What private equity wants

We talk to five investors about what they look for in legaltech opportunities and the value they believe they can bring.

Early-stage investment in legaltech hit new records in 2018.  But what makes the sector attractive for later-stage growth and buyout investors?
David Sneddon (pictured left): I think you need to take a step back and say what makes an attractive investment proposition, full stop.  We are looking for growth markets where you are dealing with customers who value technology and who are likely to be good long-term clients.  Legal is one of those sectors.
Xavier Woodward: The legal sector, in general, is big and fragmented and there are lots of inefficiencies in the way services are delivered.  I would suspect legal services businesses don’t look massively different in 2019 than they did in 1919, which doesn’t describe most industries.  For investors that means two things: there are probably quite a lot of mediocre businesses out there, but equally there is an opportunity for someone to take that sector and make it more efficient and more effective.
Tom Shelford: Legal technology has been an interesting space, particularly since changes to regulation allowed alternative business structures in the sector.  It has become even more attractive as companies are increasingly forced to focus on procurement.  Management of cost is now as material as revenue growth for most corporate’s bottom lines and spend on lawyers is no exception.  Inhouse legal teams are looking for new ways of procuring legal expertise.  Part of that is unbundling the advice they are getting – managing workflows and driving efficiency.  Technology has a key role to play in doing that.
Matt Singh: I agree that the market really opened up with the 2007 Legal Services Act.  Traditional partnerships don’t incentivise investment in the business.  Partners are incentivised to take money out in their drawings.  That has often resulted in under-investment and slow growth.  The advent of private equity interest in the sector and a number of legal IPOs, following the regulatory changes, has shown the value to be had in corporatising the legal model and putting capital behind businesses to grow through acquisition, but also to invest in back office systems to drive efficiency.  Technology is not the only component of making the sector more efficient but it is a really important component and it makes legaltech a very interesting space for us to look at.
Greg Coates: I would say that the obvious attraction is the market potential.  Around $500bn is spent on legal services in the US alone each year and there is a long way to go in improving the efficiency of lawyers in delivering that service.  Today, the total IT spend by law firms is only around $4bn, but, as firms continue to feel client pressure to improve delivery, we’ll see more of that spend shift towards software vendors.  This is a clearly defined market where the horizontal vendors have consistently failed to deliver products or support that really meets the needs of the way law firms operate.
The second, less obvious, factor is the close community that’s developed around law firm purchasers.  Communities such as GlenLegal and ILTA mean that if a vendor does a great job at delivering for CIOs, they can very quickly build a quality brand as the ‘go to’ provider for a segment of the legaltech landscape.  Legal CIOs tend to see each other more as peers than competitors, which means that software vendors who provide compelling products and great support can scale quickly.  These two factors mean that we’re seeing some really big, interesting software platforms emerge in legal.  Beyond Hg’s own portfolio, you can see the likes of iManage, NetDocuments, Intapp, Relativity, Clio and many more, all building lasting businesses of meaningful scale.
What’s new?  How is the sector evolving?
Coates: We see two trends which are interestingly contradictory.  On the one hand, there’s been this sudden wave of innovation and start-ups in legal trying to bring neat, new tools to attorneys.  On the other hand, the complaint we hear most often from CIOs is the proliferation of IT vendors.  As a result, there is a CIO push to consolidate their IT stack onto a few strategic platforms.  This is going to shape legaltech for the next five to 10 years, with big vendors such as the DMS players expanding their reach, both organically and through acquiring these emerging start-ups.
How does legaltech compare to fintech or other areas of technology as an investment proposition?
Coates: There’s probably 50 to 100 times more spend in total on fintech than there is on legaltech, which is perhaps why fintech gets more attention.  In addition, legaltech is comparatively hard to scale.  This dynamic is mostly driven by the partnership model often used in law firms, which makes IT decision-making more complex, and a general reluctance from attorneys in changing how they work.  You can build a fantastically innovative product in legaltech but the highest mountain to climb is convincing CIOs to undergo the change management needed to drive adoption.  It requires a lot more thought around sales approach and customer success than any other industry we’re investing in and is where a knowledgeable investment partner can add value.
What subsectors do you see as particularly exciting?
