"Investors are generally looking for growth, stability, and resilience," says George Beaton, executive chairman of Australian corporate advisory firm Beaton Capital Pty Ltd, which operates its own fund to invest in midsize professional services businesses. "If 30 partners leave a large, well-established business like McKinsey, life goes on. If you have a practice that is dependent on a handful of key people who could walk out the door at any minute, or that focuses on a really narrow sector that could just fall off a cliff like we saw during the recession, then that's going to be worth less, as the risk is higher."
Applying this concept to large law firms can require some tinkering. Take international scope. Most global law firms are based either in the United States or Western Europe markets that are mature, competitive, and, as things stand, offer little to no opportunity for growth. A higher percentage of overseas business could therefore reasonably be seen as something that would add value both in terms of the "portfolio effect" of spreading risk across different sectors and countries, and also in providing better prospects for growth.
But simply awarding higher multiples based on the percentage of each firm's lawyers who are based outside its home country would risk overvaluing such resources. Those international lawyers could be struggling to generate business within Eurozone or Middle Eastern offices both areas that in recent years would be more likely to result in a discount, rather than an increased multiple. Even just crediting emerging-markets exposure has drawbacks, for while the presence of such practices could boost a firm's growth potential, converting that additional revenue into profit is far from straightforward. Firms often encounter extreme pressure to discount fees in such markets, due both to undercutting from rivals and the fact that clients are unaccustomed to paying Wall Street or City of London rates. (Global firms have struggled for years to make money in China, despite rapid development and plenty of big-ticket transactions.) Similarly, it would be unrealistic to quantify the relative strength of all 100 firms' client rosters, or to accurately assess how dependent each practice is on a small number of rainmakers.
We therefore decided to base our multiples on three core areas: total revenue, annual growth rates in both revenue and profit, and brand strength. We set out to achieve a multiples range of around 57, which mirrors the current-year trading levels seen at other professional services companies, such as Accenture; FTI Consulting Inc.; Huron Consulting Group Inc.; Navigant Consulting Inc.; and Towers Watson.
When it comes to size, it turns out that the adage is true: Bigger is better. A larger firm generally is more stable and resilient, and it offers greater opportunity for economies of scale in such areas as technology and support functions. (There are exceptions to every rule, such as the now-defunct Dewey & LeBoeuf.)
For the purposes of our survey, each firm started with a multiple based on its annual revenue. A firm with yearly revenues of less than $500 million received an initial multiple of 4; a firm with revenues of $501 million to $1 billion got a multiple of 4.5; and those with revenue exceeding $1 billion, a multiple of 5.
Next up, growth rates. It is fair to say that investors are principally concerned with profit without it there can be no returns but they would also be likely to consider growth in revenue, since steady top-line growth is crucial to achieving long-term profit gains.
Investors would typically look for projected figures over the next three to five years. Given that law firms don't produce forecasts (other than short-term budgets, which they don't tend to distribute outside the partnership), we had to rely on historic data.
The next question was how far back to go. Now, perhaps more than ever, this is particularly pertinent. With the effects of the deepest recession in decades still lingering, premium transactional work remains in short supply, and growth in virtually all developed economies has slowed to a crawl.
For most firms, the downturn was steepest in 2008 and 2009. Using either as a starting point would automatically lower annual growth rates across the board, and provide a natural advantage to firms with large countercyclical practices. Going back to the boom years before the recession would add some balance and allow the more deal-focused firms to shine, but would also introduce annual growth rates that would be almost impossible to achieve under current conditions.