A private equity firm will buy a Magic Circle firm in the next 3 years.
Scoff at that?
I bet RJR Nabisco didn’t think so either when KKR came after them in 1988.
Here’s the reality though.
Law firms, and in particular those at the higher end of the market, are prime targets for leveraged buyouts.
There are a confluence of factors which make now the right time for this to happen.
- Dry powder – Private equity firms are drowning in cash. Bain recently put the figure at £2.5 trillion dollars(1). The funds are also getting bigger meaning that deal sizes in the £5-10bn range are not uncommon. They also have pressure to get money out the door and at the same time there is more competition for traditional opportunities. Ambitious young executives are hungry for creative ways to make a name for themselves.
- Know how – Investments in legal businesses have been growing steadily. See Permira’s purchase of Axiom last year and CVC’s purchase of UnitedLex. Both deals were north of $500m. They’ve also been doing large deals in other professional services verticals. PE houses are increasingly comfortable buying and managing businesses where the assets walk out the door every night.
- Optimization – It’s a truism to say that technology is changing industries all over the world. To outsiders there’s no reason that the business of law will be any different. Change to date has been slow due to culture, incentives and capital. PE operators will see these as three things they get paid to change and improve.
Let’s do some math to demonstrate this. (Don’t worry if multiples aren’t your thing!)
For purposes of this analysis we’ll exclude Slaughter & May given that they aren’t the most likely target given their size, profitability and structure.
The other 4 Magic Circle firms each have revenue of ~£1.6bn.
20% of that goes to overheads (those nice cookies in the meeting room, buildings, etc.)
40% goes to non-partner staff costs.
The next part is a bit tricky because of how LLP’s are structured and we’ll have to be satisfied with being directionally correct.
Roughly 15% of income goes to guaranteed partner draws or what non-lawyers would call partner salaries.(2)
That leaves us with a rough gross margin of 25% after we’ve paid all the bills.
Normally that 25% goes straight out the door every year to partners as a return to their equity.
If we’re buying the firm though that £400m represents the free cash flow from the business and it’s what we’re interested in.(3)
So how much would a firm cost?
The nearest public comparable we have is DWF which trades at ~10x free cash flow.
Obviously a Magic Circle firm is considerably more valuable than that given their brand, business defeasibility, etc.
For arguments sake let’s say then that a top tier firm would go for double that, i.e. 20x free cash flow.
That would put the purchase price at £8bn.
£8bn is a lot of money but it’s well within the reach of any top tier PE house.
None of the Magic Circle have any meaningful debt apart from revolvers which means that a buyer could add a considerable amount of debt to help fund this, let’s say 6x cash flow (or £2.4bn of debt).
This reduces the cash required for a purchase to a very manageable £5.6bn.
Let’s assume that the all in cost of the debt is 6% for a total interest cost of £144m. This reduces our cash flow to £256m per annum.
That amounts to a running yield on the PE house’s investment of 4.6% which is a good start.
The PE house will also look at the cost structure of the firm, efficiencies and expansion.
Let’s assume they figure that they can double cash flow over the next 5 years. (Goodbye expensive real estate, art collections and fresh flowers)
At the end of 5 years that would take our cash flow to £656m per year.
Assuming they dispose of the business at the same 20x multiple in 5 years, they would generate a return of 25% per annum.(4)
That’s right down the fairway of deals that private equity want to do.
Phew, that was a lot of numbers.
The point is that from a financial analysis perspective that a deal makes a lot of sense.
But wait you cry, the partners will never go for this!
Really?
Let’s look at the deal from the perspective of a partner who owns 0.25% of the equity.
Right now they’re earning their salary plus £1m on top from the profit pool every year.
The conversation will go something like the following:
Private equity – You know how you earn a £1m plus your salary right now? Why don’t we make that £2.0m for the next 5 years for you?
Partner – My place in the south of France does need a bit of sprucing up…
Private equity – Great, we’re going to do even better than that though. We’ll potentially more than double that every year based on your performance. We both know you’re the star around here and we want to reward you for being outstanding.(5)Partner – Very true, the guy down the hall from me just sits in his office all day and coasts along, getting paid the same as I do!
Private equity – It’s not fair. We’re also going to make some changes so that the people who matter around here can get things done without the bureaucracy. We’ll want you to be a big part of that.
Partner – I know exactly how this place should be run!
Private equity – Looking forward to getting them put into action! If you can now just sign here, by the way you have to stick around for a minimum of 5 years…
It’s likely to be a very persuasive argument, especially for partners slightly lower down the ladder.
The negotiation will have to be handled deftly and with a good understanding of the politics of the firm in question to ensure that the best people stick around.
The thing is though that these types of conversations will be second nature to anyone who’s ever worked in an investment bank. (Which in terms of people management is a very similar star system.)
In some senses a private equity buyer is uniquely well placed to have them.
Once the deal is done the real changes will start.
We’ll go into that in another blog but expect an organization that looks a lot more like an investment bank to emerge.
Painful for some but ultimately moving from a consensus organization to a more corporate one may be beneficial to most in the longer term.
Ultimately, a PE firm buying a Magic Circle firm makes financial and people sense.
The only real question is when.
The best time for a PE firm would obviously be if there was some dislocation that put one or more firms in trouble.
The pandemic hasn’t been as severe as 2008 on firm revenues but that may yet change if the economy slows.
Expect to see one or more PE firms pounce if it does.
Sold,
Christopher Thurn
Founder – Alacrity Law
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(1) Bain 2020 PE Research Report
(2) A&O provides this number directly, Freshfields, Clifford Chance and Linklaters make you dig through their Company’s House filings to get a sense of it
(3) You’re right, it’s actually less because it’s pre-tax but let’s ignore that as it will largely come out in the wash later.
(4) I won’t bore you with the discounted cash flow analysis that gets us here, if you’re interested reach out to me and I’ll share it with you.
(5) Doubling partner equity payments and setting up a 2x bonus pool gets you roughly to your £8bn purchase price. Yes, I’ve ignored the time value of money and tax, there were enough numbers in the first part of this post!.
