- Legal sector facing scepticism from investors and threats from US firms
- Entry of Big Four into legal services could shake up the top tier
The past few months have reminded us that listed law firms are still in their infancy. Gateley (GTLY) – which is a stock market veteran compared with its peers – floated less than eight years ago, well after the financial crash. This hasn’t mattered much so far, but with recession looming and business confidence down, investors want proof that companies will be able to withstand a prolonged downturn.
Shares in listed law firms ranged from disappointing to dismal in 2022. Knights (KGH) has lost three-quarters of its value since last January; Keystone’s (KEYS) share price has fallen by 50 per cent; DWF (DWF) is down 30 per cent; and shares in Gateley are down by a tenth.
“Sentiment has deteriorated,” said Jamie Murray, an equity research analyst at Shore Capital Markets. “A key point last year was costs. We were receiving lots of notifications that law firms were paying record-breaking wages to newly qualified solicitors. Listed law firms aren’t in the top tier, so they are not facing as much wage pressure, but they are still feeling it.”
Investors have also turned on companies that are too reliant on transactional work, given the slowdown in M&A.
Even when you discount immediate economic concerns, law seems to have lost some of its lustre. “It’s seen as a steady, income play,” said Murray. The sector wouldn't provide any thrills for growth investors, he added.
Case-by-case basis
When it comes to legal services, however, the market has an unhelpful tendency to generalise. “The companies all behave quite differently and when one of them has a company-specific issue, it sometimes brings the sector back into a negative spotlight,” said Mike Allen, head of research at Zeus Capital.
Knights is an obvious example. Last March, the regional player issued a profit warning that rippled across the industry, setting investors on edge. Meanwhile, concerns about its growth prospects and acquisition strategy still haunt the sector as a whole. This is despite the fact that it has a different business model and different end markets from its stock market peers.
Gateley, for example, has continued to enjoy strong organic growth, despite exposure to cyclical markets such as property, and is confident that its litigation and employment divisions will help to offset any decline. Meanwhile, it has defied worries about wage inflation by simultaneously growing its headcount and reducing its personnel costs as a percentage of revenue.
“For Gateley, growth accelerated as a result of coming to market in 2015," said Liberum analyst James Allen. "Growth has been consistent and well in excess of the legal sector as a whole."
Cash is one of the most important things to keep an eye on when making comparisons. Firms often run into difficulty with liquidity because they get paid at certain project milestones, meaning a lot of cash is tied up in unpaid invoices and unbilled work in progress. Solicitors, on the other hand, must be paid a regular salary.
Keystone sparkles in this regard, as its lawyers are self-employed and take a direct chunk of what they bill. This means solicitors only receive their fees once their clients have coughed up and – as of summer 2022 – operating cash conversion sat at 101 per cent.
Threat from outsiders
No company is immune to wider tectonic shifts, however – and investment bank Arden thinks these shifts are gathering speed. In a report published last autumn, Arden argued that US legal practices are “besieging” elite London firms, fuelled by bumper balance sheets and powerful client bases.
This isn’t having a direct impact on listed practices, which do not compete with the glossiest corporate players. However, it could reshape the listed landscape more generally. “It’s only a matter of time before we see some of the larger firms come to market,” said Allen. “And as US law firms get more competitive, it might be time for firms to reassess their model.”
Mishcon de Reya is the most likely candidate. The group tried to IPO last year, but was thwarted by plunging valuations. While another listed firm would increase competition for capital, some analysts believe a big listing would boost confidence in the sector again – and encourage more partners to take a similar path.
How quickly this will happen is unclear, though. Knights chief executive David Beech predicted a “generational shift” away from traditional partnerships, but said it wouldn’t happen in just a year or two. “There’s an appetite to do so, but as a group of partners it is challenging and investors aren't necessarily queuing up to facilitate it.”
More imminent is the threat posed by the Big Four accountancy firms.
In recent years, these businesses have beefed up their legal arms, and things stepped up a notch in 2022. In May, KPMG announced plans to double its legal headcount. Meanwhile, EY is expected to fuel more money into law following the break-up of its audit and consulting divisions, as it won’t have to worry about conflicts of interest (earlier this month, the Financial Times reported that EY had set aside $2.5bn to fund acquisitions for its consulting arm, and planned to target niche law firms).
It's not entirely clear which practice areas the Big Four will focus on, but companies are on guard.
“There’s no point denying the fact that the Big Four, as a collective, are focusing more on legal services,” said Gateley’s chief executive, Rod Waldie. “I don’t view the Big Four as massively direct competition to us – they are probably a bigger threat to the magic circle and silver circle. But I do recognise that they are focused more now on legal services than they ever have been, and we have to have a weather eye on that, for sure.”
In some ways, of course, the Big Four's interest is a testament to the sturdiness of the sector in which investors have lost confidence.
