Slater and Gordon was once the golden child of the ASX. Since becoming the first law firm in the world to list on a stock exchange in 2007, its success seemed to know no bounds.

Its share price roared upwards, providing the company with the financial fuel to vacuum up numerous law firms through acquisitions. But then, mid-way through last year, its fortunes took a dire turn.

A $1.3 billion UK acquisition, followed by investigations by UK and Australian regulators into the firm’s accounts, left investors feeling suspicious. In April 2015, the firm had a total share value of $2.75 billion. By January this year, that figure had reached a devastating low of $250 million.

Shortly after, a similar fate befell Australia’s largest personal injury firm Shine Corporate, a plaintiff firm which listed on the ASX in 2012. Shine’s share price plummeted as the firm issued a trading halt and announced a dramatic halving in expected profits for the year.

What happened? Why have these two listed law firms, with similar business models, imploded over the past year? And, what does this turn of events mean for the two other listed law firms in Australia, Xenith IP and IPH Holdings?

A world first

The intense interest surrounding the fate of Slater and Gordon and Shine Corporate is largely due to the novelty of the listed law firm model. After enacting laws to permit incorporation of law practices in 2001 in NSW, Australia became the first country to allow law firms to float on the stock exchange. Today, Australia and the UK are among a small group of nations where law firms are able to list.

Slater and Gordon’s IPO was quickly followed by that of another legal business, Integrated Legal Holdings Limited (ILH) in August 2007. Slater and Gordon quickly gobbled up firms using cash provided by shareholders and swelled in size, building up a staff of 2,500 across 70 locations in Australia and 18 locations in the UK. Meanwhile, ILH became the first listed law firm to go into voluntary administration after pursuing fast growth and experiencing difficulty retaining senior lawyers.

Between 2014 and 2015, two of intellectual property firms, Xenith IP and IPH Holdings, also launched IPOs. But, despite the apparent success of most listed firms up until last year, other Australian law firms have remained reluctant to follow suit.

Lawyers Weekly approached Slater and Gordon, Shine Corporation, Xenith IP and IPH Holdings for this story but only Xenith IP chose to provide a response to our questions.

Roll-up trap

The decline of Slater and Gordon directly followed its aggressive expansion into the UK market, leading some to suggest that this accelerated growth is at the root of the company’s troubles.

Gareth James, equity research analyst at Morningstar, says Slater and Gordon has fallen into the common trap of trying to consolidate a highly fragmented industry – a business strategy known as a ‘roll-up’.

The legal industry contains a multitude of independent practices because value sits primarily with individuals, he says.

“There has not been much sense for it to be consolidated because if you are a good lawyer, then you can just set up on your own,” Mr James explains.

But now, Slater and Gordon has taken advantage of changes in restrictions around corporatisation of law firms to start consolidating the industry through acquisitions, according to Mr James.

“The key attraction to the roll-up is that there tends to be a difference in price between what you pay for a small business and what it is valued at on the stock market – very large companies are valued much more highly than very small companies,” he continues. This valuation uplift, called ‘evaluation multiple arbitrage’, means that rapid acquisitions increase company profits without any extra value being added to the acquired business, says Mr James.

Slater and Gordon has made over 30 acquisitions over its lifespan, including Blessington Judd, Crane Butcher McKinnon, Carter Capner in 2008; Trilby Misso Lawyers, Keddies Lawyers in 2010; and Biddle Lawyers last year.

Slater and Gordon made the “common mistake” of expanding into overseas markets once it had exhausted its growth options in Australia, says Mr James. Companies that move overseas “do not always understand the markets they are going into or the businesses they are buying”, he says.

In early 2015 Slater and Gordon made a “really massive acquisition” in the UK, buying a business that did not have the best reputation and is being asked questions by regulators, Mr James says. Slater and Gordon “got their fingers burnt” by borrowing substantial amounts of money for the purchase, and the drop in share price reflects the market’s concern that Slater and Gordon is saddled with debt that it cannot service, he explains.

Many Australian companies have made similar problematic overseas acquisitions, according to Mr James.

“There is also a well-established history of roll-ups unravelling,” he says.

While organically growing companies are creating real value, the stock market tends to reward companies that make rapid acquisitions even if no extra value has been created, Mr James continues.

“Roll-ups tend to go very well for a long time for a few years and it is not uncommon for them to collapse.”

Roll-ups in the professional services area are particularly risky as it is difficult to “extract synergies” or cost-savings from businesses which rely on individuals fee-earners, Mr James explains. “If you buy two law firms there’s not really many costs that you can pull out,” he says. These rollups also suffer from retention issues, as the departure of key senior staff following an acquisition can seriously affect the value of the business, he adds.

