Introduction: The time has come

Author: | Published: 1 Apr 2012
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Like so many other sectors of the global economy, and asset classes in the financial markets, the bubble in the legal profession which grew enthusiastically – and, in some cases, recklessly – through the noughties burst dramatically in 2008 with the failure of Lehman Brothers. The legal market continues to journey along the long road of correction in order that it can find its equilibrium again. This process of market adjustment and normalisation for the legal sector has been painful for many participants and has not yet run its course.

As it does, the legal profession will need to absorb many shocks, including a reduction in fee earner capacity, a decline in earnings within the sector, fewer equity participants and longer waiting periods to join the equity.

Legal practitioners and their advisers often comment that the market is over-lawyered, that there are too many firms competing for too few instructions, that the sector is characterised by mature firms operating in a mature market which is highly fragmented, and that the market is overdue for consolidation.

Despite the accuracy of these observations, the seemingly inevitable consolidation has not materialised on the scale previously expected. Indeed, the extent of any domestic consolidation in the UK has been relatively small, particularly when compared with the United States, resulting in the market fundamentals identified as the catalyst for consolidation remaining largely in place.

We are now in a different place: the profession is going through a period of unprecedented and profound change which will see the UK legal market embrace consolidation more positively and enthusiastically than at any time in its long and proud history.

What is different this time

It almost seems the planets are aligning to create the perfect environment for driving the consolidation process. The forces in play are drawing firms towards each other and stimulating a level of merger activity which has previously been threatened but has never before materialised.

Among other factors, the legal profession is facing extreme pressures from a number of forces which are grounds for law firm leaders to correctly challenge the organisation, structure and scale of their firms, together with their firm's profitability dynamics as the legal sector evolves.

Following a contraction in the demand for legal services, the market is showing little signs of any meaningful recovery. There are, however, early signs of consolidation in the sector, both domestically and globally, with heightened levels of trans-Atlantic and other international activity. Meanwhile, there are low levels of transactional activity, suppressed by weak and volatile economic conditions around the world.

Firms now have opportunities to practice under new business models, with the arrival of multi-disciplinary practices and alternative business structures in the UK; this also brings the threat of new entrants in the legal sector. Overall there is a trend to corporatisation and new legal structures.

A fragile global economy and the risk of economic shocks both in the UK and in big global economies means continuing pressure on billing rates. There is visible overcapacity in the sector, addressed somewhat but not completely through restructuring.

In terms of human resources, there is a heightened quest for talent, and increasing levels of lateral partner hiring. Inflationary pressures are emerging in the law firm cost-base, including staff compensation. Additionally, in some markets there is office space overcapacity.

For law firms, the regulatory environment is changing, and is now more complex and demanding. There are pressures on margins and profitability, and an increased appetite for sector consolidation amongst market participants along with a healthy supply of debt and equity capital available for investment in the sector; new sources of equity and ownership models are also emerging.

The above factors will inevitably unfold differently for many firms in the sector: the quality of response for individual firms will shape their destiny, including their future success, marginalisation or demise. However, it is clear that these issues will redefine the shape of the legal profession. The result will be innovation in the way legal services are undertaken by practitioners, delivered to the market and purchased by clients. New and exciting legal business models will emerge, with significant benefits to clients including lower costs, improved service, greater efficiencies, and a more client-centric profession.

As if the legal sector-specific factors were not sufficient to drive consolidation, the local and global markets in which firms are operating will also drive the consolidation process. A number of factors impacted the operations and financial performance of law firms and their clients during 2011 and appear set to play a role looking forward into 2012 (see box 1). RBS research suggests that the impact is continuing this financial year, thereby restraining the desired recovery in the broader UK economy and law firm financial performance broadly across the sector.

A number of key drivers of consolidation will also play an important role in 2012 (see box 2).

Factors impacting operations and performance of law firms and clients
  • No material growth in the size of the UK legal services market and patchy recovery in demand for legal services
  • Weak performance in developed economies, and slower and dampened growth in developing economies
  • The sovereign debt crisis in several eurozone countries, threat to the long term viability of the Euro in its present form, and possibility of political and social instability
  • Inconsistent and erratic transactional activity in UK and global markets, challenges in the banking sector, and uncertainties in the broader financial services market
  • Continuing restructuring of law firms in response to suppressed activity levels
  • Continuing government and central bank intervention in financial markets, more regulation of banking and financial services sector, and government austerity measures
  • Corporate failure at levels above the historical average
  • Slow recovery in asset values, particularly in the commercial real estate sector
  • Continuing foreign exchange volatility and the relative weakness of Sterling against other currencies
  • Stabilisation of borrowing margins combined with tight credit conditions, increasing softness and volatility in some illiquid asset classes, flight to quality, continuing favourable trends in commodity prices, particularly in precious metals and energy products and continuing de-leveraging of corporate balance sheets
  • Deferral of investment decisions and reluctance to embark upon big new capital expenditure and investment decisions

Who will do it?

