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Private equity firms typically have small legal teams and spend big on external counsel. On average, mid-size PE firms spent $3.93 million in 2020, while their larger competitors spent $10.27 million. Of course, the need for quality advice is undisputed. But what is increasingly under the spotlight is the size, predictability and transparency of this spend.
At the very end of 2020, we commissioned primary research into the attitudes and behaviours of 160 PE firms when it came to legal spend management. What became very clear, very quickly, is that mid-size PE firms are substantially more focused than large PE houses. Put simply, as a cohort they are more proactive and sophisticated in their approach to legal spend management today and, based on their plans, will extend this lead over 2021. This sophistication, founded primarily on mid-size PE legal leaders’ use of processes and technology, will provide a source of sustainable competitive advantage as their firms grow.
Legal spend: A material concern for all PE firms
Whether on individual transactions, total transactions or fundraising, seven out of 10 PE legal leaders across mid-size and large firms agree that legal spend is a material concern. But they are responding very differently.
More than one in five large PE house senior legal stakeholders say they do not currently make efforts to actively manage their legal spend. Compare this with just 4 percent in mid-size firms, who also have significantly superior visibility of legal spend (78 percent believe they have good visibility, compared with just 62 percent of large firms).
This difference in approach results in better business outcomes. For example, in the past 12 months, seven in 10 large PE houses have been billed for legal work that was, in hindsight, considered unnecessary or redundant. This falls to just over half (54 percent) for mid-size firms. More than half (55 percent) of large PE firms regularly have to re-plan budgets due to unexpected, or unexpectedly high, legal bills – a problem that affects only 41 percent of mid-size PE legal leaders. One data point suggests why this is the case: 42 percent of large PE houses occasionally lose track of accrued spend and have to manage unexpected invoices (compared with 26 percent of mid-size firms). This suggests an over-reliance on manual processes, where transparency is inherently limited.
When it comes to approaches to, and management of, legal spend, mid-size PE houses seem to be ahead of their larger rivals. They are more actively managing legal spend and are determined to become even more active, outstripping current and planned efforts of large PE firms. They have better visibility and are significantly less likely to be billed for unnecessary or redundant legal work than large PE houses. Some mid-size firms struggle with transparency, but not to the extent that they are constantly having to re-plan budgets or losing track of accruals like large firms.
Optimising legal spend
Last year Gartner research revealed that legal spend optimisation was a priority for senior legal stakeholders. This holds true in our survey. More than seven in 10 mid-size and nearly four in five large PE firms agreed that optimising their legal spend is a priority for 2021. How will they go about this?
Moving to work with alternative legal service providers (ALSPs) is the most popular strategy among both mid-size and large PE houses. Next is the introduction of more robust processes to manage spend. The adoption of technology to assist with legal spend management follows – with a large proportion of both cohorts saying that their departments are ready to benefit from technologies that provide data and analytics. Finally, nearly three quarters of PE legal leaders will be working more closely with their colleagues in procurement.
Shifting certain matters to ALSPs may well provide some of the predictability and transparency over specific areas of spend that PE legal leaders crave. However, given the volume of matters instructed by PE firms and the intractable nature of their highly bespoke, interconnected and fast-moving components it is unclear whether this strategy alone will generate significant overall efficiency savings.
If introducing processes is the second-highest rated approach to cost optimisation by PE legal leaders in 2021, what is in place today? For many firms, it seems the answer is ‘not a great deal’, though mid-size firms are ahead of their larger competitors – sometimes significantly. For example, nearly three quarters (74 percent) of mid-size PE firms have formal legal budget approval processes in place – compared with just 55 percent of large firms. Mid-size firms are significantly further ahead in retrospective budget analysis processes and for having a formal process for authorisation to instruct legal counsel.
What processes do PE legal leaders plan on introducing? The data here are encouraging. Large PE firms favour active, real-time cost tracking, formal budget approval and retrospective analysis of budget over-runs. Mid-size firms prefer external advisor performance tracking, matter cost benchmarking and longitudinal matter cost analysis. Employing technology and tools is the third most popular strategy for legal spend optimisation. The decisions PE legal leaders are making here are fascinating and suggest a forthcoming boost in sophistication.
