Legislation across Australia to enable legal partnerships to incorporate has been a long time coming but is on the near horizon with NSW and Victoria active for a few years and now Queensland with its state legislation in place from 1 July 2007 under the Legal Profession Act 2007 with other states following.
The implications for the structure of the industry are far and wide. Much attention has been focussed on the operation of multidisciplinary practices and of late the option for firms to float but the impact is much wider than that. Incorporation may well change the competitive structure of the industry over the next 5-10 years.
Critical to the whole change is the fundamental difference that legal service providers will have the ability to share profits with others and therefore will have access to capital. Lawyers will no longer be constrained (or protected) by the partnership model where all funding has to be provided by the partners and all profits have to be distributed fully to them, leaving no retained earnings in the business nor the ability to share profits with other parties.
Australia's law firms are facing challenges -
how to continue to grow in a mature market, provide excellent client service
and retain/develop talent with increasing pressure on knowledge sharing, ensure efficiencies in service delivery and find ways to export
their expertise and skills into relevant markets overseas.
Some argue however, that none of these
challenges will be resolved by an influx of capital and by bringing in outside
shareholders. The objective is to
form a "virtuous circle" whereby having the best people attracts the
best work in the market and the very best clients. This leads to the
professionals being highly utilised on meaningful work, which drives high
motivation and high profits. The
high performance of the firm then leads to its ability to attract and retain the
best people. Counter to this is
that the industry, whilst by no means being capital intensive, does require an
impetus to restructure and become more efficient. Capital is currently locked in individual’s beneficiary
accounts which either require new entrants to pay exiting incumbents or for
them to be paid out as part of the annual distribution of profits; few firms
can achieve 100% distribution.
Hence capital is now used within the business for future development and
most capital expenditure spending is funded by debt finance.
An analysis using the Structure Conduct Performance model is shown below:
■ Structure being the way the industry is set up
■ Conduct being the way the industry as a whole in most part behaves
■ Performance being the outcomes /results from the industry
This type of analysis demonstrates the possible
impacts on industry competitiveness and outcomes for industry players. Structural change at an industry level
can have a significant impact on participants especially for those who have not
examined or positioned themselves to take advantage of the imminent changes.
|
Structure |
Conduct |
Performance |
|
Current – Partnership Model |
|
|
|
Highly fragmented - only ~25 firms revenue >$40m
and 12 >$100m in a multi billion $ industry |
Many SME type operations commanding small very
localised market share Conglomerates of small pseudo-business units or
practice groups based around individuals Limited successful cross marketing within mid and
large firms; silo mentality Business security dependent on relationships of
individuals with clients |
Strong returns to equity partners at the mid – large firms with
average returns for the majority of smaller ‘suburban’ firms Stronger results for specialist, niche players |
|
Low barriers to entry § Unrestricted practicing certificate § Relatively low capital investment required |
Individuals in smaller practices enjoy control of and
influence over their own business and collegiality with like minded individuals Significant interchange of personnel; business moving
with individuals Access to development capital restricted to the
partners financial capacity |
Practitioners able to enjoy reasonable returns for
personal effort Lack of economies of scale – investment lagging
Significant movement of business with personnel
transfers especially senior partners |
|
Succession |
Succession issues for many firms with lack of ability
of senior partners to extract their built up goodwill |
Succession typically handled in ad hoc manner and
leading to significant business development and continuity issues Cyclical results over the long term dependant upon
resources and succession |
|
Competitive industry with supply greater than demand
– clients generally have choice of lawyer/firm to engage |
Significant spend on building relationships –
highly competitive environment Industry expectations including pricing methods and
levels well established for expertise with discounts limited to some sectors
of work type and volume work |
Limited visibility of viability but returns protected
by the historical expectations
of participants for most sectors |
|
Firms in ‘branding’ alliances |
National arrangements typically brand related and
limited back office support (i.e. not fully integrated single national
business.) State or regionally based firms with common branding
but financially independent Limited integration and low barrier to disbanding
alliances |
Appearance of national practices but underlying
tensions between interstate offices especially with respect to rewards Limited extraction of economies of scale – some
in marketing, IT but not as effective as if a single corporation Alliances commonly forming and reorganising |
|
Highly regulated – including self regulation by Law Societies in each State |
High quality of work across the profession Industry standards maintained |
Duty to courts paramount and high standards
maintained Professionalism strong |
|
Structure |
Conduct |
Performance |
|
Future – Partnership Model |
|
|
|
Remaining highly fragmented with individuals or small
numbers of equity participants retaining control |
No major change - individuals with strong personal
relationships will continue to command work Succession issues will continue Limited transparency of operations or results |
Smaller less efficient partnerships gradually
squeezed with reducing margins and less attractive propositions Specialist firms still able to command above market
returns Some partnerships will remain in tact until current
regime retire, withdraw or go broke |
|
Future – Corporations Model |
|
|
|
Capital funds will enable the industry to consolidate
with many smaller firms being bought out/ merged Larger number of firms in $20-100+m size range |
Increased focus on branding and corporate reputation Capital expenditure to achieve efficiency via consolidation,
technology investment Increased commercialisation including professionalism
in management of smaller firms, increased business development, marketing
including advertising spend Increased number of truly national businesses Management practices and commercial drivers will
override the wants and needs of individuals/owners/shareholders and
participants in the business Some firms may become public companies by listing on
a stock exchange Introduction of different functional structures with
true accountability |
Increased organic growth due to increased visibility
of reputation, brand strength and positioning {examples being top consulting
firms} reliance on brand reputation to command work Mergers and acquisitions increase significantly;
market consolidation Market returns gradually reducing via competition
towards typical market returns of professional services companies but with
larger more efficient firms continuing to produce above market returns Improved accountability and focus on business rather
