Why Law Firms Could Be Private Equity’s Next Conquest

This article was originally published in Forbes on February 26, 2024. Read the full article here.

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Why Law Firms Could Be Private Equity’s Next Conquest

Law firms are a lucrative $400 billion market that has long been shielded from outside ownership. In search of fresh turf, buyout firms may soon be hunting among the gray flannel suits.

It’s rough being a lawyer. And no, that’s not the set-up for a joke.

Landing a job at a top-notch white-shoe law firm offers a mix of glamor, prestige, and a hefty paycheck. But that money often comes with a high cost to personal happiness.

On the flip side, going solo promises more control over your life and might even lead to actually enjoying your work. But there’s an under-discussed challenge with going it alone: figuring out an exit strategy when you’re ready to retire.

Several factors play into this, but one is unmistakable: the legal sector might just be the only field where private equity has yet to stake a claim. Lacking access to the deep pockets, operational expertise (and to some extent, a cutthroat, profit-first mentality), the industry lags. Unlike say medicine or dentist practices, law firms tend to be stubbornly set in their ways and, at the big firms at least, operate mostly for the benefit of partners whose concerns for the future may wane once they retire—if they ever do.

That’s the dilemma Eric Pacifici was facing back in August of 2021. Back then the 2015 Duke Law School grad was grinding out billable hours as an associate for Kirkland & Ellis, the most lucrative law practice in the U.S. with $6.5 billion in annual revenue and a client list that’s a who’s who of corporate America. Pacifici was looking for a way out of the meat grinder. So, under a pseudonym, he ventured onto X (then known as Twitter), yucking it up with folks looking to buy small businesses. At first, he wondered if entrepreneurship through acquisition could be his ticket out. What he stumbled on though was a different kind of escape—leveraging his legal expertise to assist budding entrepreneurs.

His handle, @SMB_Attorney, has become a hotspot for tips on buying small businesses, though, to be fair, some of his 107,000 followers might just be there for his weekly reviews of pizza restaurants in the greater Orlando area. Pacifici’s social media blitz is working: his firm, SMB Law Group, has grown to 18 members, closing $1 billion in deals his firm has advised on since opening its doors in 2022.

While Pacifici, 37, and his team are busy turning others’ entrepreneurial dreams into reality, or helping them cash in and enjoy the fruits of their labor, finding a way out for himself when the time comes could be a different story. Because here’s a little-known fact that many lawyers dreaming of hanging their own shingle tend to miss: selling a law firm isn’t easy, and it’s far from a guaranteed jackpot.

Pacifici shed light on the problem in a February post, questioning why small law firms, even when they “print money,” attract few buyers.

One obvious reason is “key man” risk. As you might guess from their names, law firms are closely tied to their founding or leading partners. If they decide to sell and hit the beach, the firm’s most valuable assets—those lawyers’ expertise and reputations and, often, clients—walk right out the door with them. And, to add to the trouble, any remaining lawyers can easily pack up and leave too, since the legal profession frowns upon non-compete agreements.

But the most prohibitive obstacle is American Bar Association Rule 5.4, which may as well be called “The Only Lawyers Can Own Law Firms” statute. This regulation, in effect everywhere but Arizona and Utah, effectively sidelines private equity firms and other investors who might otherwise be keen to turn profitable law practices into their next cash cow.

“Blocking non-lawyer investments shuts law firms out from the capital that drives innovation in other parts of the economy.”

What you get as a result is a market that values a personal injury firm netting a cool million annually far less favorably than, for example, a similarly successful HVAC business.

“We came into this to build a firm like a traditional business,” Pacifici said. “There are a lot of tailwinds to overhaul these legal standards. My hope is that it happens and we can build a business that a private equity firm would want to acquire. Because right now, those big exits for law firms just don’t exist.”

American Bar Association Rule 5.4 serves a purpose. It’s meant to preserve the sacred independence of the profession. Think of it as a guardrail, ensuring that lawyers keep their focus on justice and client interests, rather than being pressured into producing more profits or cash flow for folks who never sat for the bar exam.

“Bringing in PE money could create a conflict of interest,” Kevin Henderson, the cofounder of SMB Law Group, acknowledged. “I’d be remiss to say that concern is made up, but other professions have been able to make it work.”

Rule 5.4’s heart might be in the right place, but it does, as Henderson said, make law an outlier. Medicine, dentistry, accounting—don’t have these hard-and-fast ownership rules. Earlier this month, San Francisco private equity firm Hellman & Friedman announced it would lead a deal to acquire accounting firm Baker Tilly, giving it an enterprise value of more than $2 billion.

Is law really so different, or could it too handle a bit of outside capital and all the strings that come attached without compromising its soul?

Some lawyers are questioning the status quo. Arizona and Utah have already eased up their limitations around ownership, and other states like California and Florida have flirted with changes. An April 2021 article on the American Bar Association website concluded that the rule does “more harm than good” while former Stanford Law School professor Deborah Rhode argued that blocking non-lawyer investments shuts law firms out from the capital that drives innovation in other parts of the economy.

