May 2011 Legal services
May 2011 Legal services
Analyst To IPO or not to IPO
Andrew Shepherd-Barron +44 (20) 7418 8901
Andrew.Shepherd-Barron@peelhunt.com The Legal Services Act envisages a radical shake-up of the law
industry as of this October. Big Bang or not, this could see third-
party investors acquiring equity stakes in everything from leading
partnerships to low-cost outsourcing plays. We discuss the
possibilities and opportunities.
£4m of equity has got to be interesting, even to a Magic Circle partner
In this note we discuss the merits and de-merits of flotation, potential new
business models, the need for capital, the investment case and how partnership
remuneration might transition. There is also the attraction that flotation could be
rewarding for the current owners. Whilst listing the Magic Circle may be
problematic, we estimate that in total the five firms could be worth £6.7bn, equal
to £4m for each partner – assuming a willingness to work for a modest £250,000
salary plus profit share. We conclude generally that whether or not a release of
value looks like carpet-bagging there is a real economic case to be made for
public market listings – even for the largest firms, where the limits of the
partnership model may be being reached.
It may work best for the aggressive, but that’s only right in a newly
Who’s first? Lawyers tend to be conservative and a publicly-listed share has its
downside as well as attractions. We expect many players to wait and see,
although recent press comment has named a number (with Irwin Mitchell a
leader) as actively contemplating an IPO. The clear front-runners are those with
external growth plans, mid-tier firms with scale and those with a volume business
with no star culture, all of which can show a need for external capital.
Investors may need some persuasion but there are plenty of successfully
listed people businesses to draw lessons from
Investor experience. Law firms would not be the first businesses to have listed
on a stock market where the assets are vulnerable to departure and the
employee compensation/profit trade-off hard to handle. Others have included
accountants, employment advisors, management consultants, advertising
agencies, stock-brokers, investment banks and, in Australia, a personal injury
practice. Investor experience has varied but the rationale is sound.
This document must be treated as a marketing communication for the purposes of Directive 2004/39/EC as it has not
been prepared in accordance with legal requirements designed to promote the independence of research; and it is not
peelhunt.com subject to any prohibition on dealing ahead of the dissemination of investment research.
Peel Hunt 2
Table of contents
Executive summary 3
The investor attraction 6
Floating a partnership needs care 10
Profit: trading pay for dividends 13
Two case studies 16
Magic Circle valuation 21
Peel Hunt 3
The business of law and the Legal Services Act
The Legal Services Act 2007 (“the Act”) introduces the possibility of “alternative
business structures” as from October 2011 where non-lawyers may have
professional, management or ownership roles in a law firm. The idea behind it is to
promote better access to legal services, greater competition between law firms for
clients, work, ownership and capital, and also to promote competition between
regulators which have been criticised in the past.
Flotation becoming a realistic option
We focus on the use of the new structures. These would permit much greater
access to outside capital and allow for the use of shares to make acquisitions and
incentivise employees. Finance may come from a range of sources, including
private equity, as part of a larger organisation, or, as we focus on here, as listed
entities. This would require cultural and management change for many, as well as
changes to pay structures.
Suitable for all?
Such a change has the potential to affect a large part of the legal services market.
The most obvious early candidates are those businesses which already operate
under an incorporated structure, particularly the volume-driven firms, including
consumer-facing businesses such as personal injury, conveyancing and will-writing
where value for money and timeliness are key customer demands. In particular we
see a business model where cheaper less qualified personnel can perform a
substantial part of the work and which lends itself to commoditisation as being
The mid-tier firms are also strong candidates, in that the sector is fragmented and
there may be a range of consolidation opportunities.
There are structural and legal issues that limit the immediate possibility for the
large global firms, including the Magic Circle, to list. This may change in time, and
might provide a solution to the problem that the partnership model has more
limitations the bigger the firm.
Uses of capital
To summarise we could see external capital used, amongst others, to:
Capitalise the value of a business
Ease partner transition
Provide partner and staff retention incentives
Provide a currency for acquisitions
Provide working capital and fund property for organic growth
Fund large-scale contingency litigation cases
Fund the creation of franchised legal service business
Advertising and promotion of brand identity
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For the investor, the sector, in our view, is fundamentally attractive, since:
Margins are good and earnings can be structurally of high quality, with a
substantial recurring element and strong brand recognition.
It is highly cash-generative and therefore capable of paying sustained dividends.
There is a pattern of secular underlying growth, driven by GDP, globalisation and
The UK is well represented amongst the leading firms.
There is an opportunity to reduce costs to offset likely future price competition.
Change on the way
Business models will change, likely sometimes in unforeseen directions. We would
Retail giants penetrating the market in ever greater depth using customer
databases to cross-sell.
The potential entry of low-cost overseas competition (from India?) into an
increasingly price-sensitive commodity market.
Advent of multi-disciplinary practices, with the proviso that this has its own
In the US there is already significant activity in the acquisition of patents in
competitive auctions with the express purpose of monetising them via licensing or
litigation against parties allegedly infringing the patents.
Not a slam dunk
The Law is a conservative profession, hence it would be no surprise if many wait to
watch the experience of the early movers. It, however, will mark a sea-change from
the past, and there is useful read-across from other people-based consultancy
sectors including accountancy services.
There are a number of challenges to floating a law firm. We would highlight some
It may be in a long-standing partner’s interest to capitalise any equity at a
premium to book value but it raises questions as to how new partners can be
attracted since overall pay must be reduced by the need to pay dividends to
outside investors. Stock options may help, but may dilute EPS growth and hence
the PER rating and valuation, and many potential partners might prefer more
cash today from moving to an unlisted competitor to risky equity.
