TRP 337: [Legal] Law Firm Mergers: Private Equity/MSO Activity with TJ Henry

[00:00:10] You are listening to The Rainmaking Podcast, hosted by legal dealmaker, author, and professional speaker, Scott Love.

[00:00:24] Scott Love This is The Rainmaking Podcast, and my name is Scott Love. Hello, friends. Thanks for listening to our show again. Our special guest today is TJ Henry, and our topic title is Law Firm Mergers, Private Equity and Managed Services Organizations Activity. We're going to talk about what's going on in that realm of law firm mergers. You've probably read about that in legal media. And this is part of our, what I call our Sometimes Tuesdays, legal-specific series of The Rainmaking Podcast.

[00:00:55] TJ Henry's company is called Federate Legal. It's a managed services organization, but he does much more than that, and he's going to talk about that in our episode. I've personally known TJ for a long time. He's a good friend.

[00:01:07] TJ Henry, I'd highly recommend that if you're a law firm leader thinking about doing these types of deals, he's someone that you want to get to know. In fact, if you're an investor or in a private equity company and you want to listen and learn and see how these deals are going down, I'd recommend that this show could be a good resource for you.

[00:01:25] We even have a special contact page for TJ on the show notes. If you're interested in connecting with him directly after you listen to this, just go to the show notes, wherever you listen to it, and you can do so right there. As always, this podcast is sponsored by SurePoint Legal Insights, formerly known as Leopard Solutions, turning legal intelligence into opportunity.

[00:01:48] The show is also sponsored by The Rainmaking Magazine for the intellectually driven and results-focused professional who wants to be the number one professional services provider in their niche. Start your free subscription today. Visit therainmakingmagazine.com to set up your free access and chart your course to create a rainmaking success. Thanks for listening. I hope you get some great insight from my conversation with TJ Henry today.

[00:02:17] Hey, this is Scott Love with The Rainmaking Podcast. Our special guest today is TJ Henry, and we're talking about law firm mergers, private equity, and MSO activity. TJ, thanks for joining me on the show. Thanks for having me, Scott. Pleasure to be here. Well, I like your experience. I like the fact that you've been in legal for quite some time, that you've done things other people haven't done. And right now, you're at the epicenter of a lot of activity in the private equity slash law firm merger acquisition world.

[00:02:45] So kind of give our listeners an overview. What's going on? What is the reason why this is so busy and how are law firm founders able to get equity through private equity? Kind of give us an overview of that, TJ. So it's a long – my response may be lengthier than I think we have time for, but I'll try to keep it short. So law firms are one of the last frontiers for private investment to not have been involved with, right?

[00:03:14] PE has been involved in a number of other industries, even recently accounting roll-ups or medical, dental, et cetera. But historically, it had been in a ton of different industries, and that hasn't really happened inside of law firms. And the main reason for that is the rules of professional conduct in every state and the ABA rules themselves, which typically say, in almost every case, that non-attorneys can't own any part of the law firm. The lawyers have to own the law firm.

[00:03:42] Well, through their experience with medical and dental and accounting firms, other similar-ish professional services firms, a structure called a management services organization was developed to enable a type of investment inside of a professional services firm where the third-party investor, who may not be licensed and legal or may not be a doctor or a dentist or otherwise, can invest in a similar fashion inside of the professional services company.

[00:04:09] So in law firms in particular, it's really the last frontier for third-party investors and private equity to attempt to get in. They have been knocking at the door for years, and it just really hasn't happened. And that started, I think one of the more recent first deals was back in the mid-teens, late teens. And then starting at end of 21, 2022, it started to become a little bit more of a conversation over the past 18 months has really heated up.

[00:04:37] And there's a ton of investors looking at the space, attempting to get in. There are nuances about running law firms that make people wary, also that lawyers are trying to protect as they rightly should. So there's a ton of balance that's going on. But it's really been a conversation over the past 18 months where that conversation has exploded in interest on both sides of the fence, both from the law firms and the equity partners at those law firms and the private equity folks themselves.

[00:05:03] Right. And tell us, what is this managed services organization and how does that give a solution and a legitimate workaround to ethics issues in terms of law firm ownership? At its core, a managed services organization or MSO is a service provider. It provides services to a law firm. If we think about it on its most basic level, think about a law firm and how it operates.

[00:05:29] A law firm can have attorneys and paralegals and finance staff, IT staff, HR staff, etc. It can also outsource some of those functions. It can outsource its HR to a third-party HR company. It can outsource its IT. And most small to mid-sized firms actually do outsource a lot of their IT to IT-specific companies, whether that's law firm-specific or generalist IT shops. Think about every other vendor that goes through.