Today, a significant percentage of both cohorts use manual data collection (eg, Excel) to manage their legal spend, at least in part. However, though still at 70 percent for mid-size and 65 percent for large PE houses, it is significantly down from our first PE legal spend study conducted in early 2020 (91 percent). Encouragingly, meaningful numbers of PE legal leaders are scrapping manual methods.
E-billing is currently popular, used by roughly half of PE firms and more than a third are planning to introduce the tool. But if e-billing is ‘today’, then specialised legal spend management software seems to be ‘tomorrow’. While only 13 percent of mid-size firms are using this today, more than six in 10 (63 percent) are planning to introduce it and 15 percent are considering it. A higher proportion of large PE firms already have spend management software in place today (22 percent), with a further 43 percent planning to introduce it and 15 percent considering the technology.
Legal spend optimisation is a key priority for the majority of PE legal leaders. Process introduction is important for both cohorts but, generally speaking, mid-size PE firms are leading their larger rivals based on both the processes in place and planned. Technologically, mid-size firms are also taking the lead. Soon, we can expect 76 percent of mid-size PE firms and 65 percent of large PE houses to be using specialised spend management software, bringing much-needed transparency and control to legal spend management.
PE legal spend management: Mid-size firms more focused
Mid-size PE firms – those with between $3 billion and $10 billion AUM – spent an average of $3.93 million on external legal fees in 2020. A majority anticipated reducing spend in 2021. They are well-placed to do this, as they are more actively managing their spend today and applying more focus on it in the future.
These firms have marginally better visibility of legal fees but appear to struggle with transparency and crave the law firm accrual data that will improve this. Cost optimisation is important to them and they are putting significant levels of effort into process improvement, allowing them to increase return on investment and remain agile against larger PE firms.
Mid-size firms are also more advanced in grasping the importance of technology in helping optimise legal spend. They recognise that legal spend management software is key to increasing transparency and accessing the accruals data from law firms that can make this seamless and actionable.
Large PE firms – those with more than $10 billion AUM – spent $10.27 million on external legal fees in 2020, on average. However, while the majority agree that legal fees for transactions and fundraising are a material concern, large PE houses are significantly less likely to actively manage their legal spend than mid-size firms. They also have poorer visibility and are much more likely to be billed for unnecessary or redundant legal work.
Transparency is an issue for many, and a significantly higher proportion of large PE firms have to regularly re-plan budgets and lose track of accruals. Senior legal stakeholders in large PE houses are lagging behind mid-size firms in implementing processes to manage legal spend and, while they have a small lead in using technology today, they look likely to cede this ground as well. Like their smaller competitors, large firms crave accrual data from law firms to help them better manage legal spend – but they are not as active in making this happen.
2021: A pivotal year
Why is there such a pronounced difference between the two cohorts? Pragmatism. Legal costs are proportionally higher in mid-size PE firms so there is more incentive to manage them. It is also fair to say that being a large PE firm does not necessarily mean having a large legal team, though it does appear that there are more internal stakeholders to work with. As we saw in our last study, a structure of distributed accountability can limit the ability of senior legal stakeholders to effectively manage legal spend.
But with all PE senior legal leaders reporting rapidly increasing scrutiny on costs, and pressure to reduce them, it will concern large PE firms to see their smaller, more agile competitors primed to run much tighter ships. Will mid-size PE legal leaders make good on their plans to implement more robust processes? To use legal spend management software to drive greater transparency and cost optimisation? Or will legal leaders in large PE houses react by using their scale to outpace their emerging competition?
It seems unlikely that large PE houses will stand idly by while their smaller competitors are building a sustainable competitive advantage. Indeed, based on our conversations with some of the world’s largest PE firms, they will not. The very best legal leaders will all be examining ways in which they can boost their contribution to the bottom line of their firms, regardless of their size. 2021 will be a pivotal year for legal spend management in the PE sector.