Law firm mergers are served with a heavy dose of risk. History suggests that only one-in-three law firm mergers will improve profits per partner. We see three prevailing industry trends that further-complicate law firm mergers. While law firm combinations can be headline inducing, the aftermath may be similar to the vast majority of corporate transactions: disenfranchised stakeholders.
Law firm merger speculation is growing
Firms such as Pillsbury, Orrick, Patton Boggs, and Locke Lord have been squarely in the sights of those that predict, observe, and track law firm combinations. While we have viewed many of the recent strategic changes in biglaw as welcome progress in an industry where growth is harder to achieve, we have a far more pessimistic view of law firm mergers and acquisitions.
As we have highlighted in related articles, mergers and acquisitions are one of the most challenging strategies by which to grow a business. The road is fraught with strategic, financial, and operational perils.
We believe that law firm mergers are no different. Consolidation is likely to be the most difficult route to achieving a bigger and more profitable business model. In order to understand why this is the case, let’s take a quick look at the M&A landscape in Corporate America. Several critical lessons can be learned.
Corporate M&A Landscape
Most corporate M&A transactions fail to produce value for their stakeholders. Numerous studies reveal that nearly two-thirds of mergers and acquisitions fail to produce a company that outperforms the S&P 500 in the 3-5 years subsequent to the transaction. The harsh reality of M&A is that companies have two distinct opportunities to “get it wrong”
Acquirers often overpay for the target
Forecasted synergies don’t always come to fruition
Since most corporate combinations require the buyer to significantly overpay for the target, synergies are typically the only way for corporate mergers and acquisitions to create value. Since synergies achieved by business combinations are often lower than the lofty forecasts embedded into the transaction price, stocks of combined companies under perform their counterparts about two-thirds of the time.
Law Firm Mergers: Different story, same ending
Complex business transactions, while headline inducing, rarely create value for stakeholders. In this case, however, the stakeholders aren’t a sea of disenfranchised shareholders. Rather, they are the very partners that provide the revenue growth and client relationships that make the law firm business model so profitable.
While law firms may have the ability to construct business combinations at a more reasonable “price” than their corporate counterparts, we believe the primary risk surrounding law firm consolidation rests in “keeping everyone happy”. This isn’t something to gloss-over. Law firms that don’t keep every desirable partner happy, dramatically increase the risk that the long-term implications of their merger will be littered with significant defections, a less competitive business model, and lower profits per partner.
If most corporate mergers fail, does that mean most law firm mergers will result in lower profits per partner?
We think so. While many law firms are led by skilled & adept executive teams, is it reasonable to assume these lawyers can pull-off what Corporate America has consistently failed to achieve over the past three decades? Is the legal service sector so unique that it will become the only highly fragmented industry that successfully uses mergers and acquisitions to stem the tide of declining revenue growth?
Law firms typically bank on using mergers to access clients that they otherwise would never be able to obtain. Law firm mergers additionally provide a short-term boost to revenue growth in an industry where growth is becoming incrementally harder to achieve. This seems to make sense. On the face, many of these combinations appear like good ideas. Until we weigh the risks.
Three legal services trends that will sour law firm mergers
Risks associated with law firm mergers are vastly different today than a mere ten years ago. The competitive landscape has changed. The risks have always been high, but three critical industry trends make us particularly concerned that law firm mergers have a high probability of ending in disappointment:
- Barriers to entry in the law firm space are lower than ever. The cost (and risk) of partners defecting big law firms to start their own boutiques continue to decline. While boutiques have been around as long as large law firms have had disenfranchised lawyers, it is easier than ever for senior partners to defect, market, and acquire profitable clients at economically acceptable levels.
- The labor pool is particularly advantageous to well-run, biglaw-founded boutiques. Unlike previous points in history, the labor imbalance in the legal profession is highly attractive to startup law firms. Boutiques have three economically-advantageous methods by which to staff their embryonic ranks:
- Acquire the super-associates that make the biglaw business model tick, providing a better work-life balance to those that are willing to work hard, but seek a professional / lifestyle change.
- Hire the recent casualties of biglaw layoffs, accessing high caliber talent and reasonable compensation levels.
- Staff the lower ranks for their growing firms with recent law school graduates unable to find steady work, yearning to work under the direction of highly experienced lawyers.
Whatever strategy boutiques chose to employ, the theme is the same. The current labor imbalance in the legal services sector is highly advantageous to boutiques and startups.
- It only takes 1 critical defection to tank your deal. We think this is the proverbial straw that “breaks the camel’s back” in law firm mergers. Sure, freshly minted transactions have to be ratified by most of a firm’s key talent. However, the road doesn’t end when the merger ink has dried. If the economics of law firm mergers fail to meet expectations, defections will happen.
Even though a burgeoning collection of boutiques and virtual law firms are unlikely to unseat the premier brands that dot the biglaw landscape, it only takes a handful of critical defections to tank an individual transaction.
From there, it’s a slippery slope. As profits per partner become less attractive, more key talent becomes vulnerable to the greener-pastures of biglaw competitors not suffering from the hangover of a law-firm-merger-gone-wrong.
The risk and reward of law firm mergers
We have a negative view of the impact of law firm mergers on the industry as a whole. The odds are squarely stacked against success, and prevailing industry trend will make the road to successful law firm combinations more difficult. But that doesn’t mean every deal is ripe for disaster.
Like any competitive industry, some constituents will “get it right”. Some firms will successfully use law firm mergers to successfully grab higher revenue growth and improving profits per partner over the long term.
History simply suggests that consolidation in low-growth industries is easier said than done. If law firm mergers are as successful as the corporate clients they advise, then expect far less than half (probably about 1/3) to improve profits per partner over the next five years. This has dramatic implications for the business of law, profits per partner, and the competitive landscape of the legal services profession.
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