Martin Partington: Spotlight on the Justice System

Since licensing began in 2011 there have been 950 ABS licences issued. As of March 2017 there were 892 active licences.  In April 2017, the Legal Services Board published a significant report into ABS. It sought to address 4 questions, which I have adapted from the report and which I try to summarise here:

1.What kind of investment activity has there been in ABS?

These businesses are predominantly existing legal service businesses converting to ABS status, with one in five respondents to our survey being new firms. Three fifths of ABS have less than 50% non-lawyer ownership. Just under one in five ABS are wholly owned by non-lawyers, with a similar proportion being fully owned by lawyers but having some proportion of non-lawyer managers….

The research shows that the majority of ABS firms (66%) either have already invested 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. The LSB sees this as evidence of the increased scale that allowing non-lawyer ownership was designed to enable.

2.Is the market attractive to all sources of finance?

The survey shows ABS firms accessing a wide range of sources of finance, and only a small proportion of ABS indicating 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 us ing 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. Partnerships are more likely to use debt funding for finance, with 55% using loans or overdrafts, but none had used external investment. Companies limited by guarantee had the highest proportionate use of any form of external funding, with 24% issuing shares, investment from private equity, or becoming a subsidiary of another company.

3. What do investors think of the legal services market?

According to the investors interviewed, 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. They appear to have concerns about the ability to exit the legal sector once their investment has matured, although there are some examples of private equity investors having sold on their investment and exited the sector.

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.

This might explain the investor’s perspective of the legal sector as being reluctant to seek investment from private equity firms, and reports of investors struggling to find appropriate firms in which to invest. While the overall size of the market and the scale of businesses operating may limit opportunities for some investors, the LSB thinks that cultural norms, governance, and non-commercial financial management practices in some businesses are likely to be more important factors.

4. Are there any regulatory barriers to investment?

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… However there is anecdotal evidence of some areas of regulation causing concern to investors. These includes restrictions on ownership and picking up liabilities for historic complaints and insurance claims.

Only 1.5% of ABS identified some aspect of wider regulation that prevented them accessing finance. The regulatory barriers to investment cited by the investor and investment consultant we spoke to relate mainly to wider regulatory and governmental activity, particularly in relation to personal injury reforms

Conclusion:

The potential link between investment and enabling better access to legal services is well–rehearsed elsewhere. However, investment remains an under-explored area of research and generally licensing authorities have not used their data to understand trends in investment and financing. [Overall it may be concluded that] levels of innovation are not increasing.

The dynamics of competition create incentives for suppliers to increase productivity through innovation, which lowers costs and hence prices through time. This is likely to involve taking a different approach to delivering a service, or developing new services completely. In the absence of strong competition, there is insufficient impetus for law firms to take the greater risks (and rewards) involved with using external capital.

Until these incentives change the LSB thinks there is unlikely to be significant growth in the use of external capital by ABS firms.

The report can bee seen at http://www.legalservicesboard.org.uk/news_publications/LSB_News/PDF/2017/20170613_LSB_publishes_investment_in_legal_services_research.html