The legal IT press seems to be full of news of Supplier A purchasing Supplier B or Supplier C receiving more funding via a funding cycle. I’m not normally one for commenting on such things publicly but the other week I saw a post on LinkedIn from an employee of a company receiving another significant slug of private equity funding (PE), describing the investment as an “incredible success story”.
I couldn’t help myself from responding to the post with a question as to what the benchmark of success was, and the suggestion that clients may well see things differently. So why am I so sceptical of investment/takeover stories, the perpetual lie that ‘bigger is better’ and that additional funding or change of ownership is always ‘brilliant news’
Note: It is also important to recognise that a significant amount of funding raised is used to purchase competition to fuel ‘turnover’ growth, which in turn makes the purchasing company more interesting to larger PE or Venture Capital (VC) investors (ie the ‘treadmill’) whilst reducing market choice.
With the prediction of another recession or at least the popping of the tech investment bubble/market realisation, I see significant and growing risks ahead for law firms who are reliant on VC/PE backed suppliers, through
- Disruption from takeovers and value extraction
- Long-term market forces
To add balance, I am not at all suggesting that all PE/VC investments are bad. Firms need investment to fund the creation and development of innovative products. My argument is with PE/VC simply to get bigger – by buying competitors who do more or less the same as the purchasing firm’s existing core product. This can be disruptive, likely to fail in the long-term and not in the best interests of the client base.
Disruption from takeovers and value extraction
As mentioned above most PE/VC coming into service providers is used to fuel purchases of competitive suppliers or the introduction of C-suite management positions. This is particularly the case for IT Managed Service Providers and suppliers of software solutions.
There are a several well-known examples in the legal market such as eknow.net, the first well-known supplier of the commodity ‘Citrix desktop’ solution who grew into the massive Nasstar; or Advanced Legal, who purchased a plethora of competing PMS and Forms providers.
The reality of a supplier being taken over by a larger supplier, or a competitor, is that they have been purchased either directly for their client base (ie to transfer current clients to other services owned by the purchasing supplier); or to enable the purchasing firm to achieve the growth demanded of it (ie turnover vanity) by their VC/PE paymasters.
What is often forgotten in these VC/PE-led funding announcements is the short-term nature of the investment. The sole purpose of a VC/PE firm is to find short-term investments (3 to 5 years), invest borrowed money and return it at a higher profit than they could have received from other investments. Once in a PE cycle the company receiving the investment has little control of the process.
Unsurprisingly the purchasing firm tends to be interested only in what else it can sell into its extended client base and how much profit it can extract. I cannot recall a time where a takeover of a smaller firm by a larger competitor or an injection of capital has directly led to the service improving or the client being happier in their relationship.
Indeed, such interactions normally result in an unhappier client base due to disruption in service delivery, account management and process; the consequence Is, unfortunately, that the purchasing firm will try to make the purchase price worthwhile and provide a return by commoditising, leveraging or sweating the assets, to achieve the returns required for their investors’ ‘sell out’ position.
The impact of this is often seen from day one:
Almost immediately the purchasing firm needs to make reductions in staff (or at least restructure) to remove duplicated functions. Often this is initially most visible in the account management or support desk functions.
We have one client who has had three account managers in the last six months. Each time round their new account manager comes in with good intentions, promises the earth, agrees a set of deliverables and then…gets reassigned. The process then starts from scratch, typically without any of the client’s priority issues having been addressed.
In the legal sector, suppliers’ employees (particularly those with software application providers) tend to be very loyal to their application and stay with suppliers for a very long time, developing a real depth of product knowledge. It is rare for them to leave without due cause and are generally happy to give their new employers a good go.
From six months to a year after the takeover staff start to consider whether they want to stay: have the promises made to them during the initial restructure been kept? Is the direction of travel one that they are happy with? It is often the case that as soon as one key member of staff makes the move it becomes a departure lounge as several others leave in short order, causing a secondary ripple of service disruption. Most significantly this results in the loss of organisational memory, customer knowledge, ethos and culture, all of which can have a major impact on service provision and customer satisfaction.
As soon as the takeover is completed most firms seek to merge the sales, account management, service and support functions. Like the service management function these functions are seen as ‘process’ and leverageable. On occasion whole existing functions are replaced with staff from the purchasing company.
It is essential to understand that law firms often make their choice of supplier based on the ownership structure of that supplier. Many prefer dealing with an owner-managed business as it gives them a feeling of familiarity, and the personal nature and strength of a ‘business owner to business owner’ relationship should not be underestimated.
Within the traditional owner-managed supplier, largely due to those personal relationships and understanding, we have become used to seeing highly personalised, bespoke service delivered consistently. Sadly, these relationships are the first to go as the original owners leave to be replaced with account managers, while support services are commoditised and delivered to contractual terms.
