Technology and services firms within the legal industry are experiencing growth in private investment from both VC, PE, and M&A. While this can be very profitable for the firms involved, it can create challenges for the law firms and corporate legal teams who rely on these services, particularly involving new technologies like artificial intelligence. In order to reduce associated risk and maximize the benefits of this activity, end-clients should consider approaching vendors with a similar level of diligence. Requesting details of where vendors are at in the legal M&A market, including money raised, money burnt, relevant investors, and a deep dive into the management team and their experience should become standard questions during procurement.
This increase in activity has been driven by several different factors. The legal market itself is worth around $500 billion, the majority of which is in small to mid-size law firms. Then there is the increase in cloud computing and software as a service (SaaS), enabling easier increase of adoption and the ability to reduce infrastructure costs. Add to this plenty of smart money from venture capital, private equity, and strategic buyers. However, there is some larger activity at scale which provides signals that this trend does not appear to be stopping anytime soon. But before we jump into that, let us set the stage by reviewing the many motivations for, and effects of M&A activity.
The dominant rationale used to explain M&A is that acquiring firms seek to improve financial performance. Several motives should be considered in this regard. Firms could seek synergy by combining companies to reduce fixed cost by removing duplicate departments or operations, lowering the cost of the company relative to the same revenue stream, thus increasing profit margins. They could seek to increase revenue or market share, assuming that the buyer will be absorbing a major competitor and thus increasing its power (by capturing increased market share) to set prices. They could be motivated by cross-selling. For example, a bank buying a stockbroker could then sell its banking products to the stockbroker’s customers, while the broker can sign up the bank’s customers for brokerage accounts. Alternatively, a manufacturer can acquire and sell complementary products. There is taxation – a profitable company can buy a loss maker to use the target’s loss to their advantage by reducing their tax liability.
Buyers could also be motivated by geographical or other forms of diversification, designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing. However, this does not always deliver value to shareholders. Then there is resource transfer; resources are unevenly distributed across firms and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.
Finally, there is vertical integration. This occurs when an upstream and downstream firm merge (or one acquires the other). There are several reasons for this to occur. One reason is to internalize an externality problem. A common example is of such an externality is double marginalization. Double marginalization occurs when both the upstream and downstream firms have monopoly power, each firm reduces output from the competitive level to the monopoly level, creating two deadweight losses. By merging the vertically integrated firm can collect one deadweight loss by setting the upstream firm’s output to the competitive level. This increases profits and consumer surplus.
However, on average and across the most studied variables, acquiring firms’ financial performance does not positively change as a function of their acquisition activity. Therefore, there are additional motives for mergers and acquisitions that may not add shareholder value. Examples include:
- Diversification: While this may hedge a company against a downturn in an individual industry, it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.
- Manager’s hubris: manager’s overconfidence about expected synergies from M&A which results in overpayment for the target company.
- Empire-building: Managers have larger companies to manage and hence more power.
- Manager’s compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders).
Over the next decade there is going to be the largest generational wealth change in history as baby boomers leave the market and new participants begin to enter. The total size of this transfer of wealth is estimate at somewhere between $30 to $70 trillion, globally. Several factors indicate that this might not be an entirely smooth process, as a significant number of private businesses within the middle market are not prepared for this transition due to gaps in succession planning. Alongside this is an estimated $2.3 trillion of dry power sitting in private markets. If you look at dry powder more as inventory on hand than as an absolute number, it is less of a concern, because deal activity has historically kept up with fundraising. This means that if you look at it over time, the amount of dry powder on hand has remains consistent. Yet this doesn’t tell the full story.
In 2018 deal activity began to fall (not legal, where it started to grow) according to McKinsey’s 2018 Private Markets overview estimated at the time to grow to $1.8 trillion. When deal activity falls and dry powder continues to accumulate, that can become a problem overall (too much cash chasing too few deals). Now, add to that that limited partners are putting pressure on their external managers to deploy that capital, and you get an increase in multiple. You get external manages doing deals they might otherwise not do; at multiples they might no otherwise pay. The conventional logic is that when there is a lot of dry powder, two things can happen. Firstly, fundraising might not occur as robustly, because people might say “Well, what have you done with all the money I already gave you?”. However, this currently does not appear to be so much of an issue. Secondly, dry powder can burn a hole in your pocket – “I have all of this undeployed money, so I need to deploy it”. In McKinsey’s 2020 Private Markets overview, it was noted that once again, dry powder had continued to build, growing to $2.3 trillion in the first half of 2019.
Alongside this money issue, there is the combined challenge and opportunity of data. Only in recent years are organizations starting to appreciate the true value of their data. Once considered a hassle in some regard, data has proven itself to be a source of immense value through improved information governance and new technologies that can explore data and extract value across different business units. An interesting fact about data is that it is not recognized by general accepted accounting principles, or the IRS. This means that so long as there is no transfer of cash, data can be bartered between companies at no cost. As such, savvy firms are waking up to the reality that data itself should be thought of as a capital asset. It can provide exceptional value and numerous avenues for indirect monetization. Yet to capture the value of data, innovative new solutions are required alongside continued development efforts of existing market players. This is because of the changing nature of data. For users this is not such an issue, but in the business of exploring data and presenting it in useful ways, new platforms create new challenges that need to be addressed as quickly as possible. The most recent example in litigation is handling chat data for review. The COViD-19 pandemic and subsequent movement of entire organizations across the world to remote working conditions elevated collaboration tools that were lightly used into the forefront of enterprise communication. With this change a new opportunity emerged for legaltech and services firms to innovate solutions for a growing demand in eDiscovery.
Finally, there is technology itself. Specifically, artificial intelligence (AI) and automation. AI might not be new, but regarding this M&A activity its important to consider where the actual adoption of AI tools currently resides. Today, many service providers have purchased licenses from several legaltech vendors that have emerged over the past decade. In fact, some technology firms have started making deliberate investments in their AI capability like Chicago based firm Reveal, who acquired several incredible technologies over the past few years, including a leader in the development of AI Models, NexLP (full disclosure, I use to work for NexLP and have known the team at Reveal for quite some time. Good times, great people, and even better technology). By now it is in wide agreement that AI is the future and the applications of this technology have finally been affirmed by corporate legal teams and law firms alike. Yet the deployment of these tools is another story. Right now, the day-to-day application of AI is not overly sophisticated. That is to say, we still have some time to go before the majority of corporations have deep learning models proactively scouring their email communications data for hints of risk. The effort is significant and requires a number of moving parts to be aligned, including IT, HR, Legal Ops, Compliance, Risk, Litigation…the list goes on. Most fortune 500 companies have sophisticated processes for the implementation of enterprise-wide solutions. Beyond the requirement for enhanced infrastructure and model development, there is the stark reality of change management and trust in the technology itself. For AI to be achieve its full potential, a lot of professional education and training is required.
What this all means is that there is a lot of money and opportunity left to continue fueling the M&A activity we are currently seeing in the LegalTech and services space. Innovation is not slowing down, and neither are the challenges and opportunities presented by data. Moreover, what we are witnessing in the legal space is happening across all business lines. Data and AI is both a challenge and opportunity for everyone, and the significant sums of data looking for a home in the near future led me to assume that there will be a healthy amount of investment in new opportunities for many years to come. relationships. M&A activity is not a bad thing if handled appropriately. The injection of capital into solving new problems is how innovation can thrive and succeed. Ultimately it is important for the end-client to ask tough questions and set terms accordingly. The real risk is substandard customer service.
