6 of the UKs biggest law firms large enough to be in FTSE 100

I have blogged previously on the difficulties of valuing law firms.  The process tends to be complex because the net profit reported by most firms does not take into account an accurate representation of the remuneration costs associated with running the firm.  Many firms do not pay partners a salary at all, or pay only a relatively modest salary which would not be sufficient to retain that partner absent his share of the profit distribution at the end of the year.  However, most firms tend to distribute all or most of their profits to the partners annually, so the overall work-related income received by each partner is far higher than any notional salary element. 

The critical question to answer in trying to value a law firm, therefore, is how much remuneration it is prudent to assume partners would need to be paid in order to keep them working for a law firm business and properly motivated – ie what percentage of the overall salary and profit distribution should be properly classified as remuneration, and what percentage as equity participation?    Only by stripping out the realistic remuneration element can one arrive at a true net profit figure to which a valuation multiple (which may be in double figures) could be applied.  This is an issue currently exercising the minds of potential investors in law firm businesses following the market liberalisation enabled by the Legal Services Act.

Europa Partners have recently published a report in which they have grasped the nettle and sought to infer a valuation of the UK’s biggest law firms.  In compiling the report, they have assumed that a realistic compensation would be 56% of the firm’s revenues, based on data from comparable professional services businesses.  If they are right in this assumption, then the outcome is that law firms in the UK are big business indeed – in fact, the valuations would show that 6 UK law firms would make it in to the FTSE 100 if they were listed entities.

The Europa calculations place Allen & Overy in the number one spot, with an estimated valuation of £2.6 billion, closely followed by Freshfields at £2.5 billion and Linklaters at £2.3 billion.  

Slaughter & May, on this basis, comes in at a valuation of just under £1 billion – a reflection of its considerably smaller size, but once the figures are looked at on a value per equity partner basis then Slaughter & May shoot up to the number one spot, at just over £8 million of value per partner, some £500,000 per head ahead of Linklaters.

A full copy of the report can be found here:

http://www.scribd.com/fullscreen/82998116?access_key=key-1nz11tjoclo94dvsy71z

For the purposes of their valuations, Europa have assumed a valuation range of 12-15 times net profit.  This may seem high given the usual range of 7-11 times for other professional services firms which have annuity-type income (such as trust companies), but at the top end of the law firm market it is a recognition of the sheer scale and power of the brands of the big firms.  However, once outside the top 20 or so law firms, it is difficult to see that multiples of this size could be sustained.  

There is no doubt that over the next few months some of the theory of law firm valuation will be put to the test as private equity investment in the area steps up.  Watch this space.