Partnerships tend to be run by lawyers through consensual decision-making,
with major matters referred to the whole partnership. To transition from this to a
more normal incorporated structure run by a Board wil take time.
For some the business model is not broken, so why fix it? The large partnerships
are highly successful, the practitioners extremely well paid and there is room
for an entrepreneurial spirit to be indulged. There are good reasons why not to
Financially, partnerships are highly cash-generative hence limiting the need for
Peel Hunt 5
Share prices can go down as well as up. There is a risk that if share prices
underperform it is both very visible to competitors and customers and will dis-
incentivise those partners looking for stock appreciation to make up for earnings
Lawyers have primary duties to the courts and to clients rather than to any
shareholders and there may be times when conflict arises. In practice we expect
such conflicts to be managed similarly to conflicts within investment banks.
Many partnerships are not unified, but in networks.
The Act applies in the UK but not overseas, especially not in the US where
external investors are prohibited.
Capitalising people-based businesses is inherently risky – the assets walk in and
out of the door each day. Flotation would not suit legal practices where too much
value is attributed to just a few key assets. A high profile recent example of this
is Gartmore and its star fund manager culture.
Peel Hunt 6
The investor attraction
The Legal Services Act 2007
The Act takes effect from 6 October 2011, although it may take a little longer for all
the regulatory structures to be in place. It provides for:
Alternative business structures (ABS), which will allow lawyers to form
partnerships with non-lawyers, accept outside investment or operate under
A single supervisory body, the Legal Services Board (LSB), will oversee
approved regulators such as the Solicitors Regulation Authority (SRA) and the
Bar Standards Board.
A single point of entry for consumer complaints about legal services, called the
Rationale behind the Act
The government's reasons for the Act:
To increase competition, flexibility and choice
To simplify the over-complex and inconsistent system of oversight regulatory
arrangements in the legal services market
To provide a single body, independent of all the professional bodies, to deal with
For the investor the sector is in our view fundamentally attractive, since:
Earnings are structurally of high quality. Not only does strong client loyalty in the
mid-tier firms create a high barrier to entry, but there is an important recurring
element, normally a wide spread of fee-earners, strong market positions, and
firms are providing a service for which there is a clear need.
The business is highly cash-generative. Operating cash conversion is often
around 90% after allowing for working capital needs.
There is a pattern of secular growth.
Some of the main beneficiaries of future regulatory change would be those that
already possess sufficient critical mass, including financial strength, to take
advantage of the new marketing opportunities. However, if law firms are to sustain
adequate stock-market ratings then, in addition to the strong cash generation that
is intrinsic to the business, we believe that they will need to display some or all of
Recurring earnings from repeat clients.
No excess dependency on a single client.
Operating leverage and margin potential from outsourcing.
Ability to bed down mergers and acquisitions if external growth is to feature.
A process-driven rather than star-culture model that provides some resistance to
key staff departures.
Peel Hunt 7
The market and growth
Most professional services operate in a structurally growing market, and legal
services are no exception. There is an acceptance of an increased role for
government and hence regulation and industry has moved cross-border. Legal
services as a percentage of GDP tends to increase as a country develops and
billing rates tend to rise at least as fast as nominal GDP (offset by any pressure on
average recovered rates). Revenues at the top 200 UK firms have increased by a
compound 10.4% in the five years from 2005-6 to £14.9bn most recently (including
the benefit of mergers), despite falling by 4% last year (source: The Lawyer). In
For the global law firms, there is a need to penetrate more deeply geographies
where today they are only thinly represented.
The M&A market adds a layer of cyclicality that can obscure such growth, but in
itself presents a major source of potential fee growth, increasingly in
geographies outside London and New York.
Increasingly regulated society
The regulatory environment is a critical determinant of sector profitability, because:
Professional standards bodies create barriers to entry. Training is expensive,
takes time and can only be done under the auspices of a professional firm.
Existing practitioners are naturally less than keen to see any reduction of these
Government action can have wider ramifications. Professional service firms are
people-intensive, and employment legislation (including the liabilities of directors)
can determine the long-run profitability of a company. In the past, one
international consultant estimated that their ability to control employee cost in a
downturn meant that a long-term EBITDA margin of 25% was achievable in the
US whilst inflexibility meant that only 15% was a reasonable assumption in
Continental Europe. In theory this would self-correct since all local competitors
should adjust their prices upwards accordingly, but the high peak margins that
this would imply are unrealistic in a fragmented industry.
The burden of red-tape. Whilst this brings additional costs for all, most
professional service firms are net beneficiaries. More red tape means more
complexity and it means change. Both require increasing amounts of external
advice – particularly if the penalties of non-conformance are rising.
In practice, change may be needed anyway.
It may be that full incorporation is in fact inevitable. The leading law firms are
already large and typically have established an LLP structure sometimes with an
incorporated shareholder (owned by lawyers only). They would also continue to
grow as they follow their clients more deeply into local markets as well as win
more locally sourced business. A partnership structure has its advantages in
terms of strong internal culture but they are becoming increasingly unwieldy. A
narrower management structure can permit quicker decision-taking and provide
the structure where professional management can more easily be brought in for
central functions such as human resources, IT, compliance and marketing.
Some partnerships already reflect this, being partnerships in name only, with
management effectively run along the lines of a corporate Board, with
substantive functions delegated to specialists brought in from outside. Others are
run purely by lawyers and hence would need to change more.
