Private Equity Investing in Law Firms

Private equity (PE) investment in law firms is a growing trend that reflects broader changes in the legal industry. As firms seek capital for expansion, technology upgrades, and operational efficiency, PE offers a strategic solution. This article delves into the mechanisms enabling such investments, particularly through management services organizations (MSOs), the importance of financial readiness, and the tax treatment implications for both firms and investors.

Management Services Organizations (MSOs)

MSOs are legal frameworks that allow non-lawyers to own or manage law firms, breaking away from traditional restrictions. These structures are essential for enabling private equity investments, as they permit external capital infusion without violating legal ethics rules.

Jurisdictions in the United States such as Arizona and Utah have implemented regulatory sandboxes to test MSOs models. For example, Arizona's Supreme Court eliminated Rule 5.4, which previously barred non-lawyer ownership. This reform has led to the emergence of firms like Elevate and Law on Call, which operate under MSOs and receive PE funding.

MSOs are business entities that provide non-legal administrative, operational, and financial services to law firms. They operate under a dual-entity structure where the law firm remains owned and controlled by licensed attorneys, while the MSO—often owned by non-lawyers or private equity investors—handles the business side of operations.

This structure allows law firms to benefit from professional management and external investment without violating ethical rules that prohibit non-lawyer ownership or control of legal practices. The relationship between the law firm and the MSO is governed by a Management Services Agreement (MSA), which outlines the scope of services and ensures the law firm retains full control over legal decision making.

MSOs also encourage innovation by allowing firms to integrate multidisciplinary services, such as combining legal advice with financial consulting or technology solutions. This holistic approach can improve client outcomes and operational scalability.

Typical services provided by MSOs include human resources, IT infrastructure, marketing, billing, compliance, and strategic planning. By offloading these functions, lawyers can focus on practicing law while the MSO ensures efficient and scalable business operations. MSOs have a proven track record in healthcare and are now being adopted in the legal industry to facilitate private equity investment and operational modernization.

Financial Readiness and Quality of Earnings

Financial readiness is a critical component of private equity evaluation, encompassing both quality of earnings (QoE) and the firm's preparedness for institutional investment. QoE refers to the reliability and sustainability of a firm's income, including revenue consistency, billing practices, expense management, and client retention.

A key aspect of financial readiness is the conversion to Generally Accepted Accounting Principles (GAAP). Many law firms operate on cash-based or modified accrual accounting, which may not meet the transparency and comparability standards required by institutional investors. Transitioning to GAAP-compliant books enables standardized financial reporting, facilitates due diligence, and supports valuation modeling.

Platform firms are designed to serve as scalable foundations for future acquisitions and face additional scrutiny. Their financial systems must support integration, consolidated reporting, and performance benchmarking across multiple entities. In contrast, standalone practices may focus more narrowly on profitability and operational efficiency. PE investors often prioritize platform firms for their growth potential and ability to absorb bolt-on acquisitions.

Tax Treatment

Tax treatment of PE investments in law firms varies depending on the MSOs model and jurisdiction.

In traditional structures, law firm profits are typically passed through to partners and taxed as personal income. However, under MSOs, profits may be distributed to corporate entities or non-lawyer investors, triggering different tax obligations.

For example:

• Corporate investors may face double taxation; once at the firm level and again on dividends.
• Pass-through entities like LLCs, S corporations, and partnerships may offer more favorable capital gain tax treatment on sale of their interests.
• Jurisdictions may impose specific reporting requirements for MSOs firms.
• Strategic tax planning is essential to optimize returns and ensure compliance. PE firms often collaborate with tax advisors to structure deals that minimize liabilities.

Private equity investment in law firms is reshaping the legal landscape. Through MSOs, firms gain access to capital and business acumen, while investors tap into a traditionally closed market.

However, success hinges on thorough evaluation of earnings quality and careful tax planning. As more jurisdictions embrace MSOs, the intersection of law and finance will continue to evolve, offering new opportunities and challenges for stakeholders.

Connect with John Fitzgerald and our Law Firms Industry Practice for more information on how an investment from private equity can affect your law firm.