Adventure of Strategy

Things that happen in the UK tend to have a ripple effect in South Africa a year or two later. Hence, law firms at the southern tip of Africa have been watching the Clementi Review process with interest, especially the bits about possible external ownership of law firms. The concerns that would be raised in South Africa would almost certainly be very similar to those that have been raised in England. There is, for instance, the matter of practicality of external ownership of law firms. South Africa has a very recent example of where such external ownership was not a resounding success. In 1999, South African banking group Nedcor bought the law firm Edward Nathan & Friedland for 400m rand (about $65m / £40m.) In 2004 the firms' directors bought it back for just 50m rand (about $9m / £4.6m.) The case study has important lessons both for UK firms considering "selling themselves" to external entities next year, when this becomes legally possible, and those that would like to "own" one.

In 1999, the world was very different. The M&A boom was white-hot. Nedcor was busy with a hostile takeover of Standard Bank. It was pre-9/11, technology stocks were stratospheric and Enron was still trading happily. There was no end to market optimism. The deal was driven by a vision to create a top-rate integrated multi-disciplinary corporate finance advisory service in South Africa.

Then, the world changed. Enron, Worldcom and Sarbanes-Oxley seriously damaged market enthusiasm for MDPs. The hostile takeover of Standard Bank failed. The technology bubble burst and M&A action slowed. 9/11 changed everything.

There were also a few unanticipated internal effects. Nedcor's shareholders required a return on their investment, besides dealflow. This required a significant portion of the firm's profits, and cash available to distribute to partners (now salaried employees) came under pressure. Partners that had participated in the sale had few complaints; they had received a large capital sum in 1999. But the firm started experiencing difficulty in attracting or retaining other top talent.

In 2004, it became evident that several key lawyers were not going to remain Nedcor employees for longer than their restraints required. Without them, Edward Nathan would be a far lesser firm. Also, under new Nedcor chief executive Tom Boardman, Nedcor was shedding non-core assets. Edward Nathan seemed a prime candidate for divestiture. But at what price?

Nedcor's benchmark was what it had paid in 1999. Edward Nathan's lawyers, on the other hand, knew what they could earn elsewhere. With the roles of buyer and seller reversed, why should the firm's lawyers pay Nedcor a premium based on the future sweat of their own brows? The 1999 valuation model was apparently based on a combination of net asset value (NAV) combined with the significant value that would likely accrue to Nedcor from a multi-disciplinary corporate finance practice under Edward Nathan's brand. The latter probably being determined on some variation of the discounted cashflow model. In 2004, the brutal reality was that (except to the firm's lawyers) Edward Nathan was worth little more than NAV, represented by its debtors book, work in progress, a nationally famous law library, some very nice office furniture, IT and those systems that new incumbents were able to take over, assuming that they wouldn't collapse if the secretaries followed their bosses. Less current liabilities, of course.

Interestingly, Edward Nathan (they dropped the "Friedland" in 2005) has elected to remain a high-end corporate legal advisory consultancy rather than returning to being a conventional law firm. This increases its future options in terms of structure and management. As an independent firm again, it seems poised to move on to great things. Wisely, the firm included a Black Economic Empowerment component in their restructuring that has pushed them to market leadership amongst the 'Big 8' South African firms in this respect. This opens the way to lucrative government and parastatal work in particular.

From the Clementi perspective, the Edward Nathan case emphasises the need for potential external owners to be clear about what they are buying. Are they buying the firm, or the people in the firm? If the former, the buyer needs to ensure that they can achieve the expected return in the time that the key lawyers are under a restraint of trade. If the latter, why not hire the lawyers directly? The firm's partners need to be comfortable with becoming employees, and that the deal will add sufficient value for profitability to increase enough to meet the dividend aspirations and also ensure that the firm's compensation is adequate to attract and retain good people. That's a very big 'ask'.

This artice first appeared in 'Legal Business' in London in March 2005. It has been amended slightly to accommodate the time that has elapsed since then. As always, comment is most welcome and may be posted below.