Fly on the wall: What PE investors look for in law firms

17 Oct 2011Feature

A firm's approach to key account management can be critical in determining whether it will obtain external investment, reveals Meirion Jones

A firm’s approach to key account management can be critical in determining whether it will obtain external investment, reveals Meirion Jones

Now that the Legal Services Act (LSA) has formally come into effect, the twin pressures of continued economic uncertainty and growing client demand dictate that many UK firms should exploit the new structural flexibility available – particularly to attract external investment.

Assuming, then, that it’s only a matter of time before law firms and private equity houses become more closely acquainted, what is the likely direction these discussions will take? What kind of assurance will a would-be investor require before deciding that the investment is worth the risk? A law firm’s assets, after all, are mostly ephemeral: its accumulated legal expertise and experience; its reputation; its people; and its clients – they can all disappear very quickly and, with them, the return on investment.

If law firms are to attract investment from one of the most demanding and unsentimentally results-driven parts of the financial community, they are going to have to turn the ephemeral into concrete. They are going to have to protect, invest in and sweat these assets like never before.

From the would-be investor’s perspective, a firm’s most important asset group is probably its client base. The strength of those client relationships, their potential for growth and the way they are managed will be key in deciding whether, and on what terms, the investment is made.

Grabbing the nettle

Let’s see how instrumental client relationships are by taking a fly-on-the-wall view of discussions between a leading UK law firm and a private equity house.

The firm in this illustration, Temblars, is a top-50 national firm with around 120 partners and offices in Manchester, Leeds, Birmingham and London (any resemblance to an actual firm is entirely coincidental).

Strategically, it is increasingly squeezed between smaller regional practices chipping away at its lower-value client work and larger and better-funded national firms that can offer clients access to international networks. The firm’s younger partners are looking enviously at their rivals and mutter seditiously about the need for change.

Temblars’ management team decides to build reserves to fund a strategic expansion programme. This may include new office openings, the hiring of lateral teams in chosen fields, new document management and client relationship management (CRM) systems, a rebrand and possible office refurbishments. In other words, the firm’s future rests on securing outside investment. And, as we’ll see, that investment depends upon its client management.

The firm has decided to extend its feelers towards external investors. A visit is arranged to a private equity house specialising in professional services, Ffolkes-Bond Partners (FBP). One bright Monday morning, a management sub-committee from Temblars arrives at FBP’s Mayfair boardroom for a preliminary discussion with three senior FBP directors.

FBP has done its homework and noted that Temblars has an enviable roster of clients. FBP’s objective is to test the robustness of those client relationships and assess their growth potential. If that test is passed, the investment may follow.

The agenda

Item one on FBP’s agenda is client planning. How are client development strategies developed? Are there plans for each important client? How are client partners incentivised to develop the firm’s key client relationships?

The firm’s managing partner attempts to answer. Smart, charismatic and empathetic, he is an instinctive leader. He gets on well will his clients but has not created a single client plan in his life. He admits candidly that he thinks they’re a waste of time: bureaucratic form-filling exercises that stifle initiative and waste valuable time. The private equity team explains the value of business planning templates and measurable revenue growth targets. The managing partner’s attention starts to wander.

Item two is client teams. How effectively do Temblars’ partners and associates cooperate in developing client relationships? How is client intelligence shared? How are new opportunities identified and converted?

These questions are directed to Temblars’ senior corporate partner. The custodian of some of the firm’s most prestigious relationships, he feels a growing sense of indignation at the questioning. He is an entrepreneur, valued and trusted by his clients, many of whom have become close friends. While he shares his clients’ pain, he does not share these relationships with his fellow partners.

For some reason, the corporate partner feels the need to defend himself. If he’s honest, the idea of exposing his client relationships – the things that give him such a strong sense of personal worth – to partners whom he suspects do not share his commitment, makes him feel wretched.

While the corporate partner talks, one of FBP’s contingent, a former big-four auditor, scans the partner’s client billing figures within Temblars’ financial disclosure pack. They imply enormous unfulfilled potential.

The clients mainly seem to generate the same types of legal work and there is little evidence of systematic cross-selling. Per-client revenue fluctuates, suggesting that little concerted effort is made to build the relationships over time. And the names of a very small cadre of partners reoccur, as if these clients are regarded by their responsible partners as their personal possessions. In short, the firm’s most important assets are the subject of self-interested neglect.

There is also a surprising disparity in partner performance, especially when there appears to be little correlation between that and compensation. The auditor asks how performance is rewarded and incentivised, and whether new business generation and client growth are linked to any kind of bonus.

The third Temblars representative responds with nervous laughter at the question. He is a highly respected technician in his late fifties. His knowledge of corporate regulatory law is widely sought by senior general counsel and company secretaries. Despite his skills, he knows he is an expensive luxury to the firm. The idea of having to actively sell his expertise to clients to justify his existence is anathema. There is something demeaning in the thought of having to peddle himself around.