[00:05:55] If you're in litigation or PI and you need e-discovery, separate e-discovery vendors often exist. So every vendor you use is a third-party service provider to the law firm. You can think about an MSO as simply a collection of a lot of those vendors under one roof. The idea being that all of your finance, accounting, billing, all of your IT, all of your HR, all of your legal admin, essentially your non-lawyers, all of your vendor contracts, all sit within one organization.

[00:06:24] And that organization runs the back office of the law firm professionally in a way that historically may not have been incredibly well run by the law firm themselves. Some lawyers are much better at business than others. Some are not that great. I say this as an attorney myself. I'm sure I'm somewhere in between that, right? But an MSO is simply a collection of MSPs, managed service providers, under one roof.

[00:06:48] But under an MSO structure, an investor can own the MSO and that MSO can contract with the law firm for all or most of the services that the law firm would need. In that way, the MSO gets paid for providing those services. And now the MSO has should have a profit margin on those services, which makes it an attractive vehicle for third party investors.

[00:07:14] If at the MSO, if you have everything collected, that means that the only real people that sit at the law firm are the lawyers and the practice of law, which means you can isolate more of the services and thereby create a lucrative business under an MSO. Interesting. So this is a separate entity that the lawyers can own and then take that entity and sell that entity to the private equity company. And now they've got their EBITDA and the multiple, which we'll get into in a second.

[00:07:43] But how long are these contracts that the law firm will usually have with the MSO? What if it's what if the MSO goes under? I mean, how does that work? How do you mitigate against that risk, TJ? Yeah, that's totally right. The lawyers typically will split out their back office assets into a separate entity called the MSO or that is an MSO and sell part of that or all of that to a third party investor. Look, I'll clarify that MSOs are not limited to third party investors. There are many different types of MSOs.

[00:08:11] There's law firms that have an MSO, but they own the MSO outright. There are benefits to that structure, both from a customer service perspective, a tax perspective. MSOs can retain earnings in a way that most law firms as partnerships don't because they distribute those earnings as cash at the end of the year. So there's a number of different types of MSOs. But if we're talking particularly about investor MSOs, right?

[00:08:39] And investors typically are going to want that MSO to have a likelier contract with the law firm. We're not talking one to two years. We're talking 20 plus. So it is a bit stickier as a result because otherwise, why would an investor come in and buy that MSO? What they're ultimately doing is buying a revenue stream from the law firm in exchange for service, right? So most of the MSO contracts that I've seen with third party investment have been 20 years plus.

[00:09:09] There are a lot of other ones, pure vendor MSOs that are two years, three years, one year, right? So a lot of different flavors of that. But from an investment perspective, it tends to be pretty lengthy. As far as what happens, the second part of your question, that is, that's all over the map depending on who wrote that contract. And that contract is called an MSA, Master Services Agreement with Multiple Scopes of Work. Beyond that, that's the contract between the MSO and the law firm itself.

[00:09:35] There are many different flavors of that that you could have unilateral renewals by the MSO, meaning that the law firm can't really get out, which is, if you ask me, maybe not the best idea. There's also other times where the MSO is not providing service. The law firm surely has an out to break the contract because the MSO is not providing what it's going to provide. It's still going to go through normal contract law.

[00:10:02] There are just going to be some additional bells and whistles and protections that obviously a third party investor is going to want to put in to make sure that that contract is a bit more protected. Right. And let me ask you a few questions within the context of a firm founder wanting to sell his or her firm. Maybe there's $100 million in revenue. There's a certain number of equity shareholders that they want to get their capital contribution back. They want to get their capital back. Maybe some people want to get paid to leave. Maybe some people want to stay and build.

[00:10:30] Let's just kind of use that $100 million revenue as a figure. And in most traditional law firms, a third is your overhead, a third is your comp, a third is your profit. How would that be structured within an MSO? And how do we get to that number, that EBITDA? And what are some of the multiples that you've seen? Maybe you can kind of talk in that regard, TJ. Sure. So law firms as historic partnerships don't really think about EBITDA in the same way, right?

[00:10:59] Whereas private equity and third party investors rely on EBITDA as far as deals go. And that's what they do multiples off of. So first and foremost, we have to figure out what is the EBITDA of a law firm. Now, it might just be as simple as profit, right? A third, a third, a third. For your purposes of this example, your $100 million firm, let's assume that it's $30 million in profit, right? That way it's not 33. We just call it 30. In that instance, let's call it 30 million equivalent to EBITDA. That may not be the exact case, but let's say that that's what the case is.

