The first regulatory pushback against PE-backed law firm MSOs has arrived, but advisers say the market is maturing rather than retreating. The new rules may eliminate poorly structured deals while legitimizing sophisticated investors willing to operate within ethical boundaries.
Illinois recently passed legislation aimed at limiting the influence of non-lawyer investors over legal practices, joining similar efforts underway in California and Colorado. But advisers active in the market say the measures are more likely to reinforce the importance of carefully structured transactions than significantly slow deal activity.
Instead, they expect the new rules to discourage less experienced investors while preserving a path for private equity firms with a long-term thesis around supporting law firm growth through properly designed MSO arrangements.
MSO structures have emerged as a way for law firms to access outside capital while complying with American Bar Association Rule 5.4, which prohibits nonlawyers from sharing legal fees or interfering with lawyers’ professional judgment. Under these arrangements, investors own the business services organization that provides operational support to the law firm, rather than the legal practice itself.
The Illinois General Assembly on May 31 passed House Bill 5487, which does not prohibit MSOs, but would place restrictions on nonlawyer entities from interfering with the professional judgement of attorneys, according to an analysis by Holland & Knight LLP. It also introduces caps on fee structures and contractual provisions.
The measure now awaits a signature from Illinois Governor JB Pritzker, who has not issued any public statements on whether he’ll sign or veto it. Meanwhile, two other measures aimed at regulating law firm MSOs are under debate in California and Colorado.
Chin Pandya, a managing director at Houlihan Lokey’s (NYSE: HL) business services group, said the Illinois legislation may discourage less committed “window shoppers” from pursuing MSO deals. But the law still leaves a path for investors “who truly have a thesis” he tells Mergers & Acquisitions.
“A properly set up MSO already meets the required principles, so the legislation shouldn’t be a problem,” Pandya says. “The Illinois ruling is more validation that well-structured MSOs can still work and should attract external funding and support growth for the right platforms from investors with the right conviction.”
Frederick Shelton, CEO of legal advisory firm Shelton & Steele, adds that a well-negotiated MSO deal is needed for law firms to retain their autonomy and culture. It is also “absolutely essential” to ensure that private equity firms are prevented from establishing fee-sharing agreements, which would violate ABA Rule 5.4.
“As long as the deal structure is done properly, you are absolutely impenetrable, because if the MSO is charging a fixed fee, fair market value or cost plus, then basically they are just a super vendor,” he says. “The firms that are going to get into trouble are firms that enter into agreements with private equity wherein anything even close to fee sharing is structured into the deal. Once fee sharing is structured into the deal, they’re doomed.”
The key is to have advisers and MSO attorneys negotiate a structure that protects the law firm from interference by capital providers in its legal activities, decisions and judgment, he says.
Shelton has been working on law firm MSO deals involving firms with $10 million to $250 million in annual billings, or firms with 15 to more than 500 attorneys, that are seeking capital to invest in AI in some cases.
He avoids working with “typical PE bros” who want to take over a law firm, cut staff to boost profits and upend a firm’s culture.
“Law firms are a breed under themselves,” Shelton mentions. “This is not building widgets, and this is not a dental practice. Lawyers are very different, and the winners are going to be the ones who come in and say, ‘OK, we’re going to partner with these law firms and figure out what’s working well for them already and just enhance that.'”
While these laws may be promoted as a way to protect the ability of law firms to handle cases without day-to-day interaction or management by private equity firms, there’s more to the story, according to Shelton.
The Illinois law in its current form appears to be unconstitutional because it says that a firm cannot pay a vendor from the direct profits of the legal practice, or indirectly through profits of the legal practice, he adds.
“In other words, they just outlawed using Amazon Web Services and ADP for payroll,” he says.
The Illinois law may be challenged in court based on some of these arguments, according to Shelton.
Shelton also argues that restricting access to outside capital could disproportionately affect midsize and smaller law firms that are seeking funding for technology investments, including AI tools that have become increasingly important for competitiveness.
“The big guns don’t want the little guys to be able to buy the same level of AI,” he says.