Is listing the problem?

Growing too quickly can lead to financial difficulties whether a company is listed on the stock exchange or not. However, the ability to raise capital through shareholders makes rapid acquisitions easier.

In this sense, listed law firms face the opposite challenge to those of private law firms, says consultant Peter Frankl, director of the Legal Practice Specialist.

“The default setting of most private law firms is a lack of liquidity in the business. The challenge of the listed law firms up until now has been to make effective use of the funds that have been made so readily available to them.”

However, problems arise when businesses rely on making larger and larger acquisitions to maintain profit growth, says Mr James.

“It is like a house of cards,” he says.

All parties involved are motivated to continue building quick revenue, including law firm executives, investment banks, advisers and shareholders.

“Obviously the person who is consolidating the industry is financially motivated to do as many acquisitions as possible,” he says.

This creates a conflict of interest and can lead to hasty acquisitions of low-quality businesses.

“The whole market falls in love with the company. And no one really cares what you buy. They say ‘keep going’,” says Mr James. “But sooner or later the music stops very often people go, ‘oh, these businesses are actually a load of rubbish and we haven’t created any value along the way’. Here comes the hangover.”

But could law firms have this problem even if they were not listed? According to Mr James, shareholders do not put pressure on companies to make risky acquisitions.

“I don’t think it is a problem with being listed,” he says.

Public companies are, however, exposed to much greater scrutiny than private firms, which can cause greater volatility, says Warren Riddell, a partner at Beaton Capital.

“A listed law firm is accountable to a market – as opposed to a room full of partners,” he says.

“The market can be unforgiving, and the dynamics today with hedge funds and professional ‘shorters’, will react and maybe overreact to negative news,” he continues.

“Halving your profit forecast as Shine has done will raise questions in the market such as, ‘do these people know what they are doing?’, and ‘what are the professional board directors doing?”

The fact that Shine and Slater and Gordon are in the same legal space – consumer law – has not helped, he adds.

“Their combined errors have compounded the negativity in the market,” says Mr Riddell.

Mr Riddell still believes consumer law firms using a leverage model (rather than a model that is highly dependent on partners to drive profit) can operate under listed ownership.

“Rather than challenging the logic of listing, the events over the last year maybe show that [Slater and Gordon and Shine] have yet to come of age and understand the demands of being a public company,” he says.

“Maybe Slater and Gordon’s aggressive growth strategy and their acquisition of Quindell demonstrates a rashness that one does not normally associate with lawyers? The market is still coming to terms with this new asset class – these strategies and actions have not helped to embed it in the system – as their share price has shown.”

In an unexpected twist, Slater and Gordon is also now facing class action law suits from its major rival in the class actions space, Maurice Blackburn, as well as ACA Lawyers. The pitting of law firms against each other in this way is an entirely new phenomenon and has done little to dull media interest or improve market confidence.

Flawed business model?

As plaintiff law firms, both Shine and Slater and Gordon have a large number of unresolved cases on the go. A proportion of these cases will result in revenue but some, such as ‘no win, no fee’ personal injury and negligence cases, never generate revenue. This build up of ‘work in progress’ (WIP) creates uncertainty in accounting, which only becomes more problematic if the company is rapidly acquiring businesses, according to Mr James.

Both Slater and Gordon and Shine acknowledged WIP as a factor in their lower than expected earnings towards the end of last year. Two weeks after reaffirming to investors that it would meet its earnings guidance on 1 December, Slater and Gordon abandoned its revenue earnings guidance for financial year 2016, citing a “poorer than expected case resolution profile” as a factor.

Similarly, Shine downgraded its EBITDA guidance from $52-$56 million to $24-$28 million on 29 January. The downgrade was related to a review, which prompted the firm to recalculate its WIP on the basis that all current cases may not succeed.

“One of the reasons both Slater and Gordon and Shine have been hammered relates to their failure to get their accrual accounting right,” says Mr Riddell.

In a partnership – or equivalent if a firm is corporatised – the focus is largely on “cash realisation”, meaning that WIP is not an important factor in measuring performance, he says.

“It is a pretty easy measure, so accrual accounting around WIP is often primitive in its sophistication for a partnership,” says Mr Riddell.

“Yes, accurate WIP is still important for tax accounting but it takes on a whole new meaning if you are a public company, with the need for continuous reporting. And quite clearly both Shine and S&G have been on a fast learning curve about the criticality of getting WIP right.”

A well-known joke in the profession holds that WIP is just ‘paper and hope’ – meaning it is essentially worthless until the client can be billed. Listed law firms are only now starting to realise that sophisticated accounting is needed to accurately measure the probability that WIP will not result in profit.