[00:11:29] Back office MSO, third party investors is through that MSO are going to want to determine a price for the services themselves. And attempt to get paid for those services. Now, that compensation that you have just put through is typically for staff and associates. Non-profit, because your partners typically are getting paid via profit, your equity partners at least, right? So let's say that now there's a third for profit and a third for services. That's two thirds.

[00:11:58] Well, your equity partners still want to get paid for doing the work. So you got to reduce that profit by a little bit. So let's assume that ultimately the profit EBITDA number and compensation staff, non-associate staff, right? But staff nonetheless, because the associates need to stay at the law firm, is the equivalent of about 50 mil. It's just a round number. MSO charges the law firm in an attempt to take that 50 mil from the law firm to the back office.

[00:12:27] Now, it has to be based in reality. It can't just be a percentage of revenue or a percentage of profits that is against state RPCs in almost every state across the country. It has to be based in reality. And it has to either be value-based or based on attorney headcount, meaning for every attorney you add at the law firm, we charge you X amount per month or per year, right?

[00:12:51] So the attempt is to sweep that 50 to the back office through services, but it has to be based in actual value or on a per head basis. It can't be based in the revenue of the law firm or the profits of the law firm. What do you think the expectation should be of a firm leader, a few leaders within that kind of firm? What are they looking for in terms of their nut, nut, nut?

[00:13:17] You know, the real bottom line EBITDA and how would that multiple look within a transaction? Yeah. Well, the most successful lawyers who are more likely to get a deal done are probably those who are willing to stay on and continue to work. If you are a lawyer who just wants to get paid and go right off into the sunset, I don't know how interesting that's going to be to a third party investment shop or PE shop. The law firm still has to be an ongoing consideration. It still has to have a revenue.

[00:13:47] It still needs to be an ongoing concern so that the back office MSO can provide services to said law firm, right? If the revenues of that law firm go down, it becomes a problem for everybody involved. So I think first and foremost, that attorney has to understand that even if they sell, even if they split out their back office into an MSO and sell part or all of that MSO, it's not like they're going to retire tomorrow on that. Or at least I would argue that no investor should allow them to do so.

[00:14:17] Multiple wise, there are there all over the map at the moment. I've seen multiples down and that's three. I've seen multiples in the low to mid teens. I would argue low to mid teens is above market and potentially problematic, not only for market setting purposes, but also from a deal perspective. That is, I don't know how anybody's going to make money off the back of that deal by reselling that MSO. There's just pay too much. You're behind the a call at that point.

[00:14:45] I think realistic multiples for most people in the room, whether it's corporate or whether it's PI, are somewhere in the five to eight range on an EBITDA that private equity or an investor has determined exists of that MSO. Remember, it's an EBITDA of the MSO, not an EBITDA of the law firm. The law firm has its own revenue and the law firm has its own compensation that it needs to pay the attorneys. So we're talking about an EBITDA of the MSO, not of the law firm.

[00:15:13] So there's some calculations that it's going to take to get there. I appreciate you clarifying that, TJ. What do you think would be your advice to someone that is an investor within a PE company or other entity that says, I'm going to get into this. I want to get involved in it. What do you think they should be looking for and what pitfalls do you think they should be avoiding as they pursue engaging with firms for these types of deals? Sure. I think first and foremost, you need to have people who have run law firms on your team.

[00:15:44] I have seen too many investors go into conversations thinking that they can write a check and law firm managing partners are just going to come, sure, buy my law firm or buy my back office to my law firm, right? Because you can't buy the law firm. But if the private equity shop doesn't know how to run a law firm, doesn't know how to run an MSO that runs a law firm, ostensibly running a law firm, it's going to be problematic. They can do three of these deals in the first 18 months, what have you.

[00:16:12] But if they don't know how to consolidate the back office under one roof to actually get economies of scale, if they haven't had leaders who have run law firms before, it's going to be really problematic and painful moving forward. So my first piece of advice is have law firm leaders or people who have run law firm operations on your team to make sure that you understand what you're buying and understand how to run it in particular. Don't learn on the fly.

[00:16:40] Don't put an inexperienced, brilliant and smart, but inexperienced non-law firm operator inside the seat. So I think that's number one. Number two, I would think they need to find managing partners and groups of managing partners who are like-minded, who want to continue to grow the firm, who want to continue to operate it and don't just want to look for a way out.

[00:17:07] So finding that's harder than you think. There's a bunch of managing partners who just want to get paid, right? And then ride off. And that becomes problematic if you want to run it. So finding a meeting of the minds, so to speak, is extremely important. And then I would add one additional thing. We can get into this if you want. But if it were me running that investment shop, there are essentially three levers I would want to make sure every deal pulls.

