A major aim of the introduction of alternative business structures (ABS) in England and Wales was to allow new forms of capital into regulated law firms to improve market efficiency. Enabling external investment in law firms was designed to allow less reliance on short term sources of financing such as personal debt and overdrafts. The expectation was that the admission of new capital would increase competition and reduce the cost of legal services, to the benefit of the regulatory objective of access to justice. In turn reduced cost should improve access to legal services translated through lower prices, as cost –perceived and actual – is a key barrier to accessing legal services for individuals and small businesses.
However, investment in law firms remains an under-explored area of research. To address this knowledge gap, the Legal Services Board (LSB) commissioned a piece of research to identify current sources of capital and establish how the investor community views the market and any barriers to investment.
Key findings of the report
The research showed:
- The majority of ABS firms (66%) either have already invested (in themselves) or are planning to do so, since they gained their ABS licence. These investments have mainly been made to hire more staff, increase marketing activity or to purchase IT.
- Overall, 52% of ABS had made an investment in their business since obtaining their licence, and 14% are planning to do so. Although only limited data is available about investment by non-ABS entities, where it exists it suggests that a greater proportion of ABS make investments than non-ABS entities.
- ABS firms access a wide range of sources of finance, and only a small proportion of ABS indicate difficulties in accessing finance. The most frequent source of funding for investments was business profits or cash reserves, which were used by 49% of those who had invested in their business. Just over a quarter of investments were solely funded using a loan from a bank, and a quarter were solely funded using the business’ overdraft facility.
- External sources of equity finance accounted for only a minority of investment funding sources either as the sole or joint source of investment funds, and only 12% of ABS had used any form of external finance.
- According to investors, the legal sector is seen as a ‘sleepy’ market with opportunities for investors to grow their investment capital by improving efficiency within the business itself. Investors appear to have concerns about the ability to exit the legal sector once their investment has matured.
- Except perhaps in the personal injury sector, it would appear that bank lending is a substitute for external capital. For the firm this means they do not have to cede ownership control of part of their business. In addition, there is a view that many firms do not present financial information in the ways investors expect and/or have a weak grasp of the value of their businesses.
- Only 6% of ABS identified some aspect of legal services regulation that prevented them accessing finance. Nor does the cost of legal services regulation appear to be a barrier.
- The low level of external investment seen to date may be a symptom of weak competition in the market overall, as found by the Competition and Markets Authority market study, LSB’s Market Evaluation and the joint SRA/LSB research revealing that levels of innovation are only increasing slowly. In the absence of strong competition, there is little impetus for law firms to take the greater risks (and rewards) involved with using external capital. Until these incentives change we may not see significant growth in the use of external capital by ABS firms.