Four ways private equity firms can overspend on legal
Lawyers charge by the hour, and that hourly rate rises with seniority. This is not news.
The recent news is that over the last 12 months the capacity of many law firms has been stretched to the limit. What has historically been a buyers’ market for clients, no longer is.
This is clearly demonstrated by the record profits reported by magic circle and other law firms. In addition, the salaries they are offering newly qualified lawyers in key centres such as New York and London are reaching all-time highs.
So, as a client in private equity (PE), your legal bills are rising. And until activity levels drop, they will stay high. You may ask yourself:
“Maybe it’s time to start managing legal spend more actively?”.
But, some might argue, clients and their lawyers usually have close working relationships that last over many years. Most transactions have fee caps agreed in advance. Why bother? Surely the existing arrangement could not possibly lead to legal bills that clients find shocking?
Well, we all know it happens. You spend valuable time and effort trying to reduce the invoice that just arrived in your inbox. As part of the deal, you may even promise further work to that law firm or partner. You then still need to have the deal approved by the investment committee or other partners – all of whom will require assurances that such a situation will not occur again in future.
Overspend is rarely planned nor deliberate. It is most often a function of things just working out differently to how they were predicted to. I hope this post can provide some insight into the common areas of overspend, with the intention of raising awareness and maybe reducing the likelihood of such situations occurring to you.
Investment process turns out to be much more difficult
Let’s start by talking about doing deals or making new investments. This is the lifeblood of private equity and PE firms. They always start off with enthusiastic momentum. But how many times have the deal team gone quiet and then started to say the following:
“The draft documents from the other side were ridiculously one-sided and unacceptable.”
“Their lawyers are inexperienced, poorly prepared, uncommercial, difficult and clearly have no idea how a PE deal works.”
Alternatively, it could be a due diligence issue, starting with a “useless data room with nearly no relevant or recent information in it”.
Perhaps the documents were full of issues and surprises, or were slipped into the data room right at the end of the process. The deal team may uncover discrepancies such as trading being much worse than advertised, propped up with provision releases. This means the profits are lower and therefore the debt comes in at less than had been assumed.
Suddenly, it’s time to reopen that offer that you made a few weeks ago.
All of these are frustrating reasons for cost overruns in and of themselves, and clearly need to be resolved to achieve a successful investment deal. However, if the other side is unwilling to cooperate or discuss the situation, it can result in further overspend. Have your advisors actually stopped work? Or are they quietly finishing things off, expecting to pick up those pens again tomorrow?
If that doesn’t happen, the abort costs bill probably just went up even further.
Fundraising takes longer than anticipated
Another area where legal spend might need some careful management is fundraising.
Of course nobody wants to admit it, but not all funds actually get to a first close and reach minimum fund size.
To quantify this, data from Preqin (analysed by the placement agent Quest) shows that 16% of the buyout funds raised in Europe from 2016 onwards failed to meet their target size. This figure nearly doubles when including funds that took more than two years in the market to reach their target.
This is despite fundraising targets usually being set to be comfortably beaten.
So what does this mean for legal fees? In all likelihood, such a raise will result in more LPA negotiations, more side letters and more tax and structuring complexity.
Will your lawyers keep you fully informed of this additional legal spend during the fundraising process?
GP growth doesn’t always scale in a linear fashion
As GPs grow into bigger and bigger businesses with more investment strategies, operating in more locations and managing bigger funds they become harder to manage. Add to that the ever-rising complexity of regulation, compliance, litigation, tax and similar unavoidable requirements, and the legal costs rise dramatically too. In most cases that is a cost that falls squarely on the management company, as does the cost of building an in-house legal team.
But are in-house lawyers given the time and tools to actively manage the firm’s own legal issues and spend? Or do colleagues also expect them to be reviewing NDAs?
Portfolio legal costs can be hidden from view
Finally, and by no means least of the areas for improved legal spend management, there are the bills you don’t know very much about at all, the ones paid by the portfolio companies.
Smart lawyers in external firms will make sure that they get the work on any dividend recaps or other re-financings, acquisitions and of course the exit. That’s where much of their margin gets made.
Other smart lawyers will of course be persuading the CFOs that they are a much better and cheaper solution, even if they might not have quite the same level of M&A experience.
Are the portfolio management teams in the GP on top of this, or are they focused on 100 day and value creation plans?
Legal spend management needn’t be another burden
How are you managing the above issues at your firm?
If you currently rely on sporadic high-level updates to manage legal spend, or worse, you're billed by the lawyers for the time taken to produce monthly reports, then it may be time to consider a technology-based solution.
Apperio’s legal spend management software provides real-time visibility to help control and optimise your spend with law firms. Data is gathered automatically, structured consistently and presented simply for analysis to help you control spend and make more informed business decisions.
To find out more or to book a short demo of Apperio for your firm, please click here.
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Neil MacDougall currently sits on the Board of Apperio as a Non-executive Director. Prior to this, Neil spent over 20 years at mid-market buyout firm Silverfleet, leading the buyout of the company from Prudential in 2007. Neil was Silverfleet’s Managing Partner between 2004 and 2019 and became Chairman in 2019. In 2020 Neil was appointed as Chair of the British Private Equity and Venture Capital Association, the industry body for the private equity and venture capital industry in the UK.