[00:17:34] The first is I would want, because there's inevitably an exit at the end of this. You purchase an MSO, you're going to want to probably try to sell it in five years. First is an EBITDA multiple arbitrage. I want to buy for four, five, six X EBITDA multiple so that I can sell for eight, nine, 10, 11, 12, right? If you buy too high in the teens, there's no exit. Second lever is law firm growth. You want the law firm to be set up to grow.

[00:18:02] And there's some questions on how do you grow? What do you use the money for? But the law firm needs to grow, add attorneys so that the MSO can add additional services to the law firm so the MSO revenue increases. And third, you want to understand how to decrease operational expenditures. So if you can get 10 to 20 percent more cost effective in running the services themselves through consolidation or roll up, you've done a great job.

[00:18:27] But if that becomes a more expensive adventure because you don't know how to run that, that's a problem. So if you can pull all three, EBITDA arbitrage, growth of the law firm, and decreased operational expenditure at the MSO, you can hit singles and doubles all day long and run a successful business. And then if one of those law firms happens to have a key man leave or has something down the line where an industry decreases and therefore the revenue of the law firm decreases, we're not – the back office MSO is not hamstrung.

[00:18:57] Interesting. Do you think that some investors are looking to possibly do combinations? Like we're going to have this firm and this firm do a combination together and then keep doing add-ons with other smaller firms? Do you think that's kind of the trend? Yeah. I don't know that that's the trend, but I absolutely think that that is one of a subset of theses that is being worked on by various investors. They're both pros and cons to one branded law firm and bolting on other law firms under that brand.

[00:19:27] That's what Morgan & Morgan has done for years in the PI space, right? So there are certainly benefits to that. That is harder to do in the corporate space, for example, because conflicts of interest are real and you can't exactly do that forever. So you start getting conflicted out of items and it becomes a problem. So there are constraints to that. But on one side, you have the bolt everything onto one brand.

[00:19:52] On the other side, you have the MSO is the brand and the law firms attach via contract to the MSO and the law firms maintain their own branding. Now, you might ask TJ, what about conflicts of interest at the MSO? Isn't it a conflict of interest for the management services organization to run multiple law firms simultaneously?

[00:20:14] It's where the private equity firm has to be really careful about how it deals with client confidential information and walling people off in certain departmental areas. So I would back up and say no one ever argues that a marketing service provider, MSP, can't provide marketing services to 10 different law firms, right? No one ever argues that an outside IT company can't service law firms only as their bread and butter.

[00:20:41] So it naturally follows that an MSO can absolutely service multiple law firms simultaneously. It just has to make sure to not contaminize the data such that it creates a conflict of interest issue for the law firms themselves. That's an important detail. I appreciate you bringing that up, TJ. What are some of the trends that you've seen? I've done mergers before. I'm one of the few legal recruiters that actually has done mergers, but they've all been in the MLA 100.

[00:21:06] And I've seen recently just through conversations I've had through my involvement in the Association for Corporate Growth and the deal space, talking with private equity companies, even investment bankers. The trend is it used to be personal injury, slip and fall, family law, now kind of trending more towards corporate defense type work. Is that something that you've seen as well, TJ? From an MSO perspective or from a merger perspective? From a deal perspective, from what investors are looking for in these type of arrangements.

[00:21:35] I don't know that it has moved from what I call B2C, like consumer PI, immigration, T&E, right? I don't know that it has moved from one to another. I think the pie is expanded and there's a bunch of other people looking at it. I think there are a number of investors that they're solely focused on PI. I think a number of them are solely focused on other B2C. So small Main Street, small business, plus trust in estate, plus immigration.

[00:22:02] I do think there are a number of larger P shops or investment firms that are looking at corporate firms. They either have an aversion to PI, either emotionally or otherwise, because whether we like it or not, there tends to often be an emotional aversion there. But often those larger P.E. shops have mandates on their fund. They need to write checks of a certain size. Right. And if you need to write checks of a certain size, let's say $300 million.

[00:22:32] Well, the example you just gave of a $100 million firm with, let's call it an effective $25 million EBITDA. $50 million sweeps from the law firm to the back office. The back office has a 50% margin on it. That's $25 million. Let's say that's the $25 million EBITDA. A 10x multiple gets it to a $250 million check. That's not even large enough for that firm to go through its investment committee and actually write a check.

[00:22:57] So a lot of the larger shops are a bit hamstrung by the fact that the law, the legal industry itself is fragmented below the AMLA 200 in a way that doesn't allow those those small to midsize, even call it NLJ 500 firms to be targets just based purely on financials. So you've got this subsect of larger PE or investment firms that can only play an AMLA 200.