Peel Hunt 8
Attractive recurring revenue stream.
Most professional service firms provide an essential need. The client must rely on
professional expertise, backed by a professional qualification, one that the client
himself is not fully capable of understanding or evaluating, even after the event.
The proviso here is the likelihood of new competition from new entrants (e.g.
The accountancy read-across. For the accountancy sector, audit, bookkeeping,
tax and compliance work cannot be avoided in a business environment. High Net
Worth individuals likewise have an ongoing need for accountancy services. For the
mid-tier practice, typically 70% of a year’s income is visible at the beginning of the
year, and up to a further 20-25% is reasonably likely to arise from the established
client base. One-off transactional business, such as business recovery and
corporate finance transactions, therefore might account for only 10% of income.
The mid-tier firms have the additional advantage of a wide and diversified client
base. For a firm with revenues of say £100m it is not atypical for there to be a base
of 20,000 separate fee-paying clients.
Tax and National Insurance
Partner drawings are currently taxed in the hands of the recipient and, in the UK,
employers’ national insurance is limited. There would be tax implications of
incorporation, from corporation tax/dividends to capital gains benefits. We would
expect there to be clever structuring such that this can mitigated or avoided.
Limited operating leverage
Operating leverage in people-based businesses tends to be low, since output is
typically intrinsically linked to time spent. Additionally, fixed overheads tend to be
limited to property and organisational costs. Other observations include:
Whilst most firms have trimmed staff, in practice there is a degree of
overcapacity that gives some operating leverage – these businesses tend to be
slow to reduce staff in a downturn when skills have been expensively acquired
and difficult to replace in an upturn.
In addition, short-term leverage can come from normal management of such
factors as the ratio of chargeable/non-chargeable hours, collection percentages
and staff-mix both senior to junior and fee-earning to administrative. In the long
term, however, these tend to fluctuate around a sustainable norm.
The outsourcing opportunity
Law firms have been outsourcing simple processes such as documentation for
some time, but have been slower to roll it out into other areas, even including IT.
Full Legal Process Outsourcing (LPO) has been even slower, given a mix of
regulatory constraints, natural conservatism and the need for consensus across all
partners on major decisions.
Capita has already tried
Capita, a major provider of outsourced services to the public and private sectors,
has long seen an opportunity to bring its skills to the legal business. In 2006 it
began by taking over the administrative, payroll, HR and IT services of Optima
Legal Services (Optima) and transferring across 234 members of Optima staff. It
cemented this by lending Optima £35m mainly to fund acquisitions including
Peel Hunt 9
Dickinson Dees' volume arm, D3 Legal, in November 2009. It also entered into a
share option agreement to acquire Optima shares as and when this was legally
permitted. This was deemed by the Regulator (the SRA), to be premature and to
breach guidelines. The arrangement has had to be dismantled. This is one example
of the sort of tie-up that could be expected once the Act is implemented.
The Therium and Juridica model
Third-party litigation funding has already started in the UK with Therium as an
unlisted example and listed Juridica as another. More such funds have been
discussed and entrepreneurial solutions are likely over time to answer the problem
that there is often huge uncertainty about costs, time and risk which many
claimants are ill-positioned to assess:
Juridica raised £80m (100p/share) in a December 2007 placing on AIM and a
good range of blue-chip investors participated. When last reported (December
2010) the company had invested, or committed to invest,US$134m, had earned
total cash returns of US$32m and had increased its NAV to US$195m.
Management cited the recession as causing the litigation process to take longer
than usual, particularly for larger cases. There is however clear demand for its
services, with over 500 cases and thousands of patents reviewed for investment.
Burford Capital raised US$300m to fund commercial disputes primarily in the
US, typically in exchange for a share of the final settlement. The share price
stands at a small premium to that at the time of issue, with investors waiting for a
track record to be built – of which the early stages are encouraging.
Therium has signed with City of London Group to establish a seed fund to invest
in litigation – in exchange for covering costs up to a pre-agreed cap, Therium
takes 20-45% of proceeds.
Peel Hunt 10
Floating a partnership needs care
Alternatives to partnership
Some law firms may consider bringing in private equity first, rather than a flotation,
as a way of testing the water of external investment. This may have some merit, not
the least of which is reduced exposure. Although we focus here on flotation, much
of the discussion is equally valid to a private equity involvement, with the proviso
that private equity’s needs include defined exits which may not be appropriate to
Given how few professional service firms are listed, it is fair to ask whether they
should be listed at all. After all they are people-intensive businesses and people are
unpredictable. In practice we believe there are strong arguments for listing,
An opportunity for individuals to crystallise a better value for their equity. With the
added benefit of a liquid market in which to realise value when required.
Where few companies in a sector are listed, the use of transparently valued
equity can be a competitive advantage in negotiations.
Access to greater capital brings a wider range of growth possibilities – both
through acquisition and any capital-intensive organic growth.
It enables the benefits of ownership to be spread throughout the group, with a
It can help build a much more public profile.
Flotation simplifies many of the problems associated with partner transition –
equity is transparently valued and incoming partners need not provide capital.
This can ease the recruitment of young partners, who rarely have built up their
own personal wealth to be able to afford to buy in from their own cash resources.
Equally, rewards above normal remuneration and after loan interest and loan
capital repayments are, in some cases, only achieved by partners in their late
forties. The best young partners, particularly those with a marketing mindset, are
likely to want a visible reward and, in particular, the possibility of capital reward
in their thirties.
