Legal MSOs: The New Pied Piper of Private Equity?

Legal MSOs. The Upsides That Have Many Investors Myopic

In recent years, I’ve made several predictions that have displayed a bit of clairvoyance.

I published this article predicting Virtual Law Firms & Lawyering would become the next big trend in the profession – a year before COVID hit. Now it’s the New Normal.

I predicted that AI would be the Tech Game Changer for the profession two years before Chat GPT was released. Now there are hundreds of legal-specific AI platforms and multiple AmLaw Firms using Harvey, CoCounsel etc.

I predicted ABS models would be a structural game-changer and that major players would enter that space before KPMG did so.

Most recently, I’ve predicted that Legal MSOs will become a billion dollar industry by the end of this year. I am watching (and helping) it happen as I write this.

Now that I've worked with legal MSOs, closed deals and spoken to dozens of funds, law firms, companies and investors seeking to enter this space, here is my next prediction:

For every fund and investor that succeeds in the Legal MSO space, twenty will fail.

While AmLaws will indeed form internal MSOs to bifurcate and create liquidity events, massively scaling a law firm that already has 500 or 5,000 attorneys is not something that will produce the MOIC multiples investors seek.

Thus the serious multiples are going to be made in the small to mid-sized law firm segment. Eventually someone will realize the potential of the micro-targets ($2 - $5M topline) and create the Shriram Group. The upsides to the $7 - $25M topline space are easy to spot. Most law firms operate on a business model that’s literally over one hundred years old. Blue-haired Boomers continue to form committees – which are the definition of inefficiency. People who have no training, experience or expertise, continue to manage HR, tech, payroll etc. This is all incredibly ripe for modernization and scale.

Having business professionals who can implement better systems, management and control over such operations seems like a no-brainer. However, such thinking proves the danger involved in things that seem easy. Operational improvement in a law firm is often straightforward for seasoned professionals, but it is not what drives the valuation multiples investors seek.

The Downsides to MSOs are Insidious and Require Expertise to Address

Traditional private equity instincts can become liabilities in the Legal MSO space. Generating MOIC multiples by scaling companies that manufacture widgets, will not work in a professional services industry. The usual levers do not translate cleanly. You cannot upgrade factory equipment to double hourly output. You cannot offshore legal labor to India. Marketing improvements help, but only if you already have the attorneys in place to service the additional work that follows.

Which brings us to the unavoidable reality:

Scaling a law firm is not primarily a systems solution. It’s an M&A and recruiting proposition. 

Capital infusions do not summon rainmakers and associates out of thin air – especially when it comes to firms that do not have the national brand, footprint and other resources that are ubiquitous in BigLaw.

My foray into legal recruiting was with a large firm where we focused on placing attorneys from one large law firm into another. The primary motivation for such moves was easy to anticipate because it was nearly always the same: financial arbitrage.

However, my experience running a small, elite legal recruiting firm focused on moving partners and groups out of BigLaw and placing them with smaller firms has shown that these moves are almost never motivated primarily by money.

Moves to smaller platforms are driven by autonomy, culture, lifestyle and myriad other factors that are idiosyncratic to each partner, group and firm.

The Cost of Amateurism

Legal MSOs are facing unprecedented scrutiny from both the profession and bar associations. At some point, an investor will inevitably cross the ABA Rule 5.4 line and the ramifications will not be a mere fine, but the potential forfeiture of the entire investment. I have already turned down investors who asked questions indicating they are seeking to enter more than just the gray area, in this regard. Thus, caution can not be over-emphasized. This is not a niche where one should source ethics counsel based on price. The stakes are existential. In this space, legal generalists are a liability. Attorneys with experience in healthcare MSOs are what I would consider the minimum bar for entry. Those with a background in professional services e.g. accounting MSOs, are far preferable due to the structural parallels and those with actual, battle-tested experience in structuring Legal MSOs are the gold standard. While I have several in my network, they are still a rare breed.

Before committing capital, wise investors must secure a solid network of finance, technology, and most critically, legal recruiting and M&A expertise. In a landscape where failure or stagnation will far exceed success, your network is your only insurance policy.

Each Type of Law Firm Pursued by Investors Presents a Different Danger

Investors are currently examining three types of law firms:

Consumer Law

Business Law  

Boutique Law   

Each has strengths and weaknesses. Each will change and evolve as the inevitable mishaps occur. But investors will face risks that should be carefully assessed, before becoming capital committed.

