The legal industry is at the peak of a structural evolution—one that may have you feeling like you’re experiencing déjà vu. Industries like healthcare and accounting have widely adopted models that enable access to private equity, subsidize growth, and create opportunities for liquidity in a compliant fashion.
Historically, law firms operated traditional models that limited their options in terms of structure and access to capital. However, many are signaling that they may be ready to join their professional service counterparts in exploring alternative structures.
Private equity interest in the legal sector
There is a long-standing history of creative structuring in professional industries to achieve growth while ensuring compliance. For example, the “friendly-PC” construct, which involves utilizing Management Service Organizations (MSOs) to separate clinical and non-clinical aspects of a professional practice, has been long used in various healthcare industries like dentistry and physician practices in preparation of private equity backed acquisitions. Until recently, utilizing MSOs in the legal industry was largely unprecedented. However, private equity has shown increasing interest in the legal industry, identifying it as an attractive and, in some circumstances, recession-proof, market. Many law firms have been receptive to private equity’s increased interest and are now considering whether MSOs can be used as a path to accepting outside investments and broadening exit options, while adhering to ethical considerations.
What is a Management Service Organization?
An MSO is a non-professional entity that provides administrative and support services to professional practices. A properly structured MSO results in the bifurcation of professional and non-professional aspects of a business. Non-licensed investors maintain ownership in the MSO, while the professional practice remains owned exclusively by licensed professionals.
Restructuring to an MSO is a multi-step process requiring assistance from both legal and financial advisors. The steps involve transferring all non-professional assets to the MSO and entering into an administrative services agreement between the MSO and the professional practice, pursuant to which the MSO provides various non-professional support services. The professional entity retains exclusive control and autonomy over the professional aspects of the practice. In exchange for services provided by the MSO, the professional practice pays the MSO a fee determined by an independent appraiser and set at fair market value. What is driving law firm interest in MSOs?
For one, private equity has become more vocal about its interest in the legal sector and more aggressive in pursuing opportunities within it. Law firms have been receptive to overtures from private equity, who see the MSO model as a means of achieving:
- Access to Capital: Access to capital offered by MSOs enables law firms to keep pace with industry demands, such as artificial intelligence and cybersecurity measures, which are now more prevalent and costly than ever before, and increased client demands for efficiency.
- Partner Liquidty: The MSO structure offers law firm owners a mechanism to realize liquidity on the value they have built over decades of practice. In a traditional non-MSO construct, a lawyer’s ownership could only be monetized through a sale to another lawyer, retirement buyout, or ownership distributions, all of which limit the pool of buyers and the pace at which value can be realized. Separation of the administrative infrastructure of a law firm into a distinct entity (i.e., the MSO), creates a path for ownership in an entity that captures the economic value of the services but isn’t restricted by the ownership limitations that are applicable to professional entities. For lawyers, the ability to sell ownership in the MSO to non-professional investors unlocks new liquidity options that are appealing to law firm owners.
Ethical compliance: Fee splitting and professional independence
While the step chart for an MSO may be easily adaptable among industries, compliance considerations are highly industry specific. For law firms, one of the most crucial components in structuring a compliant MSO is adhering to ethical rules prohibiting fee splitting. Both the ABA Model Rules of Professional Conduct, specifically Rule 5.4(a), and certain states’ equivalents, prohibit lawyers and law firms from sharing legal fees with nonlawyers. An improperly structured fee payable to the MSO can run afoul of the fee-splitting prohibitions. Establishing a fee payable to the MSO as a percentage of the firm’s profits or revenues is impermissible. However, a fee that is reflective of fair market value and not calculated based off a firm’s revenue is generally considered compliant. Further, law firms must be vigilant about preserving independent professional judgement. The administrative services agreement must clearly identify the scope and nature of services to be provided by the MSO. Arrangements that do not ensure full professional autonomy risk violating Model Rule 5.4 (c)-(d) under both the ABA Model Rules and certain states’ equivalents, which require that lawyers maintain unfettered professional independence.
Structuring a compliant and effective law firm MSO
A successful MSO relies on adherence to applicable ethical, legal, and regulatory limitations. For law firms, this hinges on safeguarding independent professional judgement and ensuring compliance with rules prohibiting fee splitting. How law firms navigate the balance between ethical compliance and operational innovation will likely determine private equity’s role in the legal sector for years to come.
Our firm has extensive experience advising professional practices on the structuring, compliance, and governance considerations associated with MSOs. For law firms evaluating whether and how these models may be relevant, particularly in connection with private equity investment and evolving law firm structures, we are available to share insights and lessons learned across industries.