PE, MSOs, and AI: The New Operating Model for Law Firms

Thanks, Daniel. I think there's nowhere to go but down from that introduction, but Alright. Thank you for it. It's a pleasure to be here today.

Yeah. It's a great question. It's obviously on, I think, every market participant's mind in one way or another. You know, one of the things that really excites me about the legal market and has excited me for the last ten, fifteen years is the different ways the market is being disrupted.

We all tend to over index partially based on the news cycle towards technological disruption, whether that disruption, you know, is AI now or whether it was machine learning when technology assisted review became a thing or whether it was attorney analytics, leveraging data off of dockets and case law. And all of those things are in fact disruptive and can in many ways change the way that attorneys practice, the way the law firms do business, the way the clients operate. So it's pretty cool stuff. There's also significant disruption and I think we'll have the opportunity to talk about it during this podcast from access to capital.

We're now at a stage where private equity and hedge fund money is coming in directly investing into law firms and also indirectly.

There's also a lot of disruption around alternative business models. So legal process outsourcing, business process outsourcing in a way that firms are doing business. It's a really fascinating time in the market. Specifically on AI, yeah, look, there's definitely an awful lot of hype and we've seen that in some of the very high valuations for some still relatively early stage legal tech companies, some of whom, by the way, are off to tremendous starts.

And frankly, starts as far as reaching levels of revenue that and where levels of ARR of recurring revenue that we really haven't seen before in the legal market. So, you know, while the billions and billions and billions of dollars of high valuations, the skeptics would admit or cynics would initially say, yeah, that's gotta be hyped up. It's gotta be a bubble. The reality is depending on how those solutions and the way they're adopted and the way clients adopt them evolve, it may not be quite as much hype as people think.

And the examples I'd give is one, the first one is the one I just gave. We've seen these companies very quickly get to a hundred million dollars of ARR or fifty million dollars of ARR. Really, haven't seen that pattern before in the legal market. You know, this is not a new thing.

Over the last five years, whether it be in high volume litigation parts of the market, where there are so areas like personal injury and mass tort and workers' compensation, where there are tremendous workflow and transparency challenges that needed to be dealt with not only for the law firms and the clients, but also for the mass torts market administrators and for the courts. And we've seen adoption of a number of platforms over the last few years that have begun to, in a very meaningful way, help the different market participants address those challenges and drive better results for their clients.

The adoption amongst large law of the kind of bigger name AI platforms that are getting a lot of buzz has been pretty aggressive.

The big questions around that are, you know, are the law firms investing in those platforms in kind of a me too way because it's a follow the leader type industry. And I experienced this when I was at Bloomberg. You really needed to get a couple of firms that people really respected to buy into what you were doing, and it was much easier to sell to the next firm. The question then becomes is how sustainable is it? Will firms begin to cancel their subscriptions because they're spending a lot of money but not utilizing them enough?

These are all the questions that I think different players in the market are grappling with. But the kind of punchline is we're seeing pretty strong adoption in all different market segments that is faster and more aggressive, for lack of a better word, than we've seen before in any other segment of the market except perhaps in any other period in the market except perhaps around technology assisted review, which was kind of the OG of AI in the legal market.

I agree with all of that completely. I think it's a very layered answer to that question I think. I think that the larger players who have decades in this industry, many who are incumbents in an industry that's slow to change, risk averse, and where change management barriers still exist, though, you know, they're lower. Those barriers have dropped dramatically since the pandemic was people got more comfortable with doing business in different ways.

The larger players do have a significant advantage still, and that is they have loads of proprietary data and content.

And our view at least, when I say our, I mean, my colleagues and I and take it for what it is. If you saw my performance in sports betting or stock ticking, you might wanna go the other direction. But our view is that the technology platforms are kind of ubiquitous. And in the end, what's going to really win the day is going to be proprietary data and content. And what this market has taught us again and again is that the incumbents often have the first shot to hold on to their customers and find ways to grow them. That said, Eric, to your point, I think the playing field has been leveled significantly.

