6 things to look out for when undertaking financial due diligence on the acquisition of a law firm

While there may have been a time when financial due diligence was performed ‘in-house,’ it is now almost unheard of for a legal sector transaction not to have external financial due diligence.

Throughout my 25-year career as a financial due diligence provider, I have been conscious of transactions taking place in the legal profession, which always seemed to result in a larger consolidated entity with enhanced capabilities and reach.

As my role over the years became more market-facing, I began to ask the question, who carried out financial due diligence on such transactions, and was there an opportunity we were missing out on in terms of providing our services to the legal sector?

The answer I was often met with, was that these processes were carried out ‘in-house’ and there was little need, or indeed perceived value, in an external provider getting involved. In essence, how could an external due diligence provider add any value?

Shift in financial due diligence

Part of the reason for the shift to external financial due diligence has been linked to the need to satisfy an external investor or funding party as growth ambitions in the sector accelerated, and the appetite of the private equity and funding community to facilitate this growth becoming more apparent.

However, I would certainly also like to think that, as the partners of law firms began to see the output from a high-quality, externally sourced due diligence exercises, the benefits of engaging with a Transaction Services specialist resonated more clearly.

At Armstrong Watson, we shape our due diligence approach and reporting around your key concerns as a buying party, which might include gaining an understanding of some or all of the following key areas:

1. The underlying mix of revenues and profits between recurring and non-recurring elements, and assessing a maintainable position.
2. The mix of revenues by core department. This will highlight any concentration or dependency issues on a particular team or individual partner – relevant not least from a business continuity and reward structuring perspective.
3. The extent to which any significant changes to asset valuation / provisioning policies have distorted reported trading activity during any financial reference period. This ensures valuation metrics have not been augmented (inadvertently or otherwise) as a result of such policy changes.
4. Whether the application of your own accounting policies would result in a diminution of the stated value of key asset captions. This is relevant in terms of balance sheet alignment between the two combining parties post-acquisition, especially with the options available for valuing Work in Progress (WIP) in particular.
5. The stability of monthly reporting, and the requirement for any significant year-end adjustments, which will provide an insight into the quality of the finance and management functions of the target entity and the job of work required post-completion to bring management reporting in line with your own (and any investor/funder) expectations.
6. The level of working capital ‘lock-up’ in the business. Whilst the target practice may well be doing the work to the level and quality you envisaged, if it has fostered a culture of non-collection, alignment back to your own working capital expectations could present a challenge post-completion. This would also assess the level of normalised working capital for equity value purposes.

External financial due diligence does not fully replace the ‘in-house’ operational due diligence an acquiring firm will carry out in key areas such as management culture and case file quality reviews, but the combined knowledge gained as a result of such joined-up efforts places buyers and financers in a far more informed and confident position in which they can make transactional decisions.