Considering that the buyout business has ballooned to more than 4,000 firms competing for deals, law could represent a new, fertile hunting ground. According to IBISWorld, law firms raked in $381 billion in revenues in 2023. Moreover, American Lawyer’s annual ranking of the world’s 200 biggest law firms by revenue, reports that the top five in the U.S. alone bagged $21.8 billion in 2022. Leading the pack, Chicago’s Kirkland & Ellis, with its army of nearly 3,000 attorneys focusing on big-time corporate deals. All told 425,000 law firms in the U.S. pocketed $78 billion in profits last year, according to IBISWorld, flaunting a 20% average profit margin—slightly higher than a darling of private equity, software publishing. Plus, with law being as fragmented as it is, it’s practically screaming for consolidation, one of private equity’s favorite tactics.

If the stodgy legal establishment is hoping to keep buyout firms at bay, it may need more than just the velvet rope of ethical rules.

Lee Minkoff, a managing director at Renovus Capital, a private equity firm in Wayne, Pennsylvania, has found one foothold into the legal market. Harbor Global, created from eight Renovus acquisitions, offers a business and tech services platform for law firms and legal departments. They’re not quite on the inside, but they’re on the cusp where it’s still plenty lucrative. Minkoff estimates the law firm tech market in the U.S. and U.K. (where Harbor has its largest footprint) is good for $25 billion in yearly sales.

“Speaking for myself, I think the rules are going to continue to change, like what you have seen in Arizona and Utah,” Minkoff said. “You can lend to firms, you can invest in cases, but you can’t acquire equity. There are investment firms trying to figure out how to do that, whether directly or indirectly. If you buy a financial advisor’s book of business, you’ll be paying a multiple of three or four times revenue, if not more. Right now you’d be paying one times or less for a lawyer’s. There are, of course, differences, but that’s an attractive deal in terms of relative valuation.”

Bargain prices for law firms aren’t the only potential benefit Minkoff notes. He thinks law firm returns are largely uncorrelated with the rest of the economy–a dream scenario for investors. What that means is that lawyers generally stay busy regardless of whether the economy is running hot or cold. Take corporate law, for example: during economic booms, there’s an abundance of mergers and acquisitions. In downturns, there’s steady demand for restructuring services. This principle also applies to areas like divorce law, personal injury, and estate planning.

Eric Hsu, the founder of Clear Focus Law, a Kennewick, Washington firm that represents buyers in small business transactions, isn’t so sure investing in law is all it’s cracked up to be.

“I think the legal profession is the biggest dinosaur of all the dinosaurs,” says Hsu. “Law firms have had this death grip on information for so long that I think it’s going to come back and bite them. They’re ripe for disruption, so who would want to buy them?” Hsu brings up another unseen, but common problem with small law practices. “I’m not even sure most lawyers actually would want to sell their practice. It’s their life, many are lawyers before they’re human beings.”

Although lawyers notoriously shy away from change, there’s historical evidence of what happens when restrictions on external investments go by the wayside. Australia opened the gates in 2001, with England and Wales following suit in 2007. The influx of private equity hasn’t been overwhelming—a 2020 report from University College London noted that only 10 percent of firms adopted a so-called “alternative business structure.” Yet, the outcomes have been reasonably positive, or, at least, not concerning. A 2014 report found no significant disciplinary issues nor an unusual volume of complaints among those that took money from outside the profession, suggesting the model is viable without compromising professional standards.

“Australia, England, and Wales have been at this for a while and the sky hasn’t fallen,” said Tom Lenfestey, the founder and CEO of The Law Practice Exchange, a marketplace for buying and selling law firms. “I think it’s reaching the point here that consumers just want something different. People need access to justice. To make that happen, law firms need to invest in technology and that’s going to take outside money and an outsider’s mindset.” Already, much of the work currently undertaken by lawyers doesn’t require a legal degree. Outsourcing or automating—areas where private equity excels—could make legal services more of a commodity than a luxury.

Austin Aaronson, a Longwood, Florida attorney, carved out a successful niche freeing clients from timeshare contracts. Recently, business has surged, a boost Aaronson credits to private equity’s aggressive foray into the timeshare market (Apollo Global, for example, bought Diamond Resorts for $2.2 billion in 2016, before taking a hit and offloading it to Hilton Grand Vacations in 2021 for just $1.4 billion).

Aaronson hit the jackpot, relatively speaking, when he sold his practice to another law firm, fetching about 1.3 times its annual revenue. And he admits that if private equity, the foe he’s been locking horns with, had the chance to kick the tires he might have done even better. Yet, he’s still skeptical about changing the rules.

“I can’t tell you how many times I had to turn bidders away because they weren’t attorneys,” Aaronson said. “But I think the rule needs to stay the way it is. I don’t think non-attorneys should own law firms. The potential for abuse is too high.”

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