I think for companies to come in and to compete with the larger players, there's development of technology, R and D, the ability to get to answers more quickly, and to find areas that customers care about, whether they're law firms or in house groups, and that could be solved by technology is a pattern that I'm noticing is there are smaller companies who are getting to market more quickly and with very little sales resource picking up multiple customers and punching above their weight. There's also, to your point about access to justice, the larger players in this market other than maybe a couple of the very large B2C type players have kind of neglected some market acceptance.

The larger players have tended to over index towards large law and large corporations because the enterprise is where the money is. So what we've seen is, you know, smaller players come into market with really innovative technology. You talk about access to justice. So one area that was one of my first deals at JGI was a company that does online divorce.

The average couple in an uncontested divorce where you're not fighting over the kids and you're not fighting over money still spend about twenty five hundred dollars apiece on attorneys. Well, if you don't have a lot of money and it's kinda you know, that is a pretty big check for somebody to write. So but the reality is you can do it online credibly with multiple vendors now for three hundred dollars. We're finding in that market is twenty five percent of the uncontested divorce market has now completely moved away from attorneys.

So in a weird way, that's an access to justice place. So people who don't have more in high income can still access legal advice and be able to in a way that doesn't violate, you know, unauthorized practice of law rules and get something done. We're seeing that pattern around trust of the stage. We're seeing that pattern for smaller law firms around addressing, I mentioned it earlier, workflow and transparency issues where it's not the big players who are capturing all the market share in this spend.

It's smaller players who are two or three years old who've taken in tech investments because maybe it's an innovator's dilemma thing or maybe it's just that they're more nimble and more focused on a specific access to justice or challenge issue that are gaining real market share.

That's a great question. I mean, I think question number one, is there a bubble? My view for what it's worth is looking at patterns, looking at the growth as you say, Danny, looking at talking to customers across the market about where they're deploying capital and looking at the trend where law firms which are the largest generator of spend with legal tech companies and tech enabled services companies are finding ways to reduce support staff and back office staff by getting more efficient and to shift those dollars in their budgets towards their technology spend and their data spend.

That to me really supports the fact that the capital or budgets that are going to spending with these solutions, whether they're the legal tech, whether they're AI within the legal tech umbrella, whether tech enabled services, the pie is growing. And that generally supports significant growth and that generally supports higher valuation. Now do I think that there have been some valuations that just I scratch my head about in the market?

Absolutely. But that's gonna happen every single if you look back at history, anytime there's been significant innovation where there's been a lot of early stage capital coming into the market, there's always gonna be a few outliers where you just, you know, kinda looking at it and not and shake your head. Like, what was the big Internet bubble back in the early naughts? Was it like pets dot com or something that raised the ridiculous valuation? And that's the example everybody gives. I think like, you know, I'm a believer that there is a bubble in some pockets, but overall the fundamentals and the data we see support the fact that there should be significant investment in any technology, and AI is clearly the bulk of this, that solves major workflow and transparency problems in different segments of the market across different practice areas.

I think the second part of your question, which I think is even more interesting, is what could disrupt that or cause that to ultimately shake out? Right? It's, you know, real bubbles. You look at, you know, the early naughts when the software bubble burst or the Internet bubble burst. You know, that was kind of a market wide public momentum, and people ultimately wake you up to the fact that there was a really big bubble.

Here, you know, over the last few weeks, I mean, this podcast is timely, there have been a couple of announcements by larger AI players, and it's caused, you know, not only in the legal market, across the market for software multiples of public companies and software stocks to go down significantly. There are questions about the seat based model for software companies and whether that's sustainable.

