Pretty soon there's going to be investment banking for law firms

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You can’t invest in American law firms—yet. But it’s only a matter of time.

We live in an age where just about any income-generating asset one can imagine, from home loans to professional football players, has been securitized, collateralized and sold to investors. So you might expect there would be no ubiquitous class of large, highly profitable businesses that has failed to tap their receivables for capital. But if so, you’re wrong. Consider the American law firm and its peculiar partnership-based capital structure.

Every state in the US prohibits outside investment in law firms by blocking lawyers from sharing profits with non-lawyers. These perfectly well-intentioned rules aren’t likely to be relaxed anytime soon. Proposals to allow outside ownership have so far been dismissed by the American Bar Association.

But over time, this ownership model is eroding. In fact, in several places around the world, you can already see the cracks, and something new emerging through them. The United Kingdom has allowed outside investment in law firms since 2012. Australia saw its first law-firm public offering in 2007. And it already happens in Washington, DC, where non-lawyers are partners in many law firms that focus on lobbying work.

Simultaneously, the partnership capital structure does US law firms a disservice when it focuses their attention on the short term, as it does far more acutely than at other privately held businesses. Partners in law firms don’t have permanent equity, so they forfeit their capital when they retire. This incentivizes them to earn as much as they can during their working years and leaves firms without anyone to think about their long-term value as businesses. Exacerbating the situation, US law firms’ earnings are taxed before they are distributed to partners, creating another disincentive for reinvesting post-tax dollars back into the firm.

Meanwhile, clients are pressuring firms to be more efficient—often code for “lower your rates”—and have shown no hesitation about taking their business to lower-cost firms. In the buyers’ market of legal services, if law firms stay focused on pulling out profits in the short term, they’re far more likely to engage in a race to the bottom.

No other industry operates this way, including other professional services. Consultants and advisors of all sorts provide high-end business services using conventional capital structures with conventional equity (and with no inherent ethical problems, I might add). There’s no reason law firms couldn’t do likewise.

The good news: there are several indications that the old law-firm ownership model is breaking down. Most of the big firms have turned to professional managers, installing CEOs or other MBA-trained officers to help them run more efficiently. Many also employ financial professionals, often to help lawyers analyze cases so they can more precisely price their services and manage their risk.

And law firms are starting to get more sophisticated in their use of financial instruments. Burford Capital, which I co-founded in 2009, provides litigation financing to clients and law firms. Litigation finance started off as a way for firms to manage the cost and risk of discrete cases. Today, however, it is becoming a form of corporate finance. Companies and firms are financing entire portfolios of litigation, using the capital to fund operations and other business costs.

Financing a portfolio of income-generating assets is different from raising cash by selling equity in the firm. But the two could be considered cousins, and they both represent a level of financial innovation that we’d never seen in law firms until the past few years.

As American firms increasingly embrace tools like litigation finance, and as they see their overseas brethren raising large sums at lower costs of capital, I believe they’ll also be more likely to start coming around on the question of outside investment and ownership.

And if that happens, it will allow firms to take a longer view that will result in better client service and better lawyering. And it will allow American capital to participate and further one of our economy’s most profitable sectors.

Jonathan Molot co-founded Burford Capital and serves as Chief Investment Officer.

He is a Professor of Law at Georgetown University Law Center and a leading expert on litigation finance. He served as counsel to the economic policy team on the Obama-Biden Presidential Transition Team and as a senior advisor in the Treasury Department at the start of the Obama Administration. He clerked for Supreme Court Justice Breyer and practiced law at Cleary, Gottlieb, Steen & Hamilton in New York, and at Kellogg, Huber, Hansen, Todd, Evans & Figel in Washington, D.C.

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