The last round of results posted by the UK’s leading law firms shows 2010/2011 profit per equity partner levels improving.
However, the results also show that even after cost cutting measures and partnership ‘clean ups’ some firms are continuing to struggle to return to pre-credit crunch profitability.
This indicates that the financial crisis has led to a sustained shift in market conditions, as lower demand across some areas (e.g. M&A) persists and as unrelenting pricing pressure from clients continues to impact on margins.
Indeed, financial performance of the leading UK firms in 2010/2011 was very diverse - in the magic circle alone, margins varied from 53 per cent to 31 per cent in 2010/2011.
The Legal Services Act came into force on 6 Oct this year and with it law firms will need to adjust to new funding models, increased competition and new entrants.
We have yet to see any radical new business models to challenge the status quo in the sector, but the impact of the legislation could be far reaching as law firms continue their search for sustainable profit.
Given these market pressures and the general uncertainty over the outlook for the global economy, law firms we are working with are increasingly looking at mergers to address some of the strategic and operational issues they face. In the UK there are just over 70 mid-tier law firms (turnover £25-£250million).
All are under increasing pressure to consider options for enhancing their firm’s ability to deliver to their clients. The recently announced mergers of DAC and Beachcroft and Clyde & Co with BLG clearly demonstrate that firms see the benefits of being able to offer a broader range of services to their chosen clients.
That said, there are not too many full scale mergers that will 100 per cent satisfy firms’ strategic needs. Given this, we are likely to see an increasing number of team lateral hires in the next few years.
There is also evidence of strong niche practices considering firms with a broader offering as possible merger partners to reduce the risks that come with an overreliance on a market or client type. However, there are some key considerations that law firms and their funders should look at when considering a merger or acquisition:
1. Secure a strategic fit for maximum synergies. Scale is sometimes presented as the panacea to achieve cost savings. In reality only firms that have a strategic fit will derive significant cost savings.
2. Contain any distress. If distress is present, it is essential that its root causes are found early on and that an assessment is made whether the business in its current form is viable or whether only parts are to be saved. If causes of distress are not identified and dealt with prior to the merger, then problems are likely to manifest themselves in the enlarged firm.
3. Sustain key revenue drivers throughout the merger process and beyond. An analysis of the revenue base (clients and fee earners comprising each merger party) and degree of reliance on one off assignments vs. regular work flow is critical. High-performing partners have to be motivated/rewarded and long-standing/institutional clients must be supported throughout the merger process to protect future revenue flow.
4. Align profit sharing. The impact of the merger on partner remuneration and future potential remuneration (once entities are merged) must be effectively communicated, especially if the start point of each firm’s profit differs through distress or otherwise. In doing this the costs of the merger must be separately treated; having a structure which penalises a distressed target could lead to a loss of key fee earners.
5. Create a strong business shape for the future. A detailed assessment of the expected shape/leverage/profitability across each critical service line is required to ensure that the business shape of the combined firm maximises profit and growth potential. The combined partnership must be aligned to areas of real competitive advantage.
We would also urge law firms to put alternative pricing and the drive for efficiency at the heart of any merger discussion.
The cost benefits of post credit crunch salary freezes and partnership ‘clean ups’ are temporary. We would say that a deeper issue underlies some of the lower margins we are seeing in the sector.
A growing number of clients are now challenging the validity of the leveraged model that law firms are built on. They question why they should pay for ‘on the job’ training of junior lawyers and they are mindful of overpaying on lower end deliverables.
It could well be that firms who fail to adapt to this development will be overtaken by others that do.
• David Dunckley is partner and head of mid market (Advisory) at Grant Thornton LLP.