Singh (pictured right): Legal firms are essentially people businesses and ultimately the way in which to make more money out of people businesses without adding more people is to drive efficiency in the way that they operate, so back office technology like robotic process automation or SaaS technology that allows processes to run more smoothly.  These are all technologies that can ultimately help drive margin.
Coates: We spent a lot of time looking at the legal ‘front office’ applications before investing in Litera Microsystems.  We think we’ve backed a really special team there who have brought together the Litera Desktop to deliver a single, seamless drafting workflow to attorneys and the benefits of a single vendor to CIOs, which is striking a chord with that drive to consolidate IT vendors, particularly on a cluttered attorney desktop.
There’s also a lot of change and opportunity going on in corporate legal, which is often underappreciated.  The rise of legal ops in the US is the root cause of the change in legal services right now and technology is core to what they’re doing, which is why we are also invested in Mitratech.  In terms of where next for Hg?  We think there are interesting opportunities around law firm ‘BizDev’ software, better serving small firms or solo practitioners and in changing the way lawyers are delivered relevant legal content.
Woodward: We find the workflow management space interesting.  Most large firms use workflow management tools, but they are using them in the context of the old-fashioned time and materials model.  At the moment, they are not really incentivised to reduce the time spent on a task and, even if they think they are, there is a cultural conditioning towards maximising hours recorded.  The other interesting area is how to get technology to perform tasks currently performed by lawyers.  There are all sorts of activity around machine learning, AI and digital scanning.  Those technologies have not been widely adopted yet but they will be and we want to invest in the ones that are going to win.
Are you looking at AI-driven businesses as viable propositions today, or building relationships for further down the line when the technology is more proven?
Sneddon: We don’t look at early-stage propositions around AI, for example.  We are following those sectors closely and will be interested in investing once they mature, but we require established revenues in order to invest.
Coates: We see a lot of cool AI vendors, but these do tend to be too early stage for us to consider right now and we’ve not got the conviction quite yet to tackle eDiscovery.
Woodward: The challenge for firms like ours is that the most exciting businesses are the ones that grow most quickly.  That means the time period between being too small for us to invest in and too big, is shortest.  I am always interested in meeting companies even if they are currently too small for us due to the size of the funds that we manage.  If they do grow well, we will have put in the hard graft of relationship building so we will be ready when the business is ready for us.
What qualities are you looking for in the businesses that you back?
Sneddon: Later-stage growth businesses are our sweet spot.  We are typically looking for companies which have disruptive technologies, established customers, recurring revenues and which are looking to grow to the next level.  Peppermint is a good example of a company that had brought a disruptive product to market and which had initial customers in place but needed to raise money for further customer acquisition and product development.  Then we are also looking at the management team, of course.  They are the glue that holds the whole thing together.  What we are ultimately backing is the professionalism and skill of that team to execute on a plan.
Singh: We are looking for businesses that can articulate a value proposition whereby the client’s investment into the software can help drive operational efficiency, in other words where the technology pays for itself.  We also look at how integrated the software is.  We want new developments to be upsold in a modular fashion.
Shelford: The key thing we are looking for is the nature of the client relationships, evidence of recurrence of spend and a large addressable market.  We are not early-stage investors and we need confidence around a sustainable track record and business model.  Where we believe legaltech has the most scalability is by being extremely focused on a particular proposition and really mining that offering, becoming as innovative and helpful as possible for users before branching out into different product groups or territories.  There can be a temptation, given the huge demand for efficiency, to try and be all things to all people.
Coates (pictured left): First, we look for an entrepreneurial team to back.  We want managers with a big vision of where they want to take their company, based on a clear, unsolved customer need and with the capabilities to build a team of engaged employees and processes around that.  Second, of equal importance, is a business with healthy customers and healthy product.  We want to find businesses that law firms love dealing with and products that lawyers love using.  It comes back to the idea of the legal community – if CIOs dread your phone call, or attorneys aren’t using your product, someone will quickly take your seat at the table.  But if you get it right and build healthy CIO relationships, you have a platform to build from and upsell new innovations.  It’s all driven by having the right people, processes and level of investment in product and support.
What do you make of the quality of management teams that you are seeing in legaltech businesses?
Shelford: I think there are impressive entrepreneurial people heading up legaltech businesses but, as is natural for a sector at this stage, further investment is often required in the broader management team, not only the usual areas such as finance, but also in sales, marketing and operations to help professionalise companies as they scale.