Even if limited liability vehicles are used for some parts of the business, there is
still substantial residual risk. Whilst this may act as a powerful incentive for high
professional standards it is increasingly outmoded. Once partnerships have
reached a certain size the less likely you are to be able to assess the skill and
probity of your partners, for whom you have joint and several liability, as
evidenced by Arthur Andersen.
Structuring the organisation
Whilst firms operating in UK jurisdictions will be able to access outside capital,
there are still legal impediments to this elsewhere. Under US law, no law firm can
be influenced by non-lawyers and this applies to its ownership structure. One
answer is to adopt a Swiss Verein structure.
A Swiss Verein is a voluntary association of independent offices each bound only
by regulators in their own countries and each of which has limited liability regarding
the others. It is commonly used by multinational professional firms.
Peel Hunt 11
The use of such a structure should not prevent a firm from operating substantively
as it does at present – permitting full business integration, albeit with less than full
financial integration. This will bring issues about how to structure for a flotation,
particularly for those firms integrated as a global partnership. A global partnership
has benefits such as stronger ethos, single point account management, recruitment
advantages and simplicity, which a new structure would be keen to avoid losing.
Because of their unincorporated nature, partnerships have had to finance
themselves, albeit with resort to debt for working capital or partnership loans. In
total, the three methods of partnership finance, cash injection, retained earnings
and borrowings, all depend upon the partner’s individual wealth.
Tight control over working capital is critical in an industry so dependent upon the
normally limited resources of the partnership. Even if bad debts are low across the
industry (practically non-existent) and collection periods similar, firms can have a
very different billing ethos. Habits can be slow to change, but there has been an
ever-increasing focus on financial discipline.
In practice partnerships have little need of cash to fund their growth plans – indeed
they would have to earn attractive returns on any external investment to justify it.
This may change with the introduction of new business models. For example, if
large-scale contingency litigation needs to be funded or new franchised businesses
initiated or growth capital required generally to fund new commoditised offers.
Often these initiatives will require advertising and promotion at a national level to
establish reach and brand identity.
For the larger firms, the hunt for scale and global coverage is accelerating but, for
all, acquisitions are a time-honoured means of growth. The main rationale being:
To create value for the acquirer.
To acquire a specialism or wider product offer to roll-out across an existing
To expand geographic coverage to capture economies of scale and widen the
Clearly a share price can play a useful role in both determining value as well as
providing incentives. We would note though that acquisition prices can be high.
RSM Tenon paid an average of 2.5x revenue for its early acquisitions and
employment services firm Hewitt Associates in the US was bought for US$4.9bn in
July 2010 (41% above the undisturbed price), equivalent to 1.65x revenue, 18x
current year PER and 8.0x EV/EBITDA.
Peel Hunt 12
Non price consideration
Acquisitions of people businesses are not simple. Consideration needs to be
Having a strong firm culture into which the acquiree slots, with the acquiree
buying into this prior to joining. It is critical that each business does not build or
try to preserve separate images which confuses clients, dilutes the marketing
effort and breeds diseconomies. This requires discipline in selecting acquisition
candidates, since some of the most apparently attractive acquisition candidates
will not bed in easily.
In firms with few owners, an early identification of the strategy for vendor
replacement. Some models actually encourage older vendors to leave within a
2-3 year period. This gives enough time to promote or recruit younger, perhaps
more flexible, replacements and retain the client base.
Tackling the integration issues such as IT standardisation, property costs, billing
rates and recovery rate philosophies.
Disadvantages of flotation
Risk of culture change
The biggest risk, but the most difficult to analyse objectively, is the extent to which
a public flotation may cause partners to change their behaviour in a way that
damages their “trusted advisor” status. The intrinsic pressure of meeting market
expectations may change the behaviour of partner/directors. If this causes them to
market more aggressively the firm’s specialist services then this may be positive. If
however it leads to a more “churn and burn” mentality then, even though this may
take years to feed through, this would severely undermine goodwill.
A very public place
Shares can go down as well as up. The listed environment is a very public place,
with an experienced financial press ready to seize on problems and investors ready
to over-react to bad news. An earnings miss can undermine sentiment for a long
time. Reputational risk is a major consideration. The particular challenge here is
that the major fee earners are likely to be the largest shareholders in the business,
and if the capital value of their shares is insufficient to compensate them for the
loss of earnings being paid to external shareholders they will be vulnerable to
poaching by unlisted competitors.
You can rely on the popular press.
The UK possesses a widely read media happy to bash the highly paid or
unpopular. It is fair to say that the legal profession is widely seen as both highly
paid and unpopular and that a stock-market listing brings a much higher public
profile, scrutiny and commentary.
Getting from A to B
The process of moving to a listing may well be uncomfortable. Not all partners will
want to work in a listed vehicle, for whatever reason, and business de-stabilisation
is a real risk. Commercial law firms are typically highly strung organisations. Time
sheets are broken into six or ten minute increments, billable hours closely watched,
prestige important, the rewards of success high and the whole system pressurised.
There may be little room for further stress.
Peel Hunt 13
Profit: trading pay for dividends
Establishing what is profit
Under a partnership, any cash left over after the business has been financed
is available as pay to partners. For there to be any cash flow left available to
pay dividends to external shareholders, partners’ remuneration will have to be
reduced by a similar amount. For partnerships, therefore a central issue
regarding flotation is whether the overall income sacrifice (dividends have to be
paid) will be more than made up by the (more riskier) capital appreciation of the
equity linked to growth.
