A combination of intense pressure on profits, increased bank debt and the imminent arrival of so-called 'Tesco law' could put some legal firms out of business, according to a new report.
The stark warning comes from accountants and business advisers Grant Thornton, who claim that the outlook for many law firms has been transformed by the economic downturn even before de-regulation of the sector takes place.
Following the introduction of the Legal Services Act in October – which will open up parts of the market to new entrants, such as supermarkets – those unable to adapt to the changes will find themselves facing a battle for survival.
The failure of national law firm Halliwells last year sent shockwaves through the legal sector – and Grant Thornton’s research shows more could follow in its wake as extra strain is placed on working capital at a time when clients are demanding more service for lower fees.
Nigel Morrison, recovery and reorganisation partner at Grant Thornton in Bristol, said: “The effects of the credit crunch and the high-profile failure of Halliwells have arguably exposed the underlying weakness of a business model that is based on the full distribution of profits each year.
“The challenges in the current business environment mean that it may be more difficult for some firms to maintain existing lending facilities and, as a result, some may cease to operate in their current form.”
The report – “How Vulnerable is the UK Legal Sector?” – identifies several factors impacting on performance, including:
• Pressure on fees resulting in lower profits. Law firm panels and e-auctions are now common place with firms exposed to “commoditised” product areas or reliant on a small number of institutional clients most at risk.
• Increase in bank debt levels. For many law firms, bank borrowing has risen far faster than average members’ capital, with cash resources reduced significantly.
• The impact of public sector cuts. Pressure on fee rates is likely to intensify among firms with a high exposure to the public sector. Meanwhile smaller firms will be affected by a likely £350 million cut in Legal Aid.
• The Legal Services Act and the effect of de-regulation. Firms relying on commoditised work, such as domestic conveyancing, will find it hard to compete with new entrants offering discounted services.
• Low capital to debt ratio of some firms. This will limit their attractiveness to investors once third party investment is allowed under the Legal Services Act.
• The drive to remove the hourly fee model. Some corporates are pushing hard to agree retainer fees for legal work such as complex litigation and merger and acquisition advice.
Banks are also re-thinking the best way to manage the risk of default among law firms, according to Mr Morrison.