Singh: Inevitably in a relatively new area, we tend to see higher risk-taking management teams.  They usually know their sector well, or else have parallels to it.  They understand that historically this has been a stable, if unexciting industry, and they can see the opportunity to tap into new ways of thinking, new law models and new technologies.  It takes management teams with vision, risk appetite and an entrepreneurial mindset to do that, and that’s what you see in this sector.
What do you look to bring to the table as investors?
Woodward: We don’t have a playbook that we roll out.  It is very much case by case.  But collectively we have seen a lot of businesses, a lot of business models and a lot of business challenges over 25 years.  Because there are always challenges.  Our job is to share that experience constructively to help management make the right calls on the big decisions, to help avoid missteps and to accelerate growth.  We are not saying we can necessarily help the business do something it couldn’t do by itself but we might be able to get it there quicker.  We have a lot of resource available to support customer acquisition, talent acquisition, data science, research, M&A and we are only too pleased to deploy it as shareholders alongside our management teams.  When we win, we win together.
Coates: Hg’s proposition boils down to four things: our specialist knowledge which comes from an entire portfolio of B2B software and service companies, our expert operational support, our network of talent and, of course, financing.  Our primary role is to support our management teams.  As businesses scale, entrepreneurs are always going to come up against problems they haven’t seen before.  The advantage of having a portfolio of 30-plus B2B software companies at any point in time is that we’ve probably seen that problem five times before and have, or know, the right person to help.  We can also use that network for support in attracting the right talent.  Lastly, we can help businesses think about how best to use their balance sheet to drive growth.  A good example is M&A, which can be really powerful if you’re disciplined in buying high quality businesses which will add value to your customers and focused on getting the integration right.  Legaltech is littered with examples of poorly executed M&A, so we think it’s useful to have a partner to help avoid the pitfalls.
What particular challenges do you associate with investment in the sector?
Sneddon: I suppose the biggest challenge is that it is an increasingly well-established market and for most product offerings there is a lot of competition.  It is about understanding the competitive advantage that you have and ensuring that it is significantly compelling to make clients want to switch.
Shelford: I would say there are fewer mid-sized businesses in legaltech than other, more mature, sectors, which is always going to be a challenge for mid-market private equity investors.  From an operational perspective, law firms are fairly conservative buyers.  That is one of the attractions of the sector but it can also make it difficult to get your foot in the door and scale early stage companies.
Coates: Relative to other sectors, it takes a while to come into legaltech and understand the jargon and the way law firms or legal departments really buy software.  As well as the experience from previous investments in this sector, it takes a lot of hard yards hanging around the right conferences and talking to CIOs and legal ops directors to build that understanding and network that allows you to make confident investment decisions and add value as an investor.
Woodward: The challenge with emerging technology, generally, is predicting adoption, which is partly driven by having the right technology but also by a whole range of factors that are out of your control.  There’s the classic example of Betamax versus VHS.  Everyone found Betamax to be the better platform but it didn’t win.  The earlier the stage and the younger the business, the more risk there is that while the technology sounds really cool, it just won’t sell.  That’s why we focus on profitable businesses that have reached a certain scale rather than start-ups where, frankly, the job is much harder.
What do you see as the most likely exit routes for these businesses?
Sneddon: There are two primary exit scenarios.  Businesses are being sold to larger companies already operating in the space.  That’s a well-trodden path.  We are also increasingly seeing sales to other private equity houses.
Shelford: Given the continued scale of growth in the sector as a whole, I think there will be a good range of exit opportunities.  Clearly demand from trade will continue, whether that be from larger consultancy businesses, the Big Four or dedicated BPO companies.  I would also expect there to be strong secondary private equity interest and we have seen the good valuations achieved by legal businesses on the listed markets, so I think all three routes will be open.  It will be down to the management teams in terms of where they want to take the company and the level of control and investment they want for the next stage of development.
Coates: Five years ago, you would have said that the big legal publishers were the obvious acquirer.  Whilst they keep making small product acquisitions, it has been a while since we saw any of them make a big move in legal software.  I think the larger legaltech platforms being built today have a long runway ahead of them as independent businesses.  It would be great to see one or two of these make it onto the public markets as a flag-bearer for legal too.
By Amy Carroll