as a legal business and a platform cannot walk out the door if it gets a better offer. Knight comments: ‘It was a very suitable firm to float in that it didn’t have to be sold internally. We’re not a partnership with 50 partners that need to be brought on board, which is one of the great impediments to law firm flotations.’

The firm’s five directors and some other shareholders have a one-year lock-in expiring this November – after which they can only slowly sell down over the next 12 months – another reason why Keystone is the float many advisers covet. The share price has rocketed since the IPO, up to more than 400p from 191p. Detractors, however, question the long-term future of its ‘franchise’ model.

One adviser comments: ‘When they retire their business stream effectively stops, so you are constantly having to find new people. My feeling is that in the longer term, more efficiency in the market as law firm models tighten and improve their IT will mean there are fewer of those types of lawyers around.’

Gordon Dadds was also acquired by a consortium in 2013, led by now managing partner Adrian Biles, while Rosenblatt brought in former Brands Hatch head Nicola Foulston as chief executive in 2016 with an eye to taking the firm public.

Gordon Dadds pitches itself as a mid-market consolidator, targeting distressed firms in particular: it is easier to pitch a move to public ownership when a firm is struggling. Biles is seen as highly ambitious.

This is evidenced in the firm’s potential merger with the waning Ince & Co, which is nearly triple Gordon Dadds’ size at more than £80m in revenue. Biles had previously talked up acquiring a £20m-£40m firm earlier this year and few saw a transaction of this size in its sights. Fewer still understand the motivation of adding an institutional law firm like Ince with no obvious practice crossover.

However, Rosenblatt attracts the most under-your-breath criticism: ‘Ian [Rosenblatt, the firm’s founder] took a lot of money off the table in that float,’ mutters one adviser. Rosenblatt’s net worth soared to more than £24m in his firm’s £43m listing in May. However, many are intrigued by the litigation funding arm established as a consequence of the float. Well-known funder Burford Capital has seen its value catapult, although Vannin Capital abruptly shelved its intention to float after a month because of volatile market conditions. Foulston says Rosenblatt is eyeing opportunities in the mid-market, £10m-£200m claims space. About £5m of the funds have been set aside for acquisitions as well, with the firm wanting to triple in size over the next three to five years.

‘If we make the call it’s not right we’ll walk away and we’ll do everything we were going to do, just slower.’
Andrew Leaitherland, DWF

Overall, the four firms since Gateley show corporatisation is key to smoothing the path to going public. One top-30 firm that had eyed a float met investor resistance and shelved its plans because of its partnership structure. Most also agree the larger the firm, the harder it gets. It took Gateley the best part of a year with 81 partners: imagine hundreds of partners across a multitude of jurisdictions.

Comments Skinner: ‘You need to corporatise a long time before [floating]. If you are corporatising at IPO you are going through probably the biggest cultural change the firm has seen. You are going through that at the time you’re asking external investors to come and put money in.’

A buzz cut

Which brings us to DWF. A quick recap: in June, the top-25 UK firm confirmed it was considering an IPO. In reality, the firm has been considering alternative structures for years and previously looked at an IPO.

A supposed £1bn price tag was reported but, after the laughter subsided, was quickly reduced to the £400m-£600m region. Based on valuations applied to the first five IPOs and discussions with bankers specialising in the area, even that price tag is high.

Pinning down the justification for floating is not easy. DWF managing partner and chief executive Andrew Leaitherland is used to getting his own way and is characteristically impatient with the process. It has been working with US investment bank Stifel on the float since October 2017.

DWF wants a structure that allows for broader firm ownership and believes investors have an appetite for a larger firm. Leaitherland comments: ‘We believe the two things will align perfectly for us: broader participation in the equity of the business and the ability to have this pot of investment to enable the boat to go faster.’

DWF has three parts, he says: the complicated, partner-led work; its managed services arm, providing volume and integrated legal services; and Connected Services, a division of independent businesses that help clients manage risk, reputation, cost, time and resources.

But these three pieces require investment – managed services saw some in August with the recruitment of one of the architects behind Freshfields’ Manchester legal services hub, Anup Kollanethu. Leaitherland says: ‘The proceeds of sale would allow us to invest significantly in the business, through M&A, investment in technology or other measures designed to drive the next phase of growth.’