[00:23:21] And in AMLA 200, that becomes a much harder prospect or not to crack because you've got a number of 100 equity partners. Right. How do you get if you never understood law firms getting 100 equity partners on the same page around a single decision is an impossible task, let alone in a short period of time.

[00:23:38] Right. So I think the ones who are more successful in doing these deals happen to have played down market in the small to midsize space and been willing to write smaller checks and take singles and doubles, so to speak, so that they can get deals over the line. Deals at the upper end of the market in law firms, particularly in AMLA 200, are tough. Yeah. TJ, I want to thank you for sharing your expertise and for being here today.

[00:24:06] And this has been very insightful for our listeners, I'm sure. Tell us about your offerings. What do you do? What do you have that you'd like our listeners to know? And by the way, everybody listening, we're going to put all of TJ's contact information in the show notes of this podcast. So you can just reach out to him directly. Well, thanks for having me, Scott. I appreciate it. So at its core, Federate, so I run a company called, I co-founded a company called Federate. Federate is an MSO, but we are a, I mentioned there are different types of MSOs.

[00:24:35] Federate is a vendor MSO. We run the back offices of law firms, but we do it under a flat monthly fee per timekeeper that is a subscription model. That is a short contract, like two-year upfront, one-year renewals. The idea for us to really is run 80 to 90 percent of a firm's back office, really bringing big law levels of tools, tech process efficiency down market to firms that can't access those tools or afford them

[00:25:02] and be able to do it in a way that is budgetable, scalable, provides cost certainty and tends to be 10 to 20 percent more cost effective than those firms can run on their own. And really, our bread and butter is actually launching brand new firms. So groups of 5, 10, 15 timekeepers leaving big law or regional firms who want to start their own. Because we've built an engine already, we're basically law firm in a box. And I can get them up and running in 60 days. And we're on day 61. They get to open a laptop and the entire thing just works. We also do a lot of consulting on the side.

[00:25:32] We are building and designing an MSO. We won't run it, but we're building that structure for an AMLA firm at the moment. We're building it for a 15 attorney firm at the moment. And we have conversations with a bunch of firms in between those two extremes. So we often have conversations with private equity about what they should do, how they should think about these deals. We have conversations with law firms about how they should do these deals. And then we actually then build and design the MSOs and hand them over to firms themselves.

[00:26:01] So we've got a couple of different service lines. But the one thing is I'm not a roll-up shop. I don't pay people money for the right to run their law firm. We either run it or we tell them how to do it. That's great, TJ. So let's say there's a firm founder. He or she has 50 attorneys and the two or three main equity partners have decided we don't want to sell. We want to continue on because we love it and we're going to do it until you pull the phone out of our cold, bony fingers. And we're never going to give it up.

[00:26:30] But we don't like doing all the administration. Would that be a good prospect for you also, TJ? I think that could be a good prospect in two different ways. One, there's certainly the potential of us taking over the operations of that firm and freeing them up to manage the attorneys, to run the firm, to focus on clients where the rest of it is set it and forget it. And it's basically infinitely scalable there afterwards. Or two, if that firm wants to set up its own MSO.

[00:26:58] And there are a ton of benefits to a captive MSO, meaning what I mean by captive is the firm owns its own MSO. One, again, you can retain earnings at an MSO because it's not a partnership. You can structure the MSO in a way that the MSO actually serves the law firm as a service provider, meaning the partners are clients in the same way that the clients to the law firm are clients. You find that the customer service level goes up. There are some tax benefits to that structure.

[00:27:25] There's certainly some succession planning benefits to that structure, like the ownership of that MSO, because it's not a law firm, can be put in a trust, for example, and passed down. So there's a ton of benefits to having even a normal 50 attorney, 50 timekeeper law firm, to having its services run by a separate entity. Even if the law firm or the equity partners own that separate entity, the structuring itself is beneficial. And then it provides optionality if they ever change their mind in the future. Well, TJ, this is great.

[00:27:54] I appreciate you bringing a very sophisticated topic in your own sophisticated way, but explaining it in simple terms. And we're going to put a special link if any firm founders or leaders want to reach out to TJ directly. Just go to the show notes of this podcast and you'll be able to schedule that directly with him. So TJ, thank you so much for being on the show and thank you so much. I appreciate this. It was really fun. I appreciate you having me on. Thank you for listening to The Rainmaking Podcast.

[00:28:21] For more information about our recruiting services for international law firms, visit our website at attorneysearchgroup.com. To inquire about having Scott speak at your next convention, conference, sales meeting or executive retreat, visit therainmakingpodcast.com. Thank you.