A delicate balance
Coupled with whether or not goodwill within the business is given any value, the
interplay between incoming, continuing and outgoing partners is complex and
different from firm to firm. Much is non-contractual, adding to the complexity.
Determining whether partners are better off from a flotation is a complex subject.
For retiring partners: The chance to extract more than 1.0x book value is highly
attractive since no income sacrifice is necessary. Any opprobrium attached to
accusations of carpet-bagging and extracting the value built up by previous
generations may be assuaged by money in the bank.
For mid-career partners: Simplistically earnings must reduce, to the extent that
dividends to external investors must be funded. This would be offset by the
prospect of a gain on that portion of capital released.
For tomorrow’s partners: As with mid-career partners, future earnings would
need to reduce. However the need for capital contributions would also be
reduced. Stock options may act as an alternative incentive, but the share price
would need to perform.
Equity and lock-ins
Incoming partner-equivalents may need to reach the same equity incentive over
time as the others if the business is to survive. To provide the partners with a
common incentive to outside investors it is probable that, in many cases, they
should own a large stake in the business, probably a majority or a percentage in
line with their share in the bonus pool. We do not see this as necessary to avoid
hostile takeovers, which are unlikely in our view in such a people-based business.
Incentives would include:
Stock options or LTIPs, perhaps one that allows up to 2-3% of the capital to be
issued each year subject to performance, on the basis of annual churn in the
range of 5-10%.
Lock-ins, where typically former partners would not be allowed to dispose of
equity acquired for at least three years and then only at a certain rate.
Anti-competition clauses are frequent, although of questionable legal
enforceability – firms may do better to impose a “selling” clause such that if a
partner leaves with a block of fees he is deemed to have acquired them,
normally at a penalty price, a much more enforceable contract.
Changes to partnership approach. Many firms are in any case reviewing equity
structures to flex profit sharing models to the current economic conditions in the
UK – typically full equity partners now account for just over half the partner group
in UK top 100 law firms (source: Deloitte).
Peel Hunt 14
It can be done
Other businesses have managed the transition from partnership to a corporate
structure successfully, although often not without problems (see Case Studies
below). In particular we note that of the 44 firms that went into the accountancy
consolidation plays of RSM Tenon, Vantis and Numerica in 2000-02, a typical
average EBIT margin before partner drawings was 31-35%. Afterwards, the EBIT
Margin moved down typically to 15-19% in the first year or so after acquisition,
suggesting that partners gave up approximately half of their earnings.
Chart 1: Pre-acquisition margin dispersion before Chart 2: Post acquisition margin dispersion, post
partner drawings partner salary
Source: Company accounts, Peel Hunt estimates Source: Company accounts, Peel Hunt estimates
Margin dispersion, pre partner drawings Margin dispersion, post partner salary
% of sample
% of sample
<21% 21-25% 26-30% 31-35% 36-40% >40% <10% 10-14% 15-19% 20-24% >24%
EBIT margin EBIT margin
Such post-incorporation margins can be sustainable over time. We have looked at
related people-intensive businesses, such as the employment advisory sector in
the US, represented by Hewitt Associates and Tower Watson (formerly Watson
Wyatt), and found that in the past 11 years they have averaged EBITDA margins of
16.9% and 14.0% respectively. Impressively both have shown resilience in harder
times, with neither company posting an EBITDA margin below 10.9% (Watson
Wyatt in 1999).
Table 1: Employment advisory services – EBITDA margin
Source: Company accounts
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Aver.
Hewitt Associates 21.9% 20.9% 18.8% 19.3% 14.7% 15.4% 14.2% 12.5% 12.5% 16.2% 19.2% 16.9%
Tower Watson 10.9% 12.6% 14.0% 13.0% 13.8% 12.4% 13.7% 13.9% 16.0% 17.0% 16.9% 14.0%
We have also looked at a more process-intensive business such as the tax
services division of New York-listed H&R Block. Over the past eight years the
EBITDA margin has remained in a narrow range of 25.9-32.3%, which we put down
to strict management of costs.
Table 2: H&R Block tax services
Source: Company accounts
2003 2004 2005 2006 2007 2008 2009 2010
EBITDA margin 30.7% 31.4% 30.5% 25.9% 27.8% 29.4% 32.1% 32.3%
Peel Hunt 15
One of the few examples of a listed law firm is Slater & Gordon, in Australia, which
has achieved a consistently high EBITDA margin, ranging from 25.0-29.9% in
2008-13E. Management anticipate that the EBIT margin can be maintained at
24-25% in future, suggesting a degree of confidence in the business model – which
reflects a high degree of utilisation of less qualified staff in our view.
Table 3: Slater & Gordon
Source: Company accounts, Bloomberg
2008 2009 2010 2011E 2012E 2013E
EBITDA margin 28.8% 26.2% 25.0% 27.8% 28.6% 29.9%
Fixed compensation vs variable
One of the keys to successful people businesses is the structure of remuneration,
with a correct balance between fixed and variable remuneration. Whilst in smaller
firms remuneration is in effect almost entirely variable, in larger firms a more
normal balance is found. We would expect that a norm can be found whereby
Fixed salary at levels consistent with a peer group of local professionals.
Variable bonus element based on a share of the remaining profit – we consider
that a 45-55% pay-out, with a lower percentage paid in a good year, would strike
a reasonable balance.
There have been examples in the past of even greater flexibility over remuneration,
in order to help meet market expectations. A classic example of the trade-off was
made by Numerica in 2002, where some former partners took a one-off salary
sacrifice. Whilst sending a strong message to the market, that fee-earners
understood the burden imposed by having to service outside investors, we do not
see this as a sustainable practice.
