Mergers in the legal profession

Merger is simply one option in a firm’s strategy. Sometimes, however, it is the only solution – a merger may be the only realistic way to achieve a firm’s ambitious strategic goal. Yet there is a choice: change the strategic goal to a less ambitious one and remove the need to merge. There is no situation where merger is the only action from a strategic viewpoint.

The underlying rationale for merging is that it is perceived to be the optimum way to achieve specific strategic goals and move into a more competitive position. It should be tested against other options, such as organic growth and lateral hires. Another rational for merger is to achieve a ‘strategic leap’ – whereby a firm is approached by another, and a merger would move the combined firm into a strategic position in the market that would not have been possible as two, stand alone firms. This change in positioning, once merger is on the table, can occur because firms tend to develop strategic goals that are an extension of their existing capabilities rather than by starting with where they would like to compete and then considering how to get there.

A somewhat negative view of merger is held by many lawyers, even though there have been some very successful firm mergers. People who express anti-merger views often struggle to identify many firm mergers that have been failures (although there are some). A merger that has a clear, strategic logic tends to have a high chance of success and will, of course, result in a new larger firm, which might worry some people. Good partners, however, are rarely ‘anonymous cogs’, even in a large firm, and a merger must be seen in terms of the benefits it brings to the whole firm and not through the eyes of individuals.

As with almost any business issue, there can be good and bad outcomes – both the quality of decision-making leading up to the merger and that of the integration processes post-merger are, more often, the determinants of good and poor mergers. Poor mergers have occurred and many were clearly the result of a bad decision – it is hard to see any strategic logic and they should never have happened. There are others that, on the surface, appeared to have a strategic logic, but have not produced the promised benefits. This is more about a failure in post-merger integration than the decision to merge.

There are, of course, pitfalls with the merger option, which is why we referred to the ‘right’ merger. But there are pitfalls with all options in implementing a strategy and merger does not necessarily raise any more issues than the others.

Some mergers are driven more by cost-saving reasons than by any major strategic logic, but it can be dangerous to drive a merger on the rationale of cost savings or economies of scale alone. A merger of two firms is a merger of two partnerships, and most of the partners, and associates, usually remain. Even though savings can be made in overheads because, for example, there is no need for two finance departments, the greater size might mean that management of the new firm will require more resources than before, and other costs can arise due to the change in market position.

There are situations where a merger might be justified on the grounds of economies of scale alone. One is where the merger leaves the ‘new’ firm in the same band of competitors that at least one of the firms was in before (i.e. where two small firms merge, but the combined size does not move it out of the pre-merger peer group, or when a larger firm bolts onto a smaller firm so there is no significant increase in size). The second is where the firms proposing to merge are focused on a volume-driven, price-competitive sector of the market where significant economies of scale are achievable with greater volume.

The more common competitive reason for merger is to increase critical mass in specific practice areas. This could be a defensive move for one or both parties, as a failure to have greater strength in depth will lead to a decline in market position. The primary reason for the merger is, therefore, the need to build critical mass to avoid a loss of market position – or an attempt to attack the market by building more depth, and improving market share, in core practices. Cost savings, while important, are a secondary reason in both cases.

An increase in the overall size of a firm is a consequence of a merger rather than a strategic benefit (unless a major divestment programme occurs immediately post-merger).

A strategic benefit is achieving a competitive depth of resources in one or more practice area (i.e. critical mass). Where a firm uses merger to build critical mass in a number of practice areas, then the firm will increase in size, but that increase is a by-product of the merger rather than a strategic aim in itself. Becoming larger overall is not generally a strategic benefit and does not add to a firm’s competitiveness: the strategic aim is achieving a competitive critical mass in specific practice areas.

There are still many who fail to understand that having critical mass is important. It is hardly surprising that there is confusion about the concept of critical mass. It is, at least in part, defined in relative terms between competitors and this can vary depending on the existing market position of the firms involved. There is no one precise measure for critical mass in terms of any practice area: it is definable only within a range determined by a number of variables including the type of client buying the service.

It is important to grasp these essential features of critical mass in order to understand many of the issues associated with merger. The need for ‘critical mass’ has been used to justify many mergers, but without any clarification as to what was meant by the term. We have seen merger prospectuses containing statements about building critical mass, which then go on to show what the number of fee-earners in each practice area would be post-merger. What was lacking was any assessment as to whether the increased number of fee-earners would make the firm any more competitive. If the target client base does not see the proposed number of fee earners as meeting their criteria for critical mass, then it is invalid to invoke critical mass as a reason for merger. In another case we have seen, a firm needed to build critical mass in order to compete for certain types of work, but the merger prospectus failed to identify what critical mass was and a subsequent examination of the size of the practice group post-merger indicated that the merger did not in fact achieve it: bigger, yes, but that does not mean it passes the critical mass test. In most cases, the term is used as a concept when it is, in fact, a potentially powerful competitive capability. But if used to justify or refute the need to merge, those using it should be prepared to put some measure on it, even if only by reference to competitors.

The particular strategy of a firm (involving defining the type of clients seen as the future core client group and the type of work that the firm wishes to do for these clients) will broadly determine the likely peer group of competitors in the future – so ascertaining some idea as to the size of each core practice group needed in order to be perceived as competitive.

The issue of competitive capabilities is embedded in the view that mergers should be ‘client-driven’ – a term often misunderstood. When partners are asked about the possibility of their firm merging, the reply is often ‘our clients aren’t asking for it’. The simple truth is that clients very rarely ask a firm to merge. There have been cases where firms are facing declining competitiveness and, in discussions with key clients, the need to consider merger as a way of strengthening the firm and retaining the client’s work has been raised. But this is not a common situation and, even when it has arisen, it was usually as a result of a discussion initiated by the firm. Yes, mergers need to be client-driven, but this is not the same thing as clients saying ‘merge!’.