“It appears that they have been too bullish about both the amount of profit that can be realised and the timing of that realisation,” Mr Riddell says.

Mr James says Slater and Gordon’s forecasts around WIP have “historically been pretty good”.

“But one of the problems is that when you are acquiring businesses very rapidly it really distorts your accounts, so it is really difficult to see what is going on,” he says.

However, for companies to make such drastic changes in their earnings guidance “is pretty unprecedented”, says Mr James.

“Normally people don’t keep their jobs if they do this kind of stuff in the market,” he adds.

Two of a kind

Listed law firms currently come in two flavours in Australia. First, there are the B2C plaintiff firms such as Slater and Gordon and Shine, which aim to commoditise low-value, highvolume consumer law and conduct complex litigation.

Then, there are the two intellectual property firms: Xenith IP Group, which listed in 2015 at $3.24 per share; and IPH Holdings, which incorporated Spruson & Ferguson before listing in 2014.

According to Mr Riddell, the listed IP firms should not be compared to listed consumer law firms. “They are different business models and have different clients,” he says. IP firms are B2B, not B2C, and matters are of greater value and smaller number, according to Mr Riddell. Additionally, the “smart IP firms” have high margin annuity work based on renewals that are highly systematised – one of IPH’s advantages, he says.

Xenith IP and IPH Holdings have emphasised their distinctness from the beleaguered plaintiff firms. In turning down Lawyers Weekly’s request for comment, IPH said it was “not comparable to the listed law firms” and that it would “therefore be inappropriate for us to comment on the subject”.

Xenith IP Group’s chief executive Stuart Smith also emphasises that “the nature of our intellectual property practice is fundamentally different to other listed legal services businesses”. He says many of the problems that listed firms such as Slater and Gordon have confronted do not arise under Xenith IP’s business model.

Whereas plaintiff firms have encountered cash flow and accounting problems due to high volumes of WIP, the IP industry is much more predictable, he continues.

“WIP never builds up to an appreciable degree,” Mr Smith says. “At the end of last financial year our WIP was the equivalent of only a few days’ billings, and averaged only a few weeks’ throughout the year.”

These “relatively immaterial levels” of WIP mean that the firm has a high degree of certainty around cash conversion, he adds.

The nature of the IP cycle means law firms can send out regular bills to clients, according to Mr Smith.

“A key aspect of the IP industry is that it’s very process-orientated, with a myriad of discrete steps and actions throughout the life cycle, many of which are deadline driven,” he says. “That means we tend to issue large numbers of invoices for relatively smaller amounts, as various stages of the process are completed.”

By comparison, commercial law firms operating on a contingency basis might have to wait several years to invoice each client and even then, only if they win, says Mr Smith.

“Their accumulated WIP can be measured in terms of years, not days,” he adds. “These factors may all be manageable with adequate capitalisation, but they are nevertheless indicative of a fundamentally different business model, with a different risk profile.”

Despite the poor fortunes of Slater and Gordon and Shine, Mr Smith believes the listed law firm model can still inspire market confidence.

“It’s important to appreciate that there is no one listed law firm model,” he says.

“The real question is whether law firms that are primarily based around contingency work are suitable vehicles for shareholders with a low tolerance for uncertainty, volatility or risk. Investors just need to align themselves with the risk profile with which they feel most comfortable.”

When Xenith IP listed on the ASX in November 2015, it effectively acquired Australia’s oldest IP firm, Shelston IP. The firm has 100 employees, including more than 40 patent and trademark attorneys and IP lawyers. The majority (73 per cent in FY15) of Xenith IP’s revenue is derived from foreign clients, with the remainder (27 per cent in FY15) from Australasia.

The firm is now looking for growth opportunities in Australia and New Zealand and has plans to expand into south-east Asia.

“As for future acquisitions, we’re open to discussing opportunities that can broaden our expertise, extend our geographical reach and grow our market share,” says Mr Smith.

However, Mr Smith said he perceived some issues with growing too quickly through acquisitions.

“We plan to grow the business in a strategic, prudent and sustainable manner,” he says. “We are certainly attuned to the risks of growing too quickly, which can be a danger for any business.”

Do listed law firms have a future?

For some, the plight of Slater and Gordon and Shine has confirmed fears that listing is a dangerous path for law firms. Traditionalists, who view law as a calling rather than a commodity and value the independence of the partnership model, might even relish the fact that the new model is struggling. For others, this recent hiccup is simply evidence that law is learning to adapt in a new context.