A dividend example
Property specialist Savills operates a compensation structure along these lines,
and pays two forms of dividend:
An ordinary dividend, which is intended to be progressive and to reflect less
volatile, non-transactional earnings.
A supplementary dividend which reflects the performance of their more cyclical
The total dividend is expected to be covered by 1.5x statutory EPS and / or 2.0x
However, different firms will undoubtedly find different structures that suit them and
Peel Hunt 16
Two case studies
Wide range of professional service businesses have listed
There have been a number of flotations of professional service businesses,
whether of a partnership or a more corporate structure. They range, globally, from
investment banks (Goldman Sachs) and fund managers (Gartmore) to architects
(SMC) and estate agencies (Savills). The experiences have been varied.
We focus mainly on the experience of the mid-size UK accountancy services firms,
since we anticipate that the most likely potential listings will be in the mid to small
segment. We also look at Slater Gordon, the Australian listed law firm.
The early premise behind the flotation of the UK accountants Numerica, RSM
Tenon and Vantis was to provide vehicles to consolidate a fragmented sector. Early
experience was not easy, with a combination of a steep learning curve and weaker
demand particularly in high-margin transactional business reducing some share
prices by up to 90%.
In particular, acquisitions were made that were poorly digested and expensive
with Tenon spending £126m on nine acquisitions in 6 months alone in 2001
at an average multiple of revenue of 2.5x, with large-scale intangible asset
Whilst the disintegration of Arthur Andersen, coupled with the introduction of
Sarbanes-Oxley requirements in the US, had not made for an easy background,
subsequent events show, in our view, that brand can be built and the model made
to work. RSM Tenon has since made successful acquisitions, generated
consistently higher EBITDA margins and the share price has oscillated between
40p and 60p (until recent forecast downgrades). We discuss how the valuation
metrics have oscillated later.
Table 4: RSM Tenon
Source: Company accounts, Peel Hunt estimates
£m 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Revenue 55.4 91.9 76.1 80.6 87.7 123.6 136.7 160.3 150.8 190.4
EBITDA 1.9 8.4 4.0 10.3 11.1 13.8 14.5 22.0 21.2 29.0
EBITDA margin 3.4% 9.1% 5.3% 12.8% 12.7% 11.2% 10.6% 13.7% 14.1% 15.2%
* excludes goodwill amortisation and exceptional items, year-end June except December for 2001/02. 2003 is pro forma
Peel Hunt 17
Chart 3: RSM Tenon share price
Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10
Rel RMS Tenon FTSE All Share
Slater & Gordon
Slater & Gordon is a predominantly personal injury “no win, no fee” law firm that
listed in Australia in May 2007, ten months after it became possible to incorporate
legal practices. At the time of listing, A$17.7m of new funds were raised and
A$17.3m of existing shares were placed. It has a leading position in Victoria and
Queensland, which gives it growth opportunities outside those states.
Since flotation, there has been a steady, albeit slow, increase in EPS (with faster
rates projected) and margins have been maintained at high levels. The listed equity
has been of use in acquisitions, with nine practices acquired in 2008 alone (on top
of double-digit organic growth) and six in 2009/10.
Slater & Gordon’s share price has never traded below issue price and currently is
showing a gain of +120% in four years. Although it has been weaker in the
meantime, this should be seen as a success.
Chart 4: Slater & Gordon share price
May 07 Nov 07 May 08 Nov 08 May 09 Nov 09 May 10 Nov 10
Rel Slater & Gordon ASX All Ordinaries
Table 5: Slater & Gordon summary results
Source: Company accounts, Bloomberg
A$m 2008 2009 2010 2011E 2012E 2013E
Revenue 80 103 124 180 220 241
EBITDA 23 27 31 50 63 72
EBITDA margin 28.8% 26.2% 25.0% 27.8% 28.6% 29.9%
EPS (A$c) 16 17 18 20 26 29
Peel Hunt 18
Distinguishing between “firm” and “personal” goodwill
Investors are rightly cautious of affording high multiples to businesses that may
disappear, particularly given the almost total absence of tangible assets. Investors
will however accord full value, in our view, to businesses where the value is seen to
The central issue is to distinguish between “firm” goodwill and “personal” goodwill:
Personal goodwill derives from the individual’s reputation, personal success,
trust and respect. It reflects the business that comes to a firm because of that
individual, and is often obtained through professional referral.
Firm goodwill reflects the tendency of clients to return irrespective of the
reputation of the individual practitioner. It reflects the firm’s ability to continue to
generate earnings without the presence of any particular professional.
Firm goodwill has a value, personal goodwill often none unless there are strong
contractual terms and an agreed client retention plan. Firm goodwill depends upon
consistency. As the experience of Arthur Andersen demonstrates it is not just
enough to have high standards in some areas, they have to be consistently applied
across the organisation. For the larger organisations, looking to deliver world-class
services across an international network in a seamless manner, this is a never-
The value of a process-driven organisation
One key to creating valuable goodwill is the establishment of a process-driven
organisation. This can permit a more fixed-cost structure for a business and
therefore bring a useful degree of operating leverage. It is mainly a function of:
The persistence of recurring business.
The degree of client sharing and cross-selling by professionals within the firm.
The difficulty of replicating the firm’s processes. This may be a mix of qualitative
process and quantitative assets such as a well-developed intranet.
Whether there is a clear product sold by a dedicated sales team independent of
the delivery team.