There's loads of uncertainty right now, and uncertainty is never a great thing for investors or frankly even for lawyers because we like to have black and white answers or as close to black and white answers as we can find. And I like you, I mean, we're covering the lawyers. So while it's kinda like Pacino and godfather three, every time they you know, I try to get out, they pull me back in. So from my perspective, like, do I think that the AI fear trade as people are calling it, not only in public markets but also in private markets, is an overreaction at this stage? Yes, I do. Do I think that AI is fundamentally going to continue to change the way that all of us do business and that lawyers work and legal is a knowledge industry and therefore ripe for AI disruption?

Absolutely. So I think adoption of AI no matter what happens, Danny, is going to continue to gain momentum. And I think it will continue to evolve very rapidly or as rapidly as this legal market, which historically was a slower moving market, will allow it to evolve.

Do I think that there's a lot of learning to be done about things like privilege, about things like hallucinations and putting stuff into your auto generated answers about cases that never actually occurred? Do I think know, and there's numerous kind of one off examples we could all come up with that will give law firms and their clients pause. Yeah. Absolutely think so. It's hard for me to think of a scenario that would be so meaningful that law firms begin to go back the other way and say, you know, we're gonna stop investing in AI. I think the horse has already left the barn.

Right now, there are fifteen to twenty law firms in the United States that have taken private equity or hedge fund money through a managed services organization, an MSO structure.

We know of four or five deals currently in market where firms are looking for third party capital to come in. Why? What's driving this? What's driving is really a need for firms to figure out how they're going to balance their investments in technology and in talent, which is a very important factor here, in order to find ways to ultimately differentiate themselves in a commoditized market and win.

And how is winning defined? Winning is defined as growing your firm, growing your profits, better serving your clients. You know historically it was very difficult for law firm partners to get an exit when they didn't sell their firm like we've seen in other industries. You know, the same was true, I think to a large extent in both health care and dental and now tax and accounting.

And those worlds have changed over the last twenty five years, tax and accounting being more over the last five, six years, around because of MSO structures. And MSO structures basically allow professional services firms to wall off the actual learned practice of whatever they're doing, whether they're a doctor, a dentist, an accountant, or a lawyer, protect themselves and their clients around issues like the duty of loyalty and things that, you know, if you were too driven by outside investors, you could potentially fall into the trap of prioritizing growing your firm over your client's interest, and clearly that can happen.

And then but the MSO structure over the years has done a very good job in these other adjacent markets of balancing the ability for professional services firms, whatever type they were, to bring in a bunch of capital, leverage that capital to once again invest in technology, invest in geographic expansion or acquisitions or just straight talent acquisitions, and to find ways to grow and ultimately maybe sell their firm and get a nice exit. So I think, you know, the MSO wave is going to continue and it's going to gain more and more steam.

We initially that wave was in high volume litigation parts of the market. So personal injury being a big one. Very large market. Firms have significant challenges with cash flow.

You all know better than me given where you sit. Firms, even the largest firms in the world, at times have challenges around the amount of cash actually flowing through. Because, you know, for large firms, it's because they pay out their money to partners at the end of the year and they don't necessarily leave you ridiculous amount of capital on their balance sheets. It's different than you know a giant Fortune five hundred corporation even though some of these firms are gigantic.

In other segments of the market, whether it's because firms work on a contingency basis or whether it's because firms, the payment cycle amongst their clients and the volume of their clients takes time and they have to deal with longer payment cycles, they have cash flow problems. So the poster child for that are kind of the parts of the market like personal injury, mass tort, some of the high volume practice that I mentioned earlier, workers' comp, social security, family law, trust of the state, immigration.

And those firms are the first ones to really buy into and engage with financial sponsors around MSO vehicles. And Arizona deregulation or liberalization of rule five point four helped because it was a bit of a catalyst. But generally, you know, what happened was those firms in those high volume parts of the market took an outside capital usually through minority deals, although now we're beginning to see more and more majority deals whereby they would sell off, pick a number, twenty five percent in their firm, they'd bring in a bunch of capital. The bulk of that capital would not go to the partners. Some of it would, but the bulk of it would go to the balance sheet of the firm itself.

