The “ING” Theory: The Right Time to Invest in Legal, Compliance & Information Management Companies
By Prashant Dubey, Executive Vice President, MergerTech Advisors
History & Current State
Since initially cropping up in the mid 1980’s, technology and technology enabled service companies in the legal, compliance and information management industry have been evolving rapidly. These companies were initially formed to support needs of the legal industry, often borne from a desire to address “bet the company” situations like litigation or government investigations. Many of these companies rapidly evolved into broader technology or technology enabled service companies supporting corporate needs in the compliance and general information management domains.
In addition to an evolution in the breadth and depth of offerings, the early days of this industry produced large profits for early participants, which attracted more players. This, along with the availability of more sophisticated commercial off the shelf software (COTS) and components to support efficient application development, lowered the barriers to entry for technology enabled service companies and software providers. At the same time, customer requirements continued to be more crisply and overtly articulated by corporate and law firm consumers, making it easier for provider companies to identify product and service solutions that added real value. In combination, these factors were the “perfect storm” to cause the number of market participants to balloon from tens to hundreds of companies over the past quarter century.
Today, there is an unprecedented opportunity for strategic as well as financial buyers to make deliberate investments in this industry by acquiring properties that have prevailed through what I call, “the different phases of ING.” As such, we see investment in this industry rapidly accelerating, which is the principal reason why MergerTech has established a specific practice area to identify and support value added transactions in the legal, compliance and information management industry.
So, what is the ING theory of investment?
The ING theory is based on the simple premise that “in order to know where you can go, it is important to know where you came from.” In other words, understanding the history of a particular market and the characteristics that are the foundation for success of market participants will allow investors to invest smarter. As a general rule, the ING theory is pertinent to many markets, but is particularly salient to the legal, compliance and information management marketplace. There are five distinct phases of ING, characterizing this market:
Market MAKING: From 1985-2000 a few key players entered and participated in the market to supply technology and technology enabled services that served the legal industry. Some of these players struggled with market definition and many players who did not understand how to navigate the intersection of law and technology essentially were like pioneers who ended up with arrows in their back. However, the providers that were able to articulate the problem space and a crisp value proposition, were able to charge premiums for products and services that were previously unavailable, which resulted in large gross margins for a number of players. For about 15 years, these provider companies, mostly focused on the US market, enjoyed significant gross margins, driven mostly by high average selling prices, rather than efficient operations. So, what happened next?
Market TAKING: With unit prices for services high, and application development tools and technology more easily available for lower prices, many more companies “threw their hat in the ring,” which rapidly increased the number of companies in the legal, compliance and information management market between the years 2000 – 2005, to about 400. Many companies, on the basis of a nascent customer understanding of the domain were able to charge exorbitant unit prices for technology and technology enabled services, where a number of companies claimed their (un)fair share of profits.
Market SHAKING: Starting in 2005 (and continuing with vigor today), deliberate standards of practice emerged from case law as well as regulatory bodies and consortiums striving to create uniformity and consistency of practice. The net result of this has been that players that did not have the ability to provide products and services that complied with these requirements swiftly faded away. In their place entered new companies with more operational discipline, deeper technology pedigree and affiliations with thought leaders in the academic and scientific communities.
This market shaking has had a positive result – the companies that today participate in the market have at least passed the basic entry exam – they understand and can represent their capabilities as being compliant with current standards of practice. However, there are still hundreds of these companies, so identifying the “posers among the players,” is still a non-trivial exercise.
Market RAKING: In 2010, the market has entered a deliberate period of raking. Overall macroeconomic conditions, tighter cash management by corporations, an emphasis on real value creation and an increase in the severity of corporate compliance and governance have all affected the provider community. The companies who have real value to add are thriving – perhaps not by acquiring a large amount of market share, but by retaining clients, decreasing their cost of sales, creating operating efficiencies and posting healthy EBITDA margins. Many of these companies have top line revenue of $3-$12 million, with single digit or flat growth year over year.
Companies who cannot articulate a solid value proposition may still exist, principally because their investors are hoping for some sort of capital recovery or stop loss strategy to take hold. These companies are over-capitalized and will never recover. However, they invested much of their money on brand building (in a crowded market, sometimes those that shout loudest get noticed) and are riding the wave of webcast and pseudo thought leadership in order to retain clients. At some point soon, however, this wave will ebb, and being able to distinguish between these companies when looking at acquisition candidates is critical to ensure that an investment is sound.
Market BAKING: Over the next 36- 48 months, the market will enter a period of baking. Corporations will want larger, vertically and horizontally integrated providers of products who service entire legal business processes. Consumers will also purchase services where the relationship is regulated by outcomes and service level agreements. Best of breed players will need to be integrated by the provider community, since consumers will not want (or have the resources) to integrate the value chain themselves. This means that a number of key strategic or financial players will need to acquire technology or technology enabled services companies in the legal, compliance & information technology market in order to become one of the three big gorillas in sub-segments of this market.
Why will this (or should this) happen? With the large number of provider companies still operating in the market, market raking will eventually cause some providers to wither away due to lack of investor intestinal fortitude to hold their limited partners at bay. Furthermore, some proprietors will exhaust themselves trying to hold together companies that are extremely draining to operate. Corporations will want to shift their consumption to providers where they (the customer) do not represent a disproportionate share of the providers business. In order to capitalize on these conditions, investors have already begun consolidating the value chain by acquiring and integrating technology and technology enabled service providers so that when baking is in full force, they are the ones that emerge from the oven.
Summary
The ING theory of market evolution and investing can be applied to many markets. It is a theory that is especially salient when describing the current state of the legal, compliance and information management market today. In particular, using ING as a lens, it is abundantly clear that there is a very lucrative investment opportunity for strategic and financial buyers that are interested legal, compliance & information management technology & technology enabled services companies.