The economic outlook for transactional firms

After an exceedingly strong 2007/08 financial year, recent reports in the legal press confirm that firms relying on transactional work are worried about the 2008/09 deal season. A quick look at the deal databases confirms a grim first six months: according to ThomsonOne, more than $30bn were withdrawn globally from the public-offering process in the first half of 2008, five times more than in the first half of 2007; the number of priced issues fell by more than 60 per cent; and, M&A transactions across the board suffered a similar fate with the first half of 2008 seeing the number of transactions generally back to 2005 levels. In the first quarter of 2008, one still saw healthy transaction volume in consumer staples, energy, telecommunications and real estate: in the second quarter, all industries were affected. Regionally, average transaction size is also pointing sharply down except for in Asia where deal size is holding steady. With some notable exceptions, there are much fewer large deals to go around and competition by both investment banks and law firms will be fierce.

Will this sharp downward-trend continue for the rest of this financial year? One set of measures seems to indicate that it will. Published monthly, the Organisation for Economic Co-operation and Development’s (OECD) Composite Leading Indicators are constructed to predict cycles of economic growth and contraction over a six-month period, distinguishing in varying degrees between expansion, downturn, slowdown and recovery. In January, this data indicated a downturn in the US, Germany and the UK, but an economic slowdown in the other major OECD economies (Canada, France, Japan, Italy). July data points towards a continued slowdown in all seven major OECD economies, with the Eurozone being the most affected. India and Russia are also seeing a downturn, with China and Brazil as the only major economies tentatively pointing towards expansion over the next six months.

Fairly depressing news; there are, however, opportunities for transactional law firms aside from shoring up cash-collection practices and cleaning house.

First, one must accept that the current financial year will be a down-year for corporate transactions. Banking (newly-styled restructuring) and tax departments will have a softer landing as their partners will be busy renegotiating previously leveraged debt. Litigation should see happy times ahead defending claims of unsatisfied investors, lenders and directors. Instead of letting go of underperforming corporate teams (and frantically recruiting laterals in the next upturn), this may be the time to motivate partners – whose nests are empty and who are looking for a final career challenge – to move to locations that were once less attractive. Most offices in the Middle East continue to scream for people to invest in growing practices there. Where relocation may prove difficult, limited retooling may be possible. Continental European law firms, whose lawyers remain suspicious of complete specialisation towards either litigation or transactions, are most likely to easily retool partners from deal-makers to forensic advisors.

Second, the larger international firms will loosen their rates to compete with smaller firms for smaller deals. This will put significant pressure on mid-market general-practice and regional firms, who already saw their transaction volume squeezed before the downturn. This pressure will have two effects: first, we will see a significant number of weaker firms disappearing, either through merger or otherwise, as stronger firms use this cycle to pick up talent that they could not otherwise afford; and, second, stronger mid-market firms in particular will find new ways to bind their key clients. One such way is to deliver work on a basis that allows clients to better manage their own outside-counsel budgets. Collection practices aside, rethinking pricing practices will yield more gain to profitability than other methods.

Third, most law firms will have a hard look at their costs, which should not just mean looking for redundant administrative functions. Gains can be made in cutting overheads, but this is not the source of significant cost savings: firms will be better served by fundamentally reviewing their service delivery models. In most law firms, the fundamental transaction support and project-management processes applied to client work have been left untouched for over 30 years (save for changing from typing pools to word processors). Scores of providers, both here and abroad, are able to provide certain aspects of due diligence and discovery at a much lower rate than any associate lawyer. Service-delivery outsourcing is the next battlefield for cost competition, in particular in the transactional area but also in dispute resolution. Instead of letting go of under-utilised partners and senior associates, having them rethink their service-delivery processes will have the corporate department gunning strong during the next upturn.

Managing partners are right to worry about a dry deal pipeline: the most successful firms will be those that continue making planned strategic investments despite the economic downturn.

Michael Roch is a senior advisor at Kerma Partners, and a member of the FD Legal editorial board. He can be contacted at michael.roch@kermapartners.com