That balance sheet would then be used by a managed services business vehicle to manage the firm, to invest in tech, to do marketing in the high volume litigation and high volume parts of the market because it tend to be more B2C focused.

Marketing is a big deal for business development. Right? Highly commoditized market, you have to get eyeballs and you have to get in front of clients. And to invest in talent.

And that's the pattern we've seen. Every indicator that we see is that it will continue to accelerate. I mentioned divorce before in a way that attorneys were disintermediated by online divorce platforms. We've obviously seen a number of online software platforms in wills and trusted estates and small business and otherwise come into the market.

The fascinating thing about MSOs is there's been no pushback. Because when you really think about it, if MSOs are structured the right way and if clients are protected, then everybody wins. The lawyers get the opportunity to practice in a much more sophisticated way, leverage tech better, serve their clients better. The clients get the benefits of technology, query what that means for the billable hour because everything becomes more efficient. I'm sure we'll hopefully get to unpack that later in this podcast. And then the investors ultimately win too because the law firm appreciates the value and they ultimately get some form of an exit or should. So we haven't seen the pushback that we've seen in other areas where third parties have tried to enter the legal industry, which I find quite interesting.

Yeah. So both good questions. In the states, as I mentioned, to the best of our knowledge, there's fifteen to twenty that are currently operating. Now I think given some investors had concerns because they were front of the curve in investing in law firms and because the concept of an MSO in the legal market three, four years ago was pretty nascent. Not everybody announces MSO deals when they make them. So there's no requirement that they put a press release out. So there could be more, but what we know of is, you know, based on public announcements and pretty strong industry knowledge, we're pretty certain there's fifteen to twenty out there.

Separately, because the United Kingdom and Australia were ahead of the United States in liberalizing their roles so third parties could invest in law firms and law firms could go public. There are probably in the UK, which is a much smaller market, fifteen to twenty private equity backed or public company law firms. And in Australia, which is an even smaller market, there's somewhere between ten and twenty also. So this is not that new a concept.

I think to your second question regarding structure, so as I mentioned before, the most critical thing that's extremely important for the clients and for the lawyers is that their ethical duties to their clients not in any way be impacted by outside capital coming into the firm. So much like tax and accounting firms where the MSO structure involves the audit practice sitting in a separate vehicle only owned by the partners or the members or shareholders, whatever term you use of the accounting firm, the same thing is true for law. So you form a vehicle that does the practice of law.

Third party will not own that vehicle at all. It will only be the lawyers who own that vehicle. Sitting next to that vehicle is a services organization. That services organization does a number of the services that frankly lawyers shouldn't be doing, like managing technology, managing marketing and BD, managing HR.

And that entity provides services to the law firm at fair market value, right? And ultimately it's that MSO vehicle that will have the opportunity to allow the partners who own part of the MSO vehicle because there's no prohibition to lawyers owning and investing in other types of entities along with private equity, that will be the vehicle, that services organization that gets sold. We're also seeing an interesting trend where vendors to the legal market, software vendors and tech enabled service vendors are either forming law firms, right? So they've extended out and formed a law firm either in Arizona or through an MSO, you know, affiliated law firm and the actual vendor becomes the MSO to the law firm in order to find ways to grow their companies.

And that's a trend where there's probably ten to fifteen players across legal tech and tech enabled services that either have an Arizona law firm or serving as an MSO to law firms in order to differentiate themselves and drive growth. All very, very conscious, Danny, about unauthorized practice of law and the ethics rules because the minute you cross that line, then you've got a real issue and a real problem. But the ethicists here, there are a number of firms now that provide ethics advice here, are usually the law firms that have a lot of experience with health care MSOs, tax up and accounting MSOs, dental MSOs, because it's a very similar structure.

It's a genuine pleasure. Thank you, gentlemen. I really enjoyed it.