Valuing goodwill is inaccurate
Assessing this value accurately even in a private market environment is difficult –
partnerships have major difficulties in valuing it for internal purposes. In a public
environment, where there is a reluctance to give information even on the
measurable data such as staff turnover, training expenditure and productivity, it is
even more challenging. Its intangible nature makes it particularly vulnerable to
mood swings. In nervous markets investors typically take both a shorter time frame
and apply higher discount rates to non-asset backed businesses. Purchased
goodwill may be no better – Tenon had to write-off 62% of net assets in 2002
(£106m impairment charge) to reflect the over-payment for acquisitions.
Peel Hunt 19
Stock-market valuations in professional services
We show in the tables below how a range of professional service firms are
valued in different markets. We have included:
Management Consulting as a listed consulting play
RSM Tenon as being the leading listed accountancy play in the UK
Savills as a largely commission-based real estate advisor
WS Atkins as a market leading engineering consultant
H&R Block as a process-driven professional tax adviser
Slater & Gordon as a listed law firm, in Australia
Towers Watson as a people intensive employment advisor
There is a wide range of PER ratings across the comparators from 6.9x to 21.9x
2010 and from 3.9x to 13.0x 2012E. This might reduce its usefulness as a valuation
metric, except that:
There is some consistency to the median rating which has averaged
14.5x/13.1x/12.3x in 2008/2009/2010.
Three of the four UK listed companies have sustained single-digit multiples for a
number of years and are forecast to continue to do so, reflecting disappointing
business performance and ongoing restructuring
The overseas listed businesses have traded at, and continue to do so, a
premium to the UK sector, reflecting in part higher local market ratings.
We would expect legal businesses to trade in the same 9-14x range seen in this
group, depending upon track record, earnings visibility and prospects. One
challenge is that the peer group is small and spread across several sectors. We
would expect most legal firms to trade under Support Services for FTSE
Table 6: Professional Services PER ratings (current year)
Source: Company accounts, Bloomberg, Peel Hunt estimates
Ticker Y/end Price 2008 2009 2010 2011E 2012E
Management Consulting MMC Dec 36 £ 4.7 4.4 6.9 9.5 8.2
RSM Tenon TNO June 24 £ 9.6 7.8 7.2 4.1 3.9
Savills SVS Dec 402 £ 13.3 20.0 11.8 14.9 13.0
WS Atkins ATK Mar 782 £ 10.4 8.2 10.6 11.3 10.6
H&R Block HRB April 17.5 US$ 15.6 13.1 12.3 10.8 10.9
Slater & Gordon SGH June 2.3 A$ 14.3 13.8 12.8 11.5 8.8
Towers Watson TW June 54.3 US$ 14.5 14.0 21.9 13.1 11.8
Peel Hunt 20
We show below the EV/Revenue ratings for the same group. The range here is
even wider than that for PERs, reflecting essentially the different margins in each
business. As a result they are of limited use in valuation analysis, although they do
show that there has been a degree of consistency for each company from year to
year which is encouraging.
Table 7: Professional Services EV/Revenue rating
Source: Company accounts, Bloomberg, Peel Hunt estimates
Ticker Y/end Price 2008 2009 2010 2011E 2012E
Management Consulting MMC Dec 36 £ 0.49 0.63 0.63 0.78 0.69
RSM Tenon TNO June 24 £ 0.74 0.79 0.87 0.54 0.45
Savills SVS Dec 402 £ 0.40 0.50 0.45 0.59 0.53
WS Atkins ATK Mar 685 £ 0.37 0.25 0.32 0.39 0.31
H&R Block HRB April 17.5 U$ 1.82 1.69 1.57 1.38 1.54
Slater & Gordon SGH June 2.3 A$ 2.99 2.71 2.10 2.15 1.38
Towers Watson TW June 54.3 U$ 1.28 1.22 1.09 1.23 1.18
Peel Hunt 21
Magic Circle valuation
The five leading UK based law firms are collectively known as the Magic Circle. As
an example of the value that is tied up in them we have focused on Allen & Overy,
chosen in part because of the accessibility of its financial statements. We show
later its financial performance over the last five years, and note:
Limited revenue growth in the past two years, restrained by the financial services
practice, and stabilisation over the past five years in total staff numbers.
High EBITDA and EBIT margins averaging 44% and 42% respectively over five
A continuing high ratio of staff to full partner, averaging 13:1.
Profit per full equity partner above £1.0m for each of last four years.
No significant capital contributions from partners, in contrast to Clifford Chance
Revenue per lawyer has consistently increased, in contrast to many parts of the
legal profession generally.
How “profit” could look upon incorporation
Taking the Allen & Overy data we show in the table below how the published profit
allocated to full partners compares to what profit might be if the firm was to be
incorporated. We have chosen a simple remuneration model, based on the
assumption that under an incorporated structure, partner remuneration would move
to a salary plus profit share. We have shown an illustration of how profitability
would look if partners took a:
Salary of £250,000/yr for all partners regardless of seniority
50% of the remaining profit paid to partners with the balance reported as
Introducing an element of fixed pay adds some gearing to results. It also reduces
the PBT margin to levels much closer to those seen in related sectors (see “Pay –
trading off profit for dividends” below).
Table 8: Allen & Overy potential revision to profit
Source: Company accounts, Peel Hunt estimates
Y/end April (£m) 2006 2007 2008 2009 2010 5 yr ave.
