More than a decade after the 2008 global financial crisis, the world finds itself gripped by a pandemic and the resulting economic turmoil. As we saw in 2008, law firms will be among the businesses hardest hit by the recession, particularly as clients trim legal budgets and reduce demand for legal services. But unlike companies with diverse sources of capital, law firms, still predominantly structured as partnerships, will more acutely feel the cash crunch as they grapple with this outdated ownership model.
Already firms have begun to reduce salaries, hold back partner distributions and furlough employees to combat sharp declines in revenue. In the short term, partners are expected to earn materially less income while firm growth and associate development are paused; in the long term, firms may need to draw down on lines of credit, lay off employees or, in extreme cases, dissolve.
To remain competitive, firms will need to deliver more for less—and those with greater access to capital will be better positioned to do so. Outside ownership thus represents a powerful protection for law firms, a financial lever that could promote innovation, allowing firms to differentiate themselves and stay competitive in the downturn.
The partnership problem
The law firm partnership model has well-documented flaws, many owing to its inevitable and distorted incentives. Though partnership is a coveted and lucrative milestone for law firm associates, the title does not immediately confer its full financial benefits. Partners must build their practices over time, such that they are often advanced in their careers when they begin to maximize their earnings. Unable to carry ownership into retirement, partners are incentivized to bill as many hours as possible—regardless of the efficiency or value delivered to clients—and disincentivized from reinvesting in their firms.
In a recession, this system creates a catch-22: Clients are generally unwilling to continue paying standard hourly rates, leading to immediate declines in law firm revenue; and law firms, lacking access to outside capital, have even less ability to offer discounts or alternative billing arrangements. Worse still, partners already lacking a reason to reinvest in their firms face even less palatable conditions in which to do so, creating potentially adverse long-term impacts.
The promise of outside ownership structures
While not a panacea, outside ownership of law firms would offer protections against some of these recessionary challenges. At the simplest level, firms with access to outside capital would have a greater ability to offer clients alternative billing arrangements. Although such arrangements would not address the full range of client pain points or prop up demand, they would help firms maintain current business and stay competitive in bids for new business. At the partner level, long-term equity would incentivize continued firm-level reinvestment, allowing firms to position themselves for post-recession success, while also helping alleviate some of the belt-tightening that comes with a macroeconomic shock.
Given the availability of the alternative business structure (ABS) in the UK—and with new ways to access outside capital—law firms will increasingly begin to consider the benefits of outside ownership. Already nearly 1,300 law firms, roughly 10% of those in the UK, have switched to the ABS model. With Reed Smith last year becoming the first major international firm to launch an ABS, there is growing momentum for firms to consider outside ownership. Further, as Burford becomes the first legal finance provider to take an outside ownership stake in a law firm—in June we announced an innovative portfolio transaction with top ranked firm PCB Litigation, in which we took a 32% equity stake—law firms look to have greater access to outside capital than ever before.
By creating permanent equity, firms not only acquire important growth capital, they also create a valuable currency to retain and attract partners. Even when firms move to an ABS or other outside ownership structure, equity partners typically retain majority ownership, leaving them with a valuable tool and nest egg to cultivate partner loyalty and incentive firm reinvestment.
Though mass adoption of outside ownership remains unlikely in the short term, the current recession will spur law firms to give it greater consideration. Firms are better prepared for a downturn now than they were in 2008, but the unprecedented nature of the Covid-19 crisis promises to create unexpected challenges for firms and clients alike. In an industry so susceptible to macroeconomic shocks, it seems needlessly shortsighted that law firms continue to rely on the outdated, cash-based partnership model. Already momentum is building for outside ownership of law firms, and in the months and years ahead, traditional ways of doing business will be challenged by novel disruption. For firms willing to innovate and take a long-term view, the rewards of outside ownership will likely be significant.
This article was originally published in Legal Business Magazine and can be read here.