In the midst of this credit crunch, there is a candy store of capital called Private Equity. What does this mean for the legal industry?
TLDR: Venture Capital (VC) focuses on supporting early-stage or high-growth companies. Hence, a dip in growth means a drop in VC funding. To stay afloat, legal tech companies as well as law firms turn to private equity or debt funding. The catch? A shift in power from founders to private equity analysts.
Private Equity (PE) involves investing in mostly privately held companies, rather than publicly traded ones. PE firms raise capital from institutional investors, such as pension funds, endowments, and high-net-worth individuals. The goal is to generate significant returns over a specific period. In order to achieve this goal, a PE firm will often take control. They need to drive growth and increase the value of their investments. Obviously, who doesn’t, so what’s the worry?
Any copilot can explain what the PE model is. We offer you a specific calculation of why we wanted to know. Since 2020, we counted an uptick in companies raising through debt financing or private equity. In 2021, it drove us to discuss the difficulties of debt. The Q3 2023 post, elaborated on differences with venture fundraising.
What did the calculations reveal? As of January 2022, we tracked $1.5 Trillion in capital raised by investment firms for various reasons. In our June ’22 report, it was still just $50 Billion. Moving the slider above left will reveal how much money went to PE firms (66%). That translates to over a trillion raised in just 277 PE deals out of over 1,200 deals. How crazy is this stat? On average, this is $1.7 billion a day. This is not just power, this is concentrated power. Now, how does this power present itself?
All of the above made us wonder: In these difficult times, how can PE firms raise so much? They are able to offer better returns. How is this possible? Well, we have to explain the most peculiar trick these financial instruments employ: Leveraged Buyouts (LBO’s). In LBO’s, companies are acquired using a combination of equity capital and loans.
Imagine a private equity firm wants to acquire a company valued at $100 million. When a firm uses an LBO, it might use $30 million of its own capital and borrow $70 million to cover the total cost.
Now, let’s say the private equity firm improves the company, and a few years later, it’s able to sell it for $150 million. Subsequently, the firm repays the $70 million of borrowed money, and the remaining $80 million is their profit. Now, look at the return on their own invested capital: They invested $30 million and got back $80 million, which is almost 3x their investment.
Why would a PE firm not use its own capital to fund an acquisition? If the firm had used all its own capital to acquire the company (i.e., $100 million), a sale price of $150 million would still give them a profit of $50 million. However, the return on their invested capital would be 50%. In this case, the return on investment is just 0.5x.
By using debt, the private equity firm magnified its return on invested capital, even though the company’s total value increased by the same amount in both scenarios. This is why leveraged buyouts are more profitable.
Still confused? We left out the key part of this strategy: The debt acquired to purchase the company is then placed on the company’s balance sheet. This makes the company responsible for repaying the $70 million loan. The private equity firm’s capital remains mostly intact and can be used for other investments or acquisitions. Isn’t that sweet.
Let’s recap: If companies need outside capital to operate, there is a giant pile of cash called Private Equity. Specifically, getting access to it requires giving up control. To ensure PE firms get their return, they will exert pressure to increase the value of the company. When there is little growth, the value can only increase by raising prices and cutting costs. The fastest shortcut is cutting staff. The hardest staff to cut is sales and core operations. Everyone else is expendable, including founders. If you have been following legal tech, you have seen this play out in several companies.
Perhaps you are wondering: Who’s the sugar daddy? In order to find out, we had to rebuild parts of our datasets. SQL gymnastic aside, complicating matters is that one company can have a mixed bag of grants, VC, and PE capital. Here’s what we found: 951 investors in 281 deals in legal tech and law firms. Surprisingly, neither Insight Partners nor HG but K1 is the most active Private Equity investor in Legal, according to Spark Match. Better yet, if ranked by participation, TA Associates bubbles to the top.
Sticking to our policy on private companies, we don’t name them in our analysis. However, we did share that public companies, like Legalzoom, hold the largest loans. Note that law firms in the UK can be listed as public companies. Law firms taking loans isn’t new, yet we also found a few that raise venture capital. Previously, we only registered tech companies having access to VCs. A sad side effect: These nuances are causing us to lose friends. These numbers don’t fit their narratives. Especially, narratives indirectly made possible by…private equity.
In closing: Our worry isn’t just pressure on the bottom line, as stated in our previous post. It is the fact that founders of legal ventures are losing control. We are at an inflection point in the history of the legal industry. For over 5,000 years, legal counsels have been the engineers of a safe society. This is the worst time for legal to lose their independence.
The way to wrestle back control is to know. Know where to get capital to survive. Know where to find customers to thrive. Schedule a chat.
**updated Oct 27, 2023 – 15:01: LBO equity checks top 50% for the first time, thanks to high interest rates – Axios**
Editor’s note: The analysis uses Legalcomplex Spark data to artificially generate parts of it.
Image Courtesy: DALL·E 3 by OpenAI based on the content of this analysis.
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