External investment could transform the UK legal market within five years.

The successes and failures of external investment in law firms have been much discussed. There have been spectacular disasters like Slater and Gordon whose value fell over (95%) following the ill-fated purchase of QLS. At Paribis, equity investors lost all of their money when the business went into administration last November.

Conversely, last year Gateleys became the first traditional legal business to float on a UK stock exchange. In July, it announced its maiden results since IPO: profits had grown by over 10% and its shares have given a healthy return to the issue price.

In the private equity world, Keoghs has built strongly on external equity investment and enhanced its position as an innovative market leader.

It is too early for a balanced judgement. What is clear is that there exist some powerful fundamentals that continue to underpin investment interest in the legal sector.

Technology will be a game-changer. New ‘law tech’ entrants have demonstrated new opportunities and threats covering artificial intelligence. These show that the modern law firm will need investment to compete. If existing partners do not have sufficient resources then external capital will be needed.

Small and middle-market firms are particularly vulnerable to technology change as the required investment may be beyond their resources. Thus technology has made access to capital a major competitive advantage.

Similarly, Brexit has has had a wide impact, increasing the uncertainty of business forecasts. Firms who are not in rude financial health may well need external investment to provide additional resources to maintain development.

Regulatory change has laid the foundation for external investment. However, some key areas such as criminal law and personal injury have been adversely affected by continued regulatory uncertainty. This has caused external investment to stall. But with this uncertainty likely to clear within the next six months, external investment will accelerate again. Investors know that the need for consolidation here provides opportunities for quality management teams and operating models. Backing the winners is where investors can get super-returns.

The UK legal ‘middle market’ –  that is, the top 50–200 – is a clear consolidation story. Too many firms are offering a ‘me-too’ service. Major economies of scale exist, especially in back-office functions. These can be unlocked with scale and the cash resources to reorganise and invest.

Finally, the aggressive development of multi-disciplinary practices (MDPs) that incorporate law will also encourage further investment. MDPs are often corporatised and offer a wide array of cross-selling opportunities. Several of the Big Four accountants have developed significant legal practices and this operational precedent acts as a further attraction to investors.

The global legal services market is vast, at $730bn of revenues. No legal services provider has more than 1% of the market. At the same time because of legislative/regulatory changes the UK is one of the first to attract external investors.

Notwithstanding the mixed impact of the first wave of external investment there is clearly a gathering groundswell of investment pace. The impact of external investment is accumulating in the sector. Further it is creating a new managed/corporatised structure for UK legal services. Our own research shows that well over £1.2bn of legal revenues are now controlled by corporate investors, equivalent to a magic circle firm.

Research has shown that such firms are more innovative than existing firms, aided by their decisive governance structures. They also have significant access to further capital to maintain development. This ‘snowball effect’ from external investment could well be the catalyst to transform the UK legal market in the next five years.

John Llewellyn-Lloyd is head of business and support services at Arden Partners, London