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Wall Street is beginning to scratch the surface of the unique investing opportunities in the legal profession. You may be thinking, “Didn’t those same folks disrupt the medical, dental, and accounting professions?” Yes, they did, and our profession is their next target.
But What About Rule 5.4 of the Rules of Professional Conduct that Prohibits Nonlawyer Ownership?
The rule, which virtually every state follows, acts as a guardrail to curb a nonlawyer owner from hindering a lawyer’s independent and professional judgment. The concern behind the rule is that nonlawyers would put aside ethical obligations to enhance profits.
But some recent developments surrounding the rule suggest that it is beginning to crack. The rule is already not absolute in a small minority of states, including Arizona, the District of Columbia, Puerto Rico, and Utah. The biggest crack is in Arizona, and it is the changes in that state that are getting the most attention.
In 2021, Arizona created a regulatory framework of licensed entities known as Alternative Business Structures (ABSs). This framework permits a nonlawyer to have an ownership interest in a law firm. The intention was to increase access to legal services by allowing for greater innovation, outside investment, and collaboration between lawyers and other professionals. According to the Arizona Judicial Branch’s website, the purpose is “rooted in the idea that entrepreneurial lawyers and nonlawyers would pilot a range of different business forms that will ultimately improve access to justice and the delivery of legal services.”
The impact has not been what the regulators envisioned. Last year, a Wall Street Journal headline expressed it best when it reported, “Why Arizona Law Firms Are a Hot Investment for Private Equity.” There are now more than 150 ABS law firms in Arizona. Estimates suggest that private equity (PE) has funded nearly half of the initiatives, a figure that significantly exceeds that of law firms whose mission is to expand access to justice.
And earlier this year, KPMG, the accounting, tax, and consulting behemoth, created its own ABS. The last time I looked, “access to justice” was not a goal cited in its vision statement.
The Workaround – Management Service Organizations (MSOs)
With Rule 5.4 firmly entrenched pretty much everywhere else in the country, private equity (PE) has turned to the business model it used to disrupt the other professions, the management services organization (MSO), to evade the rule’s restrictions.
Put simply, MSOs are companies that handle the non-legal, business side of a firm. At the same time, attorneys still technically own the firm, and are the only ones who practice law. In other words, the law firm remains a separate entity owned by lawyers; the firm then contracts with an MSO to handle most non-legal, administrative back-office services. The private equity entity owns the MSO and generates profits from the services it provides to the law firm.
What Do the Regulators Say?
To date, not much. Supporters of MSOs insist that they are no different than any other vendor selling services to a law firm. Earlier this year, Texas issued an opinion holding that an MSO fee structure cannot be based on a percentage of the law firm’s revenue. No surprise there. That’s always been the case for law firm vendors. What has yet to be examined are the contours of the relationship between the law firm and MSO. Will that be a strictly arm’s-length one as with any other vendor? No one really knows. Time will tell.
Why the Legal Profession is Ripe for Disruption
From an investor standpoint, law firms check several boxes. First, the market is highly fragmented; the vast majority of U.S. lawyers practice in solo or small firm settings. That fragmentation creates opportunity for consolidation.
Second, many practice areas produce steady and predictable revenue streams. Family law, criminal defense, estate planning, collections, bankruptcy, personal injury, and workers’ compensation all have recurring demand. The need for legal services is constant. The practice areas are usually remarkably resilient and sturdy enough to withstand economic swings. For investors, law firms become not just a source of reliable cash flow, but an asset with little fragility.
Third, lawyers are notorious creatures of habit. One of those nasty habits is an aversion to technology. That is why the efficiency gains from technology are so attractive. Client intake, case management, billing, and marketing can all be streamlined with the right tools. A firm that once relied on manual processes can quickly see improved margins when modern systems are introduced.
Finally, the opportunities are limitless. Everyone knows about the unprecedented exodus of retiring baby boomer lawyers, many of whom haven’t planned their exit strategy. A PE buyer may be exactly what they need to cash out. Many of those same firms are ripe for the PE consolidation playbook of buying a handful of small firms and “rolling them up” into one large entity, and then turning around and selling that entity to another PE investor for a tidy profit. In short, this could open the door to an enormous pool of buyers who have money, business acumen, and a “just can’t wait” attitude to disrupt the legal profession.
What is the Current State of Affairs for MSOs in the Legal Profession?
It is definitely taking off. Why am I so sure? One lawyer in the space claimed in a recent article that “activity has exploded in the past few months.” She further claims that she’s involved in a dozen deals at the moment. Another lawyer I know personally who also practices in this area recently told me that he receives a few inquiries from new market entrants every week. Lastly, as one of the few nationwide small law firm succession planning consultants and law firm brokers, I was approached by a PE investor looking for opportunities for the first time five years ago. The second one was a year after that. Now, new PE folks call a few times a month.
Why is PE seemingly late to the party in disrupting the legal landscape? I’m not sure. I find it even more puzzling because hundreds of lawyers themselves have had MSOs as clients and were undoubtedly aware of the possibilities they offered. In any event, the light bulb has definitely gone on. Indeed, it is getting brighter and brighter.
The Road Ahead
Change in the legal industry always comes slowly because of our distinct mentality as attorneys. As someone once remarked, “We’re the only profession that hasn’t changed in one hundred years, and we’re proud of it!” For now, the market for law firm acquisitions remains fragmented and opaque. There is no standardized valuation method or central marketplace exchange. But that is precisely what makes this moment unique. Early participants will have the chance to shape the norms and expectations of an emerging market.
Law may have been late to the “consolidation of the professional game” party, but its time has come. The future of law firm ownership will be defined not only by who practices law, but by who best understands its business.