PBT on partnership basis 267 363 406 390 388 363
% revenue 36.3% 40.9% 40.0% 35.7% 37.0% 38.0%
yoy change - 36% 12% -4% -1% -
PBT on incorporation 91 137 158 149 150 137
% revenue 12.3% 15.5% 15.5% 13.6% 14.3% 14.2%
yoy change - 51% 15% -6% 1% -
Peel Hunt 22
What it might be worth
Assuming nil tax and a base-case PER multiple of 10x, to the PBT average of the
last 3-4 years would value the equity on this basis at £1.48bn, equal to £4.0m each
per full equity partner.
A PER of 10x is within the 9-14x range for the peer group as discussed, and
The positives of brand name, fee diversity and global spread.
Offset by the lack of recent growth, transactional nature of fee income,
uncertainty linked to novelty of listing and potential impact on growth of option
issuance as incentives.
In practice we would expect the PER to fluctuate over time and increase as a track
record is built in a listed environment.
Clearly for this to be in an individual partner’s interest, he or she would amongst
other issues have to compare the NPV of the value of the potential earnings given
up against the value of the equity released. Those closest to retirement are the
most likely immediate beneficiaries of a listing.
Peel Hunt 23
Table 9: Allen & Overy consolidated accounts
Source: Company accounts, Peel Hunt estimates
Y/end April (£m) 2006 2007 2008 2009 2010
Profit & Loss
Revenue 736 887 1016 1091 1050
EBITDA 307 413 472 465 466
Depreciation & amortisation -19 -20 -27 -33 -33
EBIT 288 393 445 432 433
Net financials 1 2 2 -1 -4
Profit before taxation 289 395 448 431 429
Allocation to "other partners"* -22 -32 -42 -41 -41
Profit allocated to full partners 267 363 406 390 388
Taxation -15 -22 -31 -37 -24
Partners remuneration charged as expense -42 -60 -65 -94 -35
Profit available for distribution 211 281 309 259 329
EBITDA 307 413 472 465 466
Working capital -21 -18 -18 6 24
Other 3 -3 10 13 -19
Operating cashflow 289 392 464 484 471
Tax paid -19 -24 -17 -47 -20
Capital expenditure -37 -76 -28 -31 -12
Partners capital introduced 16 17 12 18 22
Capital repayment to partners -8 -9 -10 -16 -21
Payments to partners -235 -304 -391 -439 -361
Retirement benefits paid to partners -5 -7 -8 -7 -36
Other 6 6 0 8 -5
Change in net cash 7 -5 22 -30 38
Net Cash at 1 May 59 66 61 83 53
Net cash at 30 April 66 61 83 53 91
Average number of:
Full partners 342 354 362 372 355
Other partners* 82 95 112 118 96
Total partners 424 449 474 490 451
Lawyers 1882 2033 2212 2302 2092
Support staff 2182 2212 2263 2297 2065
Total size of firm 4488 4694 4949 5089 4608
EBITDA margin 41.7% 46.6% 46.5% 42.6% 44.4%
EBIT margin 39.1% 44.3% 43.8% 39.6% 41.2%
Revenue per lawyer (£m) 0.319 0.357 0.378 0.391 0.413
Profit per full partner (£m) 0.78 1.03 1.12 1.05 1.09
Ratio all other staff / full partner 12.1 12.3 12.7 12.7 12.0
* mainly those in their initial years of partnership where remuneration is predominantly fixed
Peel Hunt 24
Magic Circle in full
We have summarised in the table below the last two years’ results for all the Magic
Circle firms, as published by The Lawyer. It is difficult to know whether results are
reported consistently but, on the presumption that they are, and after allocating a
derived amount for partners’ remuneration charged as expense, we find that over
the last two years the Magic Circle would have produced a profit of £670m on our
incorporation pay assumptions.
Using a 10x PER and ignoring tax this works out at £6.7bn total market
capitalisation and £3.9m per full equity partner, close to the number for
Allen & Overy.
Peel Hunt 25
Table 10: Magic Circle results
Source: thelawyer.com, Peel Hunt estimates
Year end 30 April (£m) 2009 2010
Revenue 1262 1197
Net profit 307 350
Total partners 637 562
Total equity partners 368 372
Equity spread - low 350 451
- high 870 1130
Profit per equity partner 733 933
Revenue 1295 1181
Net profit 514 507
Total partners 513 486
Total equity partners 428 442
Equity spread - low 642 622
- high 1605 1555
Profit per equity partner 1302 1074
Revenue 1287 1141
Net profit 603 589
Total partners 444 444
Total equity partners 417 419
Equity spread - low 659 627
- high 1647 1500
Profit per equity partner 1443 1406
Slaughter & May
Revenue 504 439
Net profit 281 228
Total partners 131 128
Total equity partners 125 124
Equity spread - low 1200 1050
- high 2400 2100
Profit per equity partner 2250 1840
Allen & Overy
Revenue 1091 1050
Net profit 390 388
Total partners 490 451
Total equity partners 372 355
Equity spread - low 538 661
- high 1345 1652
Profit per equity partner 1047 1090
Revenue 5439 5008
Net profit 2095 2062
Partners remuneration charged as expense * -314 -309
Adj. Net profit from partnership 1781 1753
Total equity partners 1710 1712
Net profit on incorporation ** 677 662
* Assumed to be same 15% rate against partnership profit as at Allen & Overy;
**On basis of £250,000 salary per full partner and 50% profit share
Peel Hunt 26
Recommendation structure and distribution as at 11 May 2011 No %
Buy > +10% expected absolute price performance over 12 months 139 55
Hold +/-10% range expected absolute price performance over 12 months 91 36
Sell > -10% expected absolute price performance over 12 months 23 9
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