“Let’s move onto the next item,” says the head of the FBP delegation. “How does your sales process work? How do your practice groups share cross-selling targets?”

“Oh, we leave it up to them to decide their own business development targets,” says the managing partner.

“What about your clients? How do you gather client feedback? Check how well you’re doing? Learn more about their own market challenges?”

“Our partners prefer to do that kind of thing themselves. Our relationships are paramount, you see, and we feel that to employ an external agency to conduct feedback for us runs counter to the importance of fostering individual relationships.”

“What about setting growth targets?”

“No, we don’t do that.”

The third member of the FBP group, an organisational design specialist, broaches the final item on the agenda: industry sectors. The firm’s annual report places great emphasis on its cross-practice industry sector teams but, according to the firm’s internal organisational charts, these teams do not exist in any formal sense. The nominal heads of the sector teams have no reporting line responsibility for their industry sector specialists – who sit in separate silo practice groups – nor, according to the summary accounts, do the teams have any profit and loss targets.

Has a separate information memo been omitted? No, says the managing partner sagely, that’s just the challenge of operating in a matrix environment.

A note of opportunity

The meeting breaks up, leaving each party to reflect upon what they’ve learnt. The head of the private equity team writes a memo to his board, as follows.

“Temblars lacks a strategic client vision. It is run for the benefit of the equity partners, who resent and resist the suggestion of client planning, personal accountability or sharing client opportunities for the greater good.

“Client relationships are not managed for growth: there are few genuine cross-practice teams, the CRM system is treated as a glorified – and inaccurate – contacts list, information on clients is not shared and there is no client feedback process.

“On the other hand, although its profit margins are only mid-ranking for the legal sector, they exceed those of any other organisation that we have invested in. Temblars has an enviable client grouping with strong residual goodwill and many partners are technically outstanding.

“I believe that by imposing a more systematic commitment to client development, we could substantially enhance profitability. The question for the board is: can we realistically tamper so fundamentally with the firm’s culture to achieve the requisite changes?”

A second meeting is organised to take the Temblars delegation through FBP’s conditions.

The investment plan

The take-it-or-leave-it investment plan presented by FBP is as follows.

A five-man executive board structure will be created comprising three partners, a mutually-agreed externally nominated ‘wise counsel’ and an appointee from FBP.

The FBP appointee is to be the chief operating officer, with budgetary and decision-making responsibility for all non-lateral investment decisions (such as IT, learning and development, premises, know-how and marketing), as well as line responsibility for all relevant directors.

Crucially, the COO will recruit a senior sales and marketing director – either from a major accountancy firm, management consultancy or investment bank – who will be responsible for developing the firm’s first-ever key account management strategy.

Under the COO’s aegis, the firm’s accounting databases will integrate with the CRM system, a client service coaching programme will be introduced for all client team leaders and the resulting client development plans will be directly linked to the success of the teams’ client development efforts.

Finally, the firm’s marketing communications (such as brochures, website and event organisation – the current mainstays of its marketing activities) will be outsourced to release funds for a client analysis and feedback programme.

If the partnership agrees to these terms, FBP will make the investment.

Impact on the firm

After a lot of internal recrimination, some tantrums and the odd partner retiring hurt, the partnership duly votes in favour of the proposal. Within three years, there is a transformation in the firm’s fortunes.

Following substantial partner attrition in the first year – including all three members of the negotiating team – per-client turnover and profitability has soared. Interestingly, overall partner numbers have hardly grown at all compared to pre-investment levels – and a long tail of low-return clients has been jettisoned. But the average share of key clients’ legal spend is up by 40 per cent.

The partners responsible for leading the high-growth client teams have seen their personal remuneration climb. Client satisfaction levels are substantially above the market norm and the firm is now a honey pot to some of the highest profile would-be laterals in the market.

Catalyst for change

So, what does this story tell us? Will external investment be the salvation of law firms in future? No, probably not. The critical variable is not external investment but the way in which client relationships are managed.

Private equity firms are sector agnostic. With their instincts for maximising returns, they may just as easily invest in care homes or software companies as law firms. That they see firms as attractive options comes down to their recognition of the legal sector’s huge underlying potential.

In the next few years, every firm will have to fundamentally and systematically realign the way it services its clients if it is to attract outside investment. The question is, will it take the involvement of external investors to unleash that potential – or can firms learn to do it themselves?

Questions to consider

Do we take the necessary steps to genuinely understand our clients’ businesses needs?
Is our service aligned to truly anticipate and meet these needs?
Do we view our client relationships as strategic assets to be nurtured and managed?
Do we treat clients institutionally – planning collectively, sharing information and building a network of relationships?
Are our partners incentivised to invest in developing long-term relationships and to shift from the personal to the institutional?
Are our partners trained in relevant skills such as consultative selling, team leadership and project management?

meirionjones@me.com