As with every float, brand enhancement plays a part. Leaitherland claims DWF suffers from brand lag, meaning clients view the firm a few years behind where it now sits. He also argues the increased accountability an IPO would bring to its existing governance structure – featuring former DLA Piper boss Sir Nigel Knowles as chair – will benefit the firm’s culture. Cost and distraction are the main downsides.

Corporate partner Matthew Doughty is the firm’s lead on the float, which is planned as a main board listing. A feasibility study in the first six months of this year tested how it could be done. An obvious complexity is regulatory restrictions around third-party investment in legal businesses in certain jurisdictions, but the firm is confident of finding a solution. It also had to produce audited financial accounts on a three-year track under International Financial Reporting Standards.

DWF appears at first blush to be a prime IPO candidate, given investors are keen on businesses that can show a strong record of growth. Its revenue for 2017/18 was £236m, an increase of 25% over the last five years. However, many question whether this is organic revenue growth or the product of bolting on businesses in recent years.

But the prospects look worse the harder you look. The firm needs to create a corporate profit on which to be valued, not an LLP profit, which goes to partners. Public listings are based on earnings forecasts, which Leaitherland and Doughty are barred from speaking about because of the IPO process. They cannot talk about anticipated valuations or partner remuneration – or how much equity partners will have to give up either.

But there are clues. City PR shop Finsbury was deployed by DWF – that talk of £400m-£600m valuations reflects DWF’s ambitions. Legal Business took a closer look at what it would take to achieve that range and one adviser could only give a four-letter response when pondering what it would take for DWF to even reach £200m. It appears the bigger valuation range is based on revenue multiples: Knights had revenue of £35m when it was valued at £100m, DWF has revenue more than six times that, so its value could be £600m. But it is not that simple. Investors value businesses on profit, not turnover, as per the old adage: ‘Revenue for vanity, profit for sanity, cash flow for reality.’

DWF is struggling for profitability, with a profit per lawyer well below top 25 peers at just £23,000 last year. The profit margin is just 11%, again well below its peer group, while its lawyer-to-equity-partner leverage is nearly 14:1.

Consider also that valuation calculations broadly work like this: take a law firm with 100 equity partners and profit per equity partner (PEP) of £700,000. There is no profit in this firm because it is all going to the partners. Ask each of those partners to give up £200,000 of PEP and you create £20m of profit no longer being paid directly to those partners. That creates a ‘corporate’ profit, from which an earnings before interest, taxes, depreciation and amortisation (EBITDA) forecast can be created and valuation multiples applied to create an enterprise value.

Of the two biggest firms to float, Gateley and Knights, the latter attracted the highest valuation multiple at 10.3 times the next year’s forecasted EBITDA. Applying that same multiple to DWF, an EBITDA of about £40m is needed to reach a £400m valuation (that is before considering the need to take the firm’s £40m in debt off any valuation to give us a market capitalisation). To establish a rough EBITDA, assumptions need to be made about how big the partner profit pool is, adding back any interest, depreciation or other EBITDA elements that have been subtracted to create that profit pool.

The firm’s financial statements help, although advisers note that ‘nobody understands their balance sheet’ other than ‘the surmise is they’ve got quite a lot of debt’. The most recent accounts show interest and depreciation of about £7m. To come to an EBITDA, which is earnings before those factors have been included, we start with that £7m as our earnings pool. Investors like comparing on EBITDA because it helps strip out the impact of debt on core business.

The firm’s PEP for the 2017/18 financial year was £327,000, which at 68 equity partners is good for about £22.2m of partner profit. Even taking all of that would not give £40m of EBITDA and, sure enough, DWF confirms all its partners – there are 241 non-equity – will be participating (they will all be on five-year lock-ins too). Non-equity partner remuneration for the latest financial year is not available, but in the previous year it was about £23m. Assuming the same growth rate seen in PEP – 9% last year – we can estimate there is another £25m of non-equity partner earnings.

So, adding together interest, depreciation, equity partner profits and non-equity partner remuneration, results in an EBITDA of about £54m. You could argue a bigger law firm will attract higher multiples (though plenty of observers say the opposite). Based on the established multiple of 10x EBITDA earnings, however, DWF would need £40m in partner earnings from that £54m to reach a £400m valuation. That is a significant proportion.

But that is much more than what advisers agree is the most you can realistically ask partners to put into the corporate profit pot from their own remuneration. Generally, the amount handed over from partner profits for investors would be a third to a half at most. Under those parameters, EBITDA is closer to a maximum of £27m, suggesting a £270m enterprise value.

