My guest blog for Totum Partners (www.totumpartners.com) the leading law firm management recuitment consultancy.

This month we welcome guest blogger Andrew Hedley, who provides a few salutary lessons for law firms that are serious about attracting external investors.

There was much excitement from the private equity community a few years ago when the possibility of external investment into law firms first raised its head.  I had a number of conversations with potential investors who waxed lyrical about the “mouth-watering” profitability available in the sector. They clearly had no understanding of the operating basis of the traditional law firm financial model!

This is one in which the concept of retaining profit and building capital value does not exist. In which partners enter with proscribed capital requirements and leave, many years later, with repayment of the same capital, no more and no less. The profits made each year are fully drawn down in due course and distributed in the most tax efficient way possible. Crucially, the partners work for free on the “promise” of a share of profits generated at the end of each financial year.

Of course, the fact that equity partners carry no cost insofar as the preparation of financial statements is concerned has some profound effects on the apparent profitability of firms – which appear wildly profitable when contrasted with a corporate model. However, re-stating accounts to include a notional salary for equity partners gives quite a different perspective.

Let’s just assume for the moment that profit is not drawn down by equity partners and instead efforts are made to create a sustainable shareholder dividend. What might such a shareholder return look like?

For a start, we would need to pay equity partners a salary in order to retain their services, which will be important to the on-going viability of the firm. This would have to be lower than their full profit share under the current system (in order to generate any external shareholder return) but what would be an appropriate level of remuneration? For the typical firm, one might assume that equity partners are paid, as a salary equivalent, 20% more than the current highest paid salaried employee.

This is reasonable since they are the group tasked with vision, strategy, high-level management, client relationship development, winning new clients and the achievement of revenue targets.  In addition, they also have “risk capital” invested in the firm; for which they should earn a commercial return. Taken together the aggregation of notional salaries and return on existing partner capital will be a very substantial sum, eroding any investment appraisal EBITDA significantly.

I have conducted this exercise on numerous occasions over the last few years, in order to disavow partners whose only concern was how they would spend Croesus-like riches after cashing their external investment cheques. The underlying profitability is somewhere around 5% for mainstream firms which are well-managed. It is lower for those that are not.

There are also some significant risks for the vast majority of firms that would accompany any external investment decision – poor brand strength, lack of embedded knowledge, weak processes, limited client loyalty, partners who are highly mobile and a very-transactional model to name but a few!

It should be no surprise therefore that investments made thus far into the sector have predominantly focused on those firms which are process-rich, have long term contracts and are not reliant on a small number of individuals to secure key client relationships. It is also worth noting that the market for investment into suppliers to law firms, for example LPO providers, has proved attractive – they too have good security; provided by brand, process and long term contractual arrangements.

There is a lesson here, in terms of strategy and business model, for any firm which is considering whether external investment is something it should seek and how best to shape itself.

Andrew Hedley is the founding director of Hedley Consulting. He has over 25 years’ experience of the professional services sector, with more than 16 years of that focusing specifically on the legal sector.

He can be contacted at andrew.hedley@hedleyconsulting.com