What is certain is that the recent bad press for listed law firms hasn’t dissuaded firms from considering it as an option.

In November last year, mid-market commercial firm Thomson Geer announced that it was contemplating going public. The firm will not make a decision for another year but it has been conducting research. Adrian Tembel, chief executive partner at Thomson Geer, believes listing could give the firm a competitive advantage. If the firm lists, it will be the first corporate law firm to do so.

Many professional service firms tend to do poorly on the ASX, with notable recent exits including ILH, HR/recruitment firm Bluestone Global Limited and accounting business Crowe Horwath. However, the current issues facing Slater and Gordon and Shine can “in no way be characterised as an ILH-type end-game scenario”, says Mr Frankl.

“The services sector, including professional services, make up an ever-increasing proportion of the economy,” he continues. “Professional services businesses in other fields have thrived when provided access to capital via the ASX, such as in the medical, IT and outsourcing fields. It is still early days for legal services but it will also find its place.”

Moreover, ILH operated in a different market to that of Shine and Slater and Gordon, mostly providing services to corporations and high net-worth individuals. This means that Shine and Slater and Gordon are less likely to encounter the same problems that arise when key fee earners leave a firm such as ILH, says Mr Frankl.

“Remuneration paid by ILH to fee earners made it much harder to find an adequate economic reward for external shareholders,” he adds. “No matter what acquisition was made by ILH, it never seemed to be able to overcome this challenge. This is a different dynamic, for example, to the Quindell PSD acquisition by Slater and Gordon.”

Mr Frankl says Slater and Gordon and Shine have proven their success based on an array of financial metrics in the past.

“For seven years after listing, Slater and Gordon grew in size while maintaining profitability,” he says.

Shine had a tough year financially in 2015-16 but “for most of their listed histories Slater and Gordon and Shine have [thrived]”, continues Mr Frankl. “This is evidence that there is a place for law firms to be listed on the ASX.”

In Mr Frankl’s opinion, the current situation is an opportunity to learn invaluable lessons.

“New public listings and funds for existing firms can now be assessed with the benefit of all of these experiences and lessons,” he says.

Mr Riddell argues that the events of last year show that listed law firms need to play their cards carefully to remain competitive.

“How you are judged [by the market] will impact your ability to direct your own strategy,” he says. “If you list at a high price – and some consider Xenith was over-priced – then you are putting yourself under the stress of having to produce a market acceptable dividend yield,” he continues.

“The higher the listing multiple, the more you need to allocate for dividends to be competitive in the public market. If you are not competitive your share price will lag, become unattractive and devalue, and it will be hard to garner the same excitement about your strategy again. So in the first year, you must out-perform.”

While IPH’s strategy has translated into strong share price growth, “this is a new asset class so, despite their success, they should not take their market credibility for granted”, Mr Riddell warns.

All eyes on Oz

The world is watching closely as Australia pioneers the listed law firm model. While there has been little enthusiasm so far in Canada and the US for this option, there are strong arguments for adopting the Australian system, according to Canadian legal consultant Jordan Furlong.

“The overriding concern expressed […] among regulators and rank-and-file lawyers […] has been that lawyers will lose their independence and professionalism if control of their firms is ceded to ‘non-lawyers’,” says Mr Furlong.

There has been little evidence of these outcomes in Australia and the UK to date, but that has not influenced the debate in the US and Canada, he says. “Opponents’ resistance has been far stronger than proponents’ support,” says Mr Furlong.

The difficulties faced by some of the pioneering firms has not made the effort to being about similar reforms in North America any easier, according to Mr Furlong. “But that hasn’t been the main point of contention here,” he continues.

The proponents of law firm ownership reform have tended to push the access-tojustice benefits of ‘non-lawyer’ ownership and financing, he says.

“Opponents in turn have asked: ‘How is access better in Australia and England than it was before these changes?’ And there hasn’t been a lot of evidence to date on that subject,” he continues.

Mr Furlong argues that the entrance of well-financed competitors into the legal industry provides a strong rationale for ownership liberalisation.

“The legal marketplace is already filling up with competitors from outside the legal profession, such that lawyers will soon want a level playing field to compete against newcomers with much deeper pockets,” he says.

The big four accounting firms remain the greatest threat for commercial lawyers, while low-margin, high-efficiency platforms such as LegalZoom are edging the market usually serviced by solos and small firms, according to Mr Furlong.

“These companies can raise equity from anywhere; lawyers can only raise it from themselves,” he continues.

“Once the limits of self-financing in this kind of highly competitive marketplace become clear, I expect there’ll be more interest from lawyers in outside funding options. Whether it will be too late by that point is another question.”