‘We’re appealing to lawyers much more than somebody who pays a salary and says: “I’ll tell you what to do.”’
James Knight, Keystone Law

Leaitherland cannot provide the level of haircut partners would have to take: ‘Partners would remain significant shareholders in the business, ensuring their interests remain aligned while also incentivising them to drive growth through their equity holdings.’

The big caveat is that public flotations are based on forecasted earnings, which we do not have. But it paints a picture all the same, which suggests DWF’s partners are going to need to give up a lot of remuneration: this is more of a buzz cut than a trim. ‘The more you decimate equity partner pay to create the necessary EBITDA, the harder it looks,’ notes one adviser. Harder, because the more taken from partners’ pockets, the tougher the sell and the more investors question whether partners will stick around.

DWF partners are apparently convinced or pliant, however, with Leaitherland saying every equity partner voted in favour of the proposal at a retreat earlier this year. There are claims that non-equity partners have been told this is their only shot at ownership. The firm is believed to be targeting an early 2019 listing. Leaitherland insists he is equally comfortable dropping it if market conditions are inhospitable, though the hurdles and costs of floating make that a debatable assertion.

Anything other than an IPO at this stage will be seen as a massive reverse with management having extended much goodwill in pushing this far. Leaitherland concludes: ‘We’ve got a mandate to do whatever we think is appropriate. If we make the call it’s not right we’ll just walk away and we’ll do everything we were going to do, just slower. The IPO is not the end, it’s just a means to the end.’

‘On their mind’

DWF’s prospectus will find the desks of many managing partners, though its planned IPO will not result in a seismic market shift.

Leaitherland has backers interested in what DWF could do with an injection of capital, but that does not detract from the fact that floating a top-30 law firm looks incredibly difficult. Almost every person interviewed for this piece dismissed the idea a top-end firm will ever list. The largest firms do not struggle for support from banks and can make the investments they need – for now – while remaining lucrative for partners. That is without considering the enormous task of convincing a sizeable equity partnership to do it. It was at least a year of work at the lower end of the market in one jurisdiction, not just a push of a button.

Llewellyn-Lloyd comments: ‘Every firm with sensible management should have had a look at it and talked to a few institutions, but it’s a long way off converting a fully consensual partnership.’

However, five firms have successfully floated. Law firms can no longer be pigeonholed as not belonging on the stock market. Many financial services businesses were once partnerships – Goldman Sachs floating is the most common reference point.

Even allowing for the fact that legal firms have far less need for capital than banks, it has already been demonstrated that publicly-floated legal businesses can be used to drive consolidation and build new models for legal services in the volume sector of the market.

The float of a larger law firm soon would also raise the profile of legal IPOs in general and create a sector, forcing investors to sharpen their approach. Peel Hunt head of IPO origination, Indy Bhattacharyya, comments: ‘Look at video game manufacturers. There’s been a flurry of those come to market and suddenly the investor base is forced to understand the different business models. Five years ago, you were vaguely aware that the companies were out there and that your teenage kids played them, but you didn’t have to understand them.’

There is appetite out there for the right opportunity, beyond the oft-cited criticism of partners cashing out. One top-ten leader sees a future legal market where clients pushing for greater use of technology, fewer firms on panels and broader global coverage leads to fewer, but much bigger, law firms at one end and smaller, niche firms at the other. ‘Most sectors in the last 20 years have had the same dynamics law is seeing at the moment and that’s ultimately where they’ve ended up: I don’t see why law should be any different.’

Cases have been made for large, mid-market players, like DLA, Eversheds Sutherland and Pinsent Masons, floating. The leadership at those firms dismiss it publicly, but DLA has considered it in the past (Knowles was known to be interested in floating over a decade ago, a strategy that was effectively ended by its dual US merger). The same client pressures and evolutions in technology and automation also present another scenario. Law firms are still people businesses, but the alternative legal services and New Law business models most have developed are highly scalable and could be spun off to sit alongside a conventional partnership. For many, the tensions are too great to simply float a conventional legal partnership, but there are undoubtedly cases to be made for external capital.

Numis Capital’s Skinner concludes: ‘We’ve had three or four law firms get in contact with us since Knights floated, it’s on their mind. There is scope for a good quality, high-growth law firm in the top 30 to come to market. The IPO is just the start. This is a marathon, not a sprint.’ LB

hamish.mcnicol@legalease.co.uk

tom.baker@legalease.co.uk