There have been situations where a firm has discussed with a particular client how it can obtain work that was at the time going to another firm, or how it can receive higher value work in areas that it is already providing to the client. Clients will spell out the competitive capabilities the firm needs to build in order to get the work, but rarely will they tell the firm to merge. If the firm decides that the best way of building these capabilities is to merge, then that is a client-driven strategy.

Client-driven does not mean that clients are asking a firm to merge nor that they are threatening to take away work unless the firm merges. The latter situation is only likely to happen when a firm is declining in competitiveness but, even then, clients rarely suggest merging. When lawyers say that clients have not asked them to merge, the immediate question back is whether clients have been asked about the competitive capabilities a firm will require in the future given its strategy and whether a firm’s strategy is sufficiently clear so as to be able to ask the question: it is not about asking whether or not the firm needs to be bigger, but whether its strategy will require a build up of strength in core practice areas, of which one solution is merger.

This brings us back to competitiveness – a merger that does not enhance competitiveness should not be undertaken. As noted earlier, competitiveness has two meanings –competitiveness in a firm’s existing market position, and projection into another market position and the competitive capabilities required to compete there.

This still leaves a key question – do mergers work? An oft-repeated statement is that 70 per cent of mergers do not work – yet most of those who use it have no idea of the evidence supporting the statement or of its origins.

One source lies in work carried out by KPMG in 1999, which estimated that only 17 per cent of major global M&A deals enhanced value for shareholders, 53 per cent destroyed value and 30 per cent were neutral. By 2002, however, their estimates were 34, 31 and 39 per cent respectively.

It is important that the methodology used in these studies be understood – while supporting or decrying it – it does make a difference as to how the results might be interpreted. For one, the study is based on major global corporations, not professional firms. Further, the primary measure as to whether value was enhanced, destroyed or neutral was the share prices of the companies pre-deal and then approximately one year later. This was put into relative context by comparison with the industry segment change in price. The question that goes unanswered is the effect of measuring the post-deal price two or three years later, given that it can take up to three years before the benefits start to accrue.

While the KPMG study is a useful piece of data, it does not lead to the generalisation that 70 per cent of mergers fail. Even if only a minority of M&A deals enhanced value within a year, the rest might still have turned out to be effective mergers. Also, we do not know what would have happened to the share prices of the two companies if the mergers had not taken place.

Other studies have revealed contradictory data. Booz Allen Hamilton (1999) estimated that 51 per cent of corporate M&A lost value and 49 per cent gained in value. The time frame measured was one year, which could suggest that over a longer period, more would be seen to add value.

In Making Acquisitions Work: Capturing Value After the Deal, Booz Allen Hamilton argued that where value had declined after a transaction, the issue was more about poor post-merger execution than the strategic logic of the decision to merge. McKinsey, in various publications about the value of M&A, make similar points.

In the UK legal market, there have been mergers that appear, from the outside, to have been very successful. The most obvious was the 1987 Clifford Turner/Coward Chance merger that created the springboard for that firm’s development into a leading global transactions practice. Other notable mergers include Dibb Lupton Broomhead/Alsop Wilkinson (1995), Addleshaw Sons & Latham/Booth & Co (1998) and Addleshaw Booth/Theodore Goddard (2003) and Berwin Leighton/Paisner & Co (2002). CMS Cameron McKenna is a merged firm, as are Denton Wilde Sapte and Lovells, for example. Notable cross-border mergers include, for example, Clifford Chance, Linklaters and Freshfields Bruckhaus Deringer. In fact, of the top-50 firms by size in the Legal 500 (2004), 25 have had a merger or brought in a group equivalent to a merger, either domestically, internationally or both.

While there will undoubtedly be differing views about the degree of effectiveness of these mergers, most of these firms have performed well over recent years, certainly within the relative trends of their market segment. There have, of course, been some mergers that appear to have done less well – mergers into the legal arms of the major accountancy firms were all somewhat difficult even before exogenous forces created problems.

Nevertheless, the evidence in the legal market is that mergers per se are not necessarily bad and that a high proportion work. Of course, we cannot say what would have happened if the merger had not occurred: would Clifford Turner and Coward Chance have each earned an average PEP in excess of £800,000 per annum over the past five years? We cannot say for sure, but it is unlikely. Likewise, Addleshaw Booth – its PEP went up in the years post-merger, well above what the antecedent firms had earned before and it has continued to rise as Addleshaw Goddard. And where would DLA Piper be without a series of mergers over the past decade?

The fact that a significant number of larger firms have improved their market position and profitability post-merger leads to the conclusion that mergers can be very beneficial – what would have happened in the absence of merger can only be conjecture. They did merge, they have not fallen apart, their market position has been enhanced and their profitability is higher than before.

Another critical point, often overlooked, is the very different market structures that apply in many industries. A number of the well-reported corporate mergers that appear to have damaged shareholder value (for example, Hewlett-Packard/Compaq) were in industries that were already highly consolidated – in contrast, legal markets throughout the world are still very fragmented. While the very top end of the legal market has undergone some consolidation, there is still a long way to go.

Not only are there more strategic opportunities available in a fragmented market, the merging of two small organisations is much more manageable than merging two behemoth corporates the size of Hewlett Packard and Compaq, quite apart from the fact that strategic opportunities are always relatively fewer in a highly consolidated market.

We see the prospect for many more successful firm mergers in the coming years for those with a clear strategy and the abilities to implement it effectively, and the evidence overall is that firm mergers can work: and that is why firms will continue to merge.

Alan Hodgart is the founder of H4 Partner Ltd. He can be contacted at alan.hodgart@h4partners.co.uk