Consumer Law Firms

These firms tend to operate as brands rather than a mix of institutional and individual client bases. Like dental MSOs, consumers may not even know the name of the equity owners. This mitigates the risks of having partners walk out the door with clients in tow.

On paper, this makes perfect sense.

In reality the downsides are significant. A few big cases can skew financials. Egos and financial discipline (or lack thereof) vary much more wildly than with business law firms, and that private jet bought by the Managing Partner after a huge win (hey, it was used!), may be tagged within a few years.

Personalities must be vetted with the same scrutiny as P&Ls. There are endless stories of attorneys hitting big with a few injury or celebrity divorce cases, getting a case of Walk-On-Water syndrome, and then filing bankruptcy within a few years.  

Business Law Firms

Targeting business law firms also makes sense, albeit for different reasons. These practices are built around long-term client relationships, repeat revenue, and far more predictable cash flow. Where consumer law could be penny stocks that might hit big, these would be analogous to mutual funds wherein the portfolio is more stable but the returns are not quite as aggressive.

The risks perceived with business law firms are obvious and well known. If the deal is not structured strategically, partners can collect a check and then leave, taking their clients with them. At the same time, non-competes are non-existent and explaining clawbacks etc. to a partner requires the communication and persuasion skills of a diplomat. Additionally, equity partners tend to be very conservative businesspeople and are often resistant to change – which is exactly what is needed, to scale any organization. The potential downsides are numerous and proper deal structure is the difference between the Midas Touch and living under the Sword of Damocles.

Boutique Law Firms

Whether high-end consumer law, such as trusts & estates or business law firms specializing in intellectual property, boutique firms can be viewed as easier to scale. KPIs and other success drivers are clearer and less diffused. Additionally, the MSOs only need to improve the technology and support systems for one practice area. However, this view is specious at best, because again, the key to multiples is not operations but rather recruitment and M&A strategies. Boutiques are routinely forced to turn away business outside their niche and that makes for a much more difficult recruiting proposition than with a full-service firm. This is especially true with high-level rainmakers who cross-sell to practices outside their own.

The Biggest Challenge - Getting Firms Past the LOI

The single biggest challenge in this segment is not execution. It is access. Most of the investors who have used Wall Street have not enjoyed the success which they hoped for. Broker-dealers on the hunt for law firms, are not viewed as objective, let alone as advocates for the targeted firms – whom they have often treated as scribes. Especially now that they have an obvious self-interest in pushing firms toward a deal that is completely foreign to them. However, that's only the beginning. For an experienced legal consultant, convincing high quality law firms to come to the table is relatively easy compared to getting them across the finish line. When upfront cash, massive infusions and multi-million retirement war chests are the subject of discussion, partners will happily take a listen! But most law firm partners are deeply skeptical of structures wherein they have to share risks, in order to reap rewards – and deals wherein risks are not shared, are a sure formula for failure on the part of the investors. Thus, they will take meetings, nod in agreement and then leave their investors wondering why a deal wasn't made. Their primary objections were never verbalized and the deal-makers didn't have enough experience with this market segment to extract and subsequently, overcome them. Most recruiting firms are not much better. Because my LinkedIn profile contains the words "law firm", I have receive amateurish emails from both brokerages and recruiters who use automated outreach through LinkedIn Recruiter. These emails actually named the PE funds (truly bad form that creates an "Anyone Gets in the Door" market position) and invited me to have my law firm introduced to them. I don't have a law firm. This is exacerbated by the fact that not only do law firms receive these low-level, 4 - 5 sentence emails, but so does every competing PE and MSO who has the words "law firm" on their profile. An even bigger challenge for investors is that unlike our firm, the overwhelming majority of legal recruiting firms operate on business models that will always (and understandably) prioritize placements that will produce larger fees and an easier value proposition (AmLaws). Thus their outreach will reflect that production-line approach from the start and their lack of market position and expert counsel will fail to get firms past the LOI stage.

And yet…

Legal MSOs are not a passing experiment. They are the next structural evolution of the profession. The opportunity is real. So are the risks. Those who move quickly - but without a comprehensive understanding of the market and a full complement of expertise in their network, will become the “Pioneers with arrows in their back and dirt in their face". Those who move quickly with the right expertise will turn first-mover advantage into lasting market dominance. And of course, those who wait, will enjoy the kind of moderate gains realized by every Mass Market. Respectable - but not multiple. History – especially Business History, tends to repeat itself.

Frederick Shelton is the CEO of Shelton & Steele. He advocates and advises for attorneys and law firms on M&A and Legal MSOs. He can be reached at fs@sheltonsteele.com