Law firm risk sharing and revenue generation
As the world experiences a potentially drawn out economic downturn, law firms and their clients will face increased pressure to do more with less. Ahead of this downturn, according to the 2019 Managing Legal Risk report, 67% of CFOs and finance professionals said they would advocate for the reduction of legal budgets if the economy entered a recession. With that downturn now assured, and with legal departments now facing difficult decisions on legal spend and resource allocation, they will look to their external counsel to be proactive in offering innovative solutions.
In the last recession, despite ample grounds for affirmative litigation by businesses that had been harmed, dispute activity was limited as potential litigants shied away from heading to court due to the inherent and significant cost of litigation. This lag in activity had a knock-on effect in the legal sector, and many law firms resorted to downsizing or scaling back their litigation teams. However, when the litigation boom eventually materialized and clients needed help, those cuts left law firms less prepared to serve clients and generate revenue at a time when clients were seeking ever more creative solutions to their own business pressures.
There are lessons to be learned from the last recession. Among them, law firms should now be looking for alternative ways of managing costs, cash flow and revenue generation to better align their clients’ needs and their own business imperatives. Legal finance offers solutions, both to clients and the law firms that serve them.
More firms will share more risk with clients
With client facing increased capital constraints, law firms are increasingly being asked to share risk through alternative fee or contingency arrangements. Corporate clients will look for ways to recover value for their organizations through meritorious litigation or arbitration without shelling out millions of dollars in legal fees and expenses. This corporate mindset will result in increasing pressure on firms to recognize and respond to their clients’ growing demand for risk sharing.
Indeed, it has been almost one year since Kirkland & Ellis, the largest “big law” firm in the US by revenue, made the well-publicized announcement that they would be taking on plaintiff matters and self-funding them through contingency arrangements. This announcement was a striking example of an historically hourly fee defense firm recognizing the demand in the market and adapting to meet client needs.
While Kirkland’s announcement generated headlines in the legal world, it is far from an isolated example. Before the announcement, several AmLaw 100 firms had already been representing their corporate clients in affirmative recovery matters for years. For example, Covington & Burling has had a well-established insurance recovery practice representing corporate policyholders in coverage lawsuits against insurance companies for more than 30 years.
But competitor firms took note, and in the year since Kirkland’s announcement Burford has received a significant increase in interest from “traditional” firms that want to take on more plaintiff side matters. It’s entirely understandable why: Firms see expanded opportunity in being the go-to firm for corporate clients, no matter what side of the “v” their clients are on. Clients value working with firms that know their business well, and as the downturn becomes our new economic reality, and government-injected liquidity abates, even traditionally defense side firms will want to expand as much as possible the most profitable work they can do with clients—which must include plaintiff side work.
We already see an uptick in firms following Kirkland’s example, and legal finance is an important tool for firms that make this move. When law firms take on risk in order to expand their client base, they face the problem of managing their capital flows as they incur the significant costs of lawyer hours and litigation expenses while waiting for positive litigation outcomes. This challenge is an acute one for law firms, which operate on a cash-in, cash-out basis, with limited retained capital. A legal financier such as Burford can partner with the law firm on the risk and provide portfolio-based facilities on a non-recourse basis. Portfolio finance provides law firms the working capital and liquidity to seek out and land meritorious plaintiff-side work on contingency, maintaining upside potential without assuming all the downside risk should the cases eventually lose at trial.
Legal finance solves the partner compensation problem
One challenge that firms face as they take on more work on risk—and a problem that legal finance solves—is the partner compensation problem.
The hourly fee law firm compensation model is typically based on how much revenue a partner brings into the firm. Hourly fee law firms that have cases on contingency, often find it challenging to compensate lawyers for their work when it isn’t generating real-time revenue.
While contingency cases present the opportunity for huge upside upon the successful resolution of case, they present a big risk of expense and cash loss to the firm if the case loses. In good years there may be enough revenue and cash from billable hour work to cover for those working on contingency. However, in a downturn when transactional and other work slows, the number of hours billed decreases and the likelihood of clients paying late increases, pinching both revenue and cash flow. The cash based partnership model means that many law firms face challenges paying lawyers who are not currently generating revenue, even though in a couple of years their work may produce a windfall for the firm—and to do so without reducing profits paid to other partners still working on an hourly basis.
Portfolio finance provides law firms with an effective way to manage compensation for partners working on contingency by paying a portion of attorneys’ hourly rates on contingency matters in real-time and as billed thus creating a pool of capital from which to pay partners now. Using legal finance, law firms are able to generate revenue for the entire time a case in pending but because the finance is non-recourse, if the case loses the law firm faces no downside risk.
A better solution than laying off lawyers
It is inevitable that law firms will have to adapt to better serve their clients in a capital constrained world. Rather than resorting to layoffs and furloughs, law firms should instead consider legal finance. Legal finance equips firms to build and expand contingency practices to meet client demand, solve the partner compensation problem, weather the cost and risk of such an undertaking and reap the financial rewards upon resolution of the matters in a portfolio. By entering into a portfolio financing arrangement with a legal finance provider, law firms have access to a large pool of capital when they need it most and can foster a special risk partnership relationship with their provider of choice. Doing so leaves them more strongly positioned to be the firm of choice for their clients.
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Issue 3/2020 of the Burford Quarterly features new thinking on a variety of topics, including how Burford, as the leader of an evolving industry, can be a valuable partner to in-house and law firm lawyers today.
