Australia leads the world in law firm IPOs with Slater & Gordon, Shine and Sprusons noted as ASX success stories. Last week, Gateley became the first UK law firm to list.
While most law and other professional service firms will not see much strategic value from a public listing, I think there is significant benefit in applying “the market test”. In other words, if we did an IPO would it be successful? Would the market look at us favourably and drive our share price higher? Would the market judge our risk-adjusted short- and long-term earnings outlook as better than other investment options?
While it may be a fanciful scenario, I argue that the market test is an interesting and important question to address in your duty to current shareholders. It may reveal strategic insights that classic textbook analysis will not.
In my view, the market test comprises six key success factors.
#1 Sufficient surplus to satisfy existing, new and future shareholders
Put simply, do the numbers stack up? Taking an existing shareholder perspective, the financial modelling needs to prove that the net present value of the IPO option, taking all capital and income components into account, is likely to be comparable or better than the current model. Variations of this theme might include surplus to support employee share ownership, direct external investment or joint venturing.
#2 Predictable core business with sticky long-term client relationships
Is the core business bankable? There are two key elements to address here: [A] are the markets we compete in likely to grow and be profitable, and [B] is our current business model, offering, client base, market position and delivery system sustainable?
As an example, the top-end corporate and commercial legal market in Australia may fail test A. Recent data suggests a declining revenue trajectory, increasing competition, buyer power accelerating, new entrants and increasing commoditisation. A firm as operating a traditional partner-led pyramid business model predominantly selling time with low levels of automation, may fail Test B as well.
#3 Clear strategic plan for growth – strong upside potential
Is there a clear growth story and is it believable? Assuming the IPO results in a substantial capital injection into the firm (i.e. it’s not just a grab for cash by the incumbents), where and how will the money be used. NewCo Ltd could use its revised balance sheet to acquire smaller successful independent practices. It could invest in technology to make a step improvement in business efficiency, and/or diversify into countercyclical and congruent tech businesses. It could invest in or set up new business model enterprises that may cannibalise the existing business but also provide a competitive hedge. Fresh (patient) capital may allow for investments in new markets that are growing and have long-term profit potential. The growth story needs to be clear and compelling, not just a wish list of strategic options.
#4 Lengthy hand-cuffs on key revenue earners
Will the rainmakers stay? Most firms are very reliant on a few key people that year-in and year-out outperform their peers. The market will be very keen to ensure that these key revenue generators will be there for the long haul, and are happy to work just as hard and just as effectively in the new structure.
#5 Depth of leadership talent and systems to sustain growth
Who’s on the bench? Many of the most successful professional service firms over the past 10 years have one common characteristic: they have a ONE supremely gifted leader that has led the firm to greener pastures. The talent and energy of these key individuals has been the defining factor of outperformance.
This is all good, but the market is really sensitive to key-person risk. If the proverbial bus had to arrive, will the firm hold together without the key person on board? Is the firm a proxy ponzi with the CEO a Madoff in disguise? What’s the depth and breadth of the leadership team and beyond? How robust are the managerial systems and processes? Will they work regardless of who is in charge? The new growth story is great, but are there the requisite skills to make it happen?
#6 Cultural alignment
Most professional service firms define themselves as partnerships. Even those that are incorporated make a special effort to treat senior practitioners as partners and peers. One of the risks of listing is the potential loss of the “partnership” culture – a sense of proprietorship, stewardship, collegiality and identify that comes from being a co-owner, manager and producer. Shifting ‘down’ from partner to employee may be a big shock to the ego for some. A dilution of ownership might not mean a lot in income terms but it may be a seismic cultural shift.
There’s an interesting paradox in success factor #6. The market would want to invest in a enterprise where all the key staff were committed to its ongoing success. But perhaps a partnership is the preferred model for a high performing partner-driven professional services firm that has a widely held equity base. A firm that is tightly held by just a few equity partners or a start-up is a different story.
Many commentator love to knock the partnership model and claim it’s an anachronism. I
agree it has many flaws, but show me an alternative model that produces as many millionaires for so little risk…
So, how does your firm stack up against the market test? If you were an independent financial analyst would your recommendation be: Buy, Sell or Hold? Most importantly, what would it take to get the firm to an Immediate Buy recommendation?