Consolidation: Often discussed but will it happen?

Come the downturn, followed by a return to a more normal level of demand, many firms will see the need to strengthen their practices in what will be a much more competitive market for the next period compared with recent history. Consolidation via merger will be a course many take to increase their competitive strength.

One point of clarification is important at this stage. From a strategic viewpoint, consolidation does not just mean merger, although it is mainly thought of in that context. Consolidation, in the broad sense, is when a small group of firms come to dominate a particular sector or sectors and, as a consequence, secure a much larger market share than any other firm. The result is that they are usually among the larger members of that sector, although not always the largest in the overall industry. Some achieve their dominant position through organic growth, and others do so through merger. The UK’s Magic Circle provides a good example of this. Clifford Chance used merger to leap up the scale ladder, whereas the other members of that segment all did so by organic growth (in the UK). There are a few firms larger than the Magic Circle in the UK market, but that does not give them dominance in the Magic Circle’s segment – that of the large and complex transactions market.

The history of all professions does indeed demonstrate that there is more consolidation, both through merger and by organic growth, in a downturn than in a boom. This is especially so in a fragmented industry. During a boom, it is relatively easy for any firm that is reasonably good to generate enough work to maintain a good level of profit, provided it is even moderately well managed. The partners feel that their business is doing well and see no need for a dramatic strategic shift. The fact that much of the reason for their success was that demand was running ahead of supply, rather than any particular competitive advantages the firm has, was not apparent, at least to those in the firm. When demand falls below supply, the first affected are those that are less competitive than others. This lower level of competitiveness can take many forms, one of which is a
lack of depth in core practices, another being a lack of a specific capability in areas of work required. Overall scale can be an issue where a firm is much smaller than its direct competitors, and, as a consequence, lacks the organisational support and resources to operate effectively and to build a market profile.

Of course, it is not all about scale – at least at the overall firm size. Simply being larger than another firm does not make for a more competitive firm. The issue is when clients are comparing firms that are similar in many ways in terms of what they do and where they are seeking to compete, but where one is much smaller in some core practices than its rivals. Clients might want only one or two lawyers for a project, but they tend to favour the firm with the larger group, all other things being equal.

This is not as irrational as many lawyers seem to think. In hiring lawyers from the larger group, clients assume that they are buying the knowledge of the whole group, not just those who have been hired. In other words, they assume that there is a sharing of knowledge across the group such that one lawyer of a group has knowledge of all the experiences of the group: the larger the group, the greater will be the shared experience. There is also the sense that if one group is larger than another, then the larger group must have done something right to have grown to such a size, and the assumption is that they must in general add more value to clients to the smaller group. There is also the case of ‘safety in numbers’: there will likely be better back up in the larger group if that is required than in a smaller group.

A firm that is successful in growing a number of its practice areas will grow in overall size unless it reduces in others. Successful firms tend to grow ahead of the less successful, and using overall size as a surrogate indicator of competitiveness is not irrational, provided the firms being compared are competing in a similar market position. (Slaughter and May is significantly smaller than many other UK-based firms, but the larger firms are not competing in the same market position. Slaughter and May compete on their overall technical and commercial excellence and this puts them well ahead of many larger firms in the specific market position they occupy.)

Once a firm realises and accepts that it lacks capabilities that others (against whom it is competing) have, then it looks for ways to overcome this deficit. This is where, in a downturn, minds turn to merger. Merger is merely the implementation of a strategy – or it should be. Building depth in a strategic practice area organically, or even with lateral hires, can take a long time if the gap to competitors is large. Developing a practice area in which a firm has no position in the market, but requires one for strategic reasons, can also take a long time. Winning more clients with a specific strategic profile does not happen quickly in most cases. A firm that realises that in a downturn it has specific weaknesses around practices and/or client, and that wants to be ready to take advantage of a coming upturn, is likely to decide that a merger will be a better way to fill the gaps than to try and do so by organic growth and lateral hire – time is against it for the latter approach.

Therefore, the number of merger tends to increase late in the downturn as firms start to address the strategic issues for the upturn. Some firms do so from a position of weakness, and others do so from a position of relative strength. A firm could be quite competitive in its market position but see that a merger would add further depth in some practices and bring in more strategically-focused clients, thereby increasing that firm’s competitiveness.

In a fragmented market, there are always opportunities for judicious mergers that can add value to both parties. When the need for added depth in practices and/or clients is seen to be essential, mergers are bound to follow.

The UK legal market is still highly fragmented despite many changes and the massive increase in the size of firms at the larger end (see table one above).

It is worth noting that 15 out of the largest 25 firms (based on revenues) are the result of at least one UK merger in the past 20 years or so. For example; Clifford Chance; Lovells, Addleshaw Goddard; Halliwells; Nabarro; Berwin Leighton Paisner; Denton Wilde Sapte; Pinsent Masons; DLA Piper; Taylor Wessing; Mayer Brown; Reed Smith; Eversheds; Jones Day; and, Dechert. To some extent, this demonstrates an ongoing process of consolidation over a long period.

Furthermore, the larger firms have grown revenues faster than smaller firms (as shown in table two above).

There are firms at all levels in the market seeking to grow the quality of clients and the quality of work with those clients and who realise that they need to be larger to do so. Some will choose organic growth and lateral hires, while others will see merger as an alternative approach. The single biggest constraint on consolidation through merger is identifying firms that really are strategically and culturally compatible. Simply banging two firms together does not transform two weaker, small firms into a larger, powerful firm – it might just create a larger weaker firm.

The issue is whether the merger will allow both firms to better achieve their strategic goals than trying to do so alone, and this is not something that can be ascertained superficially. So there is a constraint on consolidation because there might only be a few firms that will give the strategic benefits to another if they merge. There is also the time it takes to agree that the business case for merger is strong enough to justify the time and expense of merging. Finally, there is often the need for one firm to convince another that it is worth exploring the possibility of merger rather than remaining independent – partners in many firms have an aversion to merger and do not see it as a strategic option. It is not surprising, therefore, that there is not a sudden rush of mergers even when the downturn is severe in its impact on profitability. These things take time, and, as noted above, tend to occur in the mid to later stages of a downturn, not in the early stages.

The current downturn in the UK’s legal market has triggered considerable discussion between firms of all sizes about merger, and the fact that only a few have occurred to-date is more a recognition of the factors above – the time it takes to find an appropriate merger partner and to conclude a deal. There are talks between UK firms and also between UK and US firms (for instance, the Lovells and Hogan Hartson discussion in the public arena).

Is it highly likely that there will there be a number of mergers over the next year or so? The answer has to be yes, given the state of the market, its fragmented nature and the inherent desire of many to move their business upwards in getting better quality clients and work. Some firms will merge because of inherent weaknesses uncovered by the downturn, but they will be able to find a stronger firm to whom they could bring strategic advantages. Firms already in a strong position will see the current environment as one in which opportunities will arise to ‘plug gaps’ in their client and practice line portfolio, and will see merger as a good way of doing this. We can expect to see consolidation gather pace in the next 12 months as firms start to position themselves for the upturn.