Private Equity & Law Firms: A Different Way to Get the Best Deal

As the Legal MSO market continues to accelerate, law firm founders are receiving increasingly enthusiastic attention from MSOs, private equity firms, investment bankers, broker dealers and various other intermediaries who have a recently discovered love for lawyers and the legal profession. This newfound affection is undoubtedly heartwarming, but how a law firm enters the Legal MSO market can materially affect valuation, negotiating leverage, transaction structure, post-closing autonomy and whether the partners still recognize the firm they spent 30 years building after the closing dinner is over.

There are essentially five ways these transactions begin, and understanding who represents whom is considerably more important than admiring the first impressive number somebody puts into an Excel spreadsheet.

1. An MSO or PE Firm Approaches You Directly

This is increasingly common. An MSO identifies an attractive law firm, contacts the managing partner, signs an NDA and begins discussing a transaction. It is efficient and there is absolutely nothing inherently wrong with it, provided the law firm remembers one detail: the buyer represents the buyer.

The MSO may have evaluated 100 firms while the managing partner has completed precisely zero Legal MSO transactions. The buyer knows current multiples, rollover structures, compensation models and what other firms have accepted. The managing partner knows how to practice law, which is tremendously useful in court but considerably less useful when phrases like “normalized EBITDA” come up. The old adage “A lawyer who represents themselves, has a fool for a client” can quickly be forgotten when the transaction involves their own $30 million.

2. A Broker Dealer Brings the Opportunity

Broker dealers and other buy-side intermediaries are also contacting law firms on behalf of MSOs. They can provide access to legitimate opportunities and there are excellent professionals in this category, but the first question should always be: Who are they representing and who is paying their success fee?

If the broker dealer was retained by the buyer, its job is generally to find attractive acquisition targets for that buyer. Again, nothing nefarious about that. But the person bringing you the opportunity is not necessarily the person evaluating whether that opportunity is best for you. Attorneys are trained from approximately the third week of law school to understand conflicts and determine who represents whom, although apparently an eight-figure valuation can occasionally cause temporary memory loss.

3. Hire an Investment Banker to Negotiate With One MSO

If a firm has already received interest, it can retain an investment banker to negotiate the transaction. A capable IB brings financial expertise, valuation knowledge and negotiating experience, which is substantially better than having the managing partner decipher EBITDA adjustments between depositions.

There remains one rather obvious problem: one buyer.

The banker can negotiate beautifully, but if the MSO decides during diligence that normalized EBITDA, meaning sustainable earnings after legitimate adjustments, is lower than originally believed, the seller's alternatives are limited. You can pound the table, send stern emails and perhaps even deploy that terrifying lawyer phrase, "with all due respect," but the buyer still knows there is nobody standing behind it. Additionally, because the banker only gets paid if the deal is closed, they are reluctant to say what we say on a regular basis: We have seen better deal structure in the market. Successful firms have walked away from structures like this one.

4. Hire an Investment Banker to Run an Auction

In most industries, this may be an excellent strategy. The banker approaches numerous buyers, generates competitive tension and encourages them to bid against one another. Capitalism works rather nicely when several people want the same thing.

Legal MSOs introduce an unusual problem because the highest bidder may also be the worst partner.

Some MSOs understand that lawyers must control the practice of law and genuinely respect autonomy and culture. Others include what I affectionately call the "private equity bros," who seem to believe that writing a large check should entitle them to influence client intake, client selection, partner elevation and practically everything except where the managing partner parks.

Ironically, those buyers can bid aggressively because their financial models assume greater control, higher margins and substantial operational changes after closing. Another turn of EBITDA, meaning another multiple of annual earnings, looks terrific until you discover “At what cost?”. The highest offer is considerably less exciting if shortly after closing, you’re informed that your firm has a new definition of what “underperforming partner” means and by the way, thirty percent of your staff will be cut for the sake of “operational efficiency”.

The law firm also traditionally pays the investment banker's success fee, which on a major transaction can mean that the slightly lower offer from the substantially better partner, was actually the best one.

5. Our Approach: Qualify First, Then Create Competition

We reverse the sequence. We first determine what the law firm actually wants from a transaction and establish its non-negotiables regarding autonomy, compensation, governance, personnel, culture, clients and control over the practice.

Then we determine which MSOs deserve to meet the firm.

We have evaluated more than 70 MSOs and rejected the substantial majority of them. Once we identify the organizations whose deal structure, investment philosophy and objectives actually fit the law firm, we then present those MSOs to the law firms for their consideration – not the other way around.

Once MSOs have been selected by the firm, we introduce them and we attend every meeting with them so that if anything is misunderstood or unclear, we can address it with them in an executive debrief, afterward. We don’t know of other advisors who do that. As opposed to the first method where an MSO might tell partners “Right now, a small law firm like yours typically receiving 3x – 3.5x valuations” we have the market data to immediately inform the founder that we have seen higher multiples. Additionally, we introduce the law firms to our network of the very best attorneys, accountants and consultants to make sure that if the MSO discounts valuation due to “fluctuations in cash flow” or “client concentration”, the law firm’s team can counter such claims so valuation can be negotiated back upward.

There is another meaningful distinction: our law firm clients do not pay our success fee. The MSO does. As these fees can range from the six to eight figures, getting a slightly higher bid is leveled by not paying that fee and more importantly, getting vetted MSOs and having a team on your side that levels the playing field. So while we make it clear on our website and in all communications that we represent and provide the law firm with market intelligence, our fee is paid by the MSO.

The goal is not the highest bid. It is the best economics from the best-qualified partner while protecting the firm that created the value in the first place.

For Legal MSOs, we think it makes considerably more sense. As one of the firms we worked with put it:

"Shelton & Steele guided us every step of the way through the Legal MSO transaction process. They steered us away from unfavorable partners and led us to the right partners and a great deal. With their help, we made the best business decision we've ever made for our firm. I'm happy to speak with other partners on a confidential basis about them."

Managing Partner, Regional Law Firm

Contact information available upon request

Frederick Shelton is the CEO of Shelton & Steele. He represents and advises law firms through Legal MSO transactions. He can be reached at fs@sheltonsteele.com