than individualistic drivers; differentiations of roles owners/employees Commercial management practices including quality
assurance will be an increasingly important differentiator |
|
Increased consolidation of more general practices
– groups including franchised operations |
Limited MDP where alignment is operationally
efficient e.g. real estate firms with legal arms; Insurance companies with
legal claims teams MDP characterised by a volume of regular transactions
which are process driven; likely to exclude complex litigation |
Supply/demand imbalance will slowly be redressed at
mid-large end of market |
|
National firms will become stronger |
National organisations will be truly national and
take advantage of economies of scale with increased investment in marketing,
IT infrastructure and HRM but particularly knowledge management |
Increased penetration into national clients with
growth in market share and protection of margins Increased niche opportunities for regionally based
firms |
|
Structure |
Conduct |
Performance |
|
Larger organisations setting up their own legal arm
and specialists becoming law firms |
Other organisations entering the legal market Examples of increased competition - Major banks
setting up in-house law firms; employer organisations/advocates becoming
legal firms |
Increased competition will impact returns –
lower usage of outsourced providers Larger firms will seek to align drivers and reduce
costs by acting as an internal law firm for their organisation {example being
major bank setting up an internal marketing agency} Specialist work will still be briefed out at
increased fee rates |
|
Highly regulated – including self regulation by
Law Society and increasing via
Corporations law |
High quality of work across the profession Law Societies will have to become more aligned if not
national in nature |
Professional standing with respect to the Courts will
be maintained |
|
Succession issues more readily resolved |
Ownership will be more readily separated from day to
day performance via shareholding with ease of facilitating changes Shareholding will evolve to more participants even
with a small shareholding |
Increased ‘liquidity’ of ownership – more
diverse ownership Equity partnership no longer being the ‘end-game’ Share ownership used as a positive reinforcement and
alignment of business outcomes and employees’ objectives |
|
Corporate governance |
Increased governance processes especially for mid
sized partnerships would be required Initial tensions between obligations to the Courts
and obligations to shareholders Increased transparency in business outcomes |
Improved governance within the corporate regulation framework Long term obligations to the Courts resolved as core
to long term business success |
Industry consolidation can occur when macro economic impediments or externalities (such as regulation) change, then market forces such as competition will drive efficiencies and the industry structure will change. Evidence from other like industries is both instructive and compelling. Examples include the medical industry with the establishment of commercially run general medical practices, the engineering services profession with companies taking over smaller partnerships and consolidating them to achieve economies of scale and economies of scope through integrated marketing opportunities. These changes have all been driven by access to capital, indeed such changes could have occurred previously but were delayed and in some cases prevented by lack of capital.
The competitive environment at a macro industry level will change with incorporation and with the increased number of more commercially focussed organisations {focus on shareholder wealth creation} operating in the industry. New entrants into the market will emerge and existing competitors will develop especially as access to capital accelerates industry consolidation with business at the smaller end of the market being ripe for consolidation. Even if the percentage of practices that incorporate is relatively small the impact will still be significant. Whilst the historical roots, the inherent conservativeness of the profession and the fiercely independent nature of equity partners will all slow the changes, they will not stop them.
Incorporation will enable affiliated business to come under a ‘one stop shop’ and provide services across markets such as real estate and conveyancing or insurance claims handling and litigation. This will carry through to areas such as workplace relations where organisations such as industry or employer associations and unions will be able to provide legal advice through their own incorporated legal practice. Financial planners would also be able to consider providing the legal aspects of wills and estate planning.
Some markets that have traditionally been the domain of lawyers in private practice will face significant changes probably more quickly than other sectors. Areas such as conveyancing, estate management and claims handling will be open to another level of competition and this could remove some baseline business revenue which will force smaller businesses to restructure to survive.
It is clear that the access to capital and the
ability to share profits with other parties will enable the industry to
consolidate and become structurally more streamlined. Incorporation may also lead to a further step of a legal
firm listing and becoming a public company. Integrated Legal Holdings (ILH), DJC Lawyers and Slater
& Gordon - each using slightly different business models - have announced
plans to go to the market to raise capital to fund future growth and
expansion. Slater & Gordon
successfully floated in May 2007 and have already announced their first acquisition.
Essentially, there are three reasons an organisation may choose to list.
1.
It can enable them to acquire the
capital needed to fund a change in business direction for example diversify
into a multidisciplinary practice which includes other related businesses
2. Listing can provide funds for acquisition – pursuit of growth and industry consolidation
3.
There's the "get-rich-quick"
motivation, where current owners prosper from a listing and can exit –
liberation of capital
Opportunities for future expansion via private equity investors or ultimately by initial public offer (IPO) can be anticipated, but will be accompanied by increased competitive pressure from areas such as changes to pricing structures and commercial arrangements particularly with large purchasers of legal services. Incorporation will enable legal practices of mid to large size to compete with these activities more readily.
External shareholders alone, such as in an IPO,
may not bring any additional required skills and having to share profits with
external shareholders may simply reduce the incomes of the people who deliver
service to clients. However
incorporation provides an entry for the required skills to drive the business
and manage the capital flows. Selection
of Directors for Board representation including Chairman of the Board will be
paramount to drive these businesses as with any other commercial operation and
can provide much needed corporate competencies to assist such organisations.
Building relationships, delivering effective legal services, growing in relevant markets, building economies-of-scale and selling cross-jurisdictional services are the best ways to meet the challenges facing law firms all over the world. Key here in making the industry more efficient is access to economies of scale which is facilitated by incorporation primarily with private equity and ultimately public shareholding funding that drives the industry to consolidate and realise latent efficiencies.