Most PE/VC backed firms opt for a ‘battery farm’ approach to proving support, with standard call answering queues, and anonymous staff who work off scripts for many different clients. They therefore have no connection with the firm and the personal touch is further lost. I appreciate that you could see all of this in the context of modernisation and that the high-touch, white glove treatment that owner-managed suppliers once offered is no longer viable. But there must be a way to move forward without sacrificing clients on the altar of commercial expediency.
Very often the relationship between client and supplier is significantly damaged because the takeover has been badly handled; or because the imposed staffing changes have negatively impacted on law firm operations. We’ve seen announcements made prior to clients (or supplier staff) being informed so the initial days of the takeover can be extremely disruptive.
The biggest problems are reserved for recently contracted new business. It does happen that before a sell-out the supplier management team goes on a ‘sales splurge’ to grow the client base or number of booked projects in order to drive up the sale price. As owner-managers there’s personal gain driving their motivation and that can tempt them to make promises they know the purchasing company will be unable to deliver.
During a system selection’s due diligence phase, prospective clients will always ask for confirmation or guarantees of ownership plans; and yet only minimal contractual guarantees are ever entered into (if at all) and there is little a client can do after the event, especially if they are mid-way through a significant project. It is extremely hard to walk away.
This unethical approach has an extremely detrimental and unrecoverable impact on relationships, especially at a time when the new purchasing company is struggling to ‘onboard’ its purchase.
In fairness to the purchasing company, they sometimes have significant surprises awaiting them. For example, in the owner-managed MSP world hardware assets can be over-sweated or staff development overlooked.
There are several well-known instances of larger MSPs being frankly horrified at what they have found when they were finally in a position to make a full assessment of their acquired infrastructure – realising just how much effort they would need to put in to address the hidden risks.
We have had experiences of data centres with supposedly robust secondary connections which, when required in the heat of an emergency, turned out to be in the same cabling duct as the main connection; and infrastructure running on 100Mb switches rather than the 1Gb minimum expected.
Long-term market forces
If, as Elon Musk states, technology companies are overvalued and there needs to be market realignment this could have significant impact on those suppliers focused on servicing the legal sector.
Musk argues that “It has been raining money on fools for too long” and that “Some bankruptcies need to happen”. His point largely boils down to the fact that the technology companies have for too long been seemingly unaffected by normal Schumpeterian market forces.
Musk is not alone: pension funds continue to disinvest into less risky investments. So far in 2022 it is reported that VC-backed companies have lost almost 50% of their market value, the Nasdaq is down as is the FTSE Techmark 100.
In this environment, the PE/VC investment cycle could well flat-line. Smaller PE houses will not be able to ‘sell up’ their assets to the larger houses for the returns they require. Essentially, it will be harder for suppliers to raise finance to fund their growth. So how could this impact law firm customers of technology providers
- Some suppliers will fail, and their client book be taken over by competitors. With a distress takeover, staff and service impacts will be even greater than with a normal takeover described above. In this scenario client law firms will take a significant operational hit.
- Some suppliers, as happened to Nasstar, may need to be sold by their investors to larger competitors, against the managers’ desire.
- Some suppliers will be forced to sweat their assets for longer than they should or to take overheads out of the business in order to provide their investors with the returns they require. This could mean reducing staff training and investments in application development or infrastructure.
In this scenario, software suppliers’ bug fixing and software enhancements will take longer and items may be removed from the roadmap.
For infrastructure/MSPs the systems will simply become out of date and not provide the optimal experience. It is also more likely that hardware will fail or be unable to support software applications’ changing requirements.
What can law firms do to mitigate supplier risk?
Truthfully? Sometimes there is very little one can do. Suppliers change hands without deference to their client base, and despite talks of ‘user voice’ there is again little clients can do to affect the method and nature of the service delivery.
We are therefore entering into the world of proactive risk management and vendor management: ensuring you are very clear on expectations and the service definitions as per contract; monitoring performance against SLAs; and having regular conversations with suppliers on delivery and future plans.
Often, following a takeover, an MSP will enter into a Service Improvement Plan (SIP). This is where both parties work through a list of identified issues. This should give you an indication as to whether you might receive the service and relationship you are looking for.
Should that not be the case, then it will be necessary either to:
Learn to live with the service provided and ‘wrap it’ with the service you desire (eg if an MSP uses a ‘battery farm’ style helpdesk, you may want to look at employing your own 1st line support).
Seek an alternative supplier which is a significant risk in itself, and no guarantee of long-term stability.
We would expect more firms to settle on the first option and we may see the return of firms insourcing the service function while MSPs are used as 3rd line infrastructure as a service suppliers.
We are aware of three firms who signed contracts with an MSP only to find they were taken over between signature and go-live.
Another client discounted one supplier due to reputation, only for that supplier (with PE money) to purchase the firms that came first and second in their selection process.
At a time when the choice of suppliers is becoming more limited, for a variety of reasons, it is clear that the risk of selecting a stable supplier is also increasing. Due diligence doesn’t protect you in the way that it once did. The protection you have available to you is in shorter contracts, stricter terms and options to extract yourself simply and successfully.