The prospect of merger activity and consolidation in the legal profession is not one which is favoured by all firms in the sector. Those firms with strong and determined leadership and a clear vision and strategy for their future will most enthusiastically embrace mergers, as will firms which are quick, nimble and agile, those which have delegated authority to the leadership team, and those with a decision-oriented culture; partners with an appetite for change; firms which do not want to be left behind; firms with the ambition to advise on larger, more complex, more multi-jurisdictional and more valuable instructions; and firms with an entrepreneurial quality which are prepared to embrace change

There is no doubt that the M&A market in the legal sector is rapidly being transformed from a quiet, nascent and thin market, historically lacking the will and determination to emerge and develop depth and scale, into one which has the characteristics of a market with the potential to overheat, and suffer all the consequences. It is undergoing rapid change and development, evidenced by acceleration in the volume and value of transactions being completed.

According to a Thomson Reuters press release (January 4 2012), law firm mergers jumped 67% in 2011. Based on the number of merger announcements in both the UK and the US in January 2012 and an extrapolation of those numbers for the full year, it is not unrealistic that law firm mergers in 2012 will exceed the numbers reported in 2011 by a considerable margin.

There are many surprises in regard to this merger activity. One of the biggest and most visible is that the trend for consolidation has emerged globally. It is therefore not confined to the bigger and deeper legal markets of the UK and the US, but is being played out in much smaller legal markets, but with the same increasing levels of enthusiasm.

Another interesting feature of this phase of the consolidation cycle is that it has emerged as a local, national, regional and global trend. It is therefore touching the market from end to end, from small local firms at the retail end of the market, through to the largest global firms with significant international presence.

It is almost inevitable that this M&A market will flourish in the short term. Another ingredient fuelling the activity, reminiscent of other expanding and appreciating markets, is the availability of capital to be deployed in the sector. The legal profession has always been extremely well supported by the banking community, and there are few instances of law firm management commenting that the strategic objectives of the firm have not been fulfilled because the firm did not have access to capital.

The Legal Services Act 2007 only serves to strengthen further the ability of a law firm to raise capital, and provide an attractive investment opportunity for new investors in a new, scarce and somewhat tightly held asset class limited previously to qualified lawyers. There are many firms which are closely analysing all the new capital-raising opportunities available. They will raise equity capital in the public and private markets, and some of these transactions will complete during 2012.

For firms willing to embrace the challenge and take the role of consolidator in the legal sector, the availability of significant amounts of risk capital (both debt and equity) to finance this expansion, including acquisitions, will no doubt be one of several drivers of M&A growth in the legal sector.

No turning back

Answering the simple question "What is the value added?" might deliver the best rationale for completing a merger or, alternatively, good reasons not to go ahead.

The question clearly needs more attention than it is now getting: a managing partner whose law firm was planning to engage in a merger with a larger one recently commented that he was not sure what made the combined entity more attractive than the individual parts – and this was a transaction scheduled to close within only 30 days. It is better to know the answer in advance so that the deal fails in the planning and negotiation phase, than to have the same outcome after closing and in the merger integration phase – or even later.

The time has arrived and there is no turning back. Consolidation in the legal sector is happening and will continue to emerge at an accelerating pace. Not only will the market imperatives require it, but survival instincts will demand it. Those firms which do not embrace the trend and become a part of the evolution may nevertheless survive and prosper, and perhaps even dominate in a particular practice area, geography, industry sector or niche which they carve-out and define as their own. However, they will have to be nimble and quick in order to mark out their territory and then define and clearly articulate their superior profile in their chosen space.

Success, particularly in a flat or declining market, will then become a contest over market share. The firms which win will capture market share from competitors and define their success by setting themselves apart as the law firm of choice for their unquestionable points of differentiation. And, as always, the clients will decide.

Key drivers of consolidation in 2012
  • Slow organic growth in the domestic UK market
  • Pressure on law firm margins
  • Access to a new client base, building ancillary legal services and non-legal services, now possible using alternative business structures
  • Improved geographic coverage
  • Building a new practice area and rapidly building scale in growth practice areas
  • Increasing the quality of the fee-earning talent pool
  • Gaining access to better clients, and to bigger and more complex instructions
  • Continuing trend for globalisation and the opportunity to capture economies of scale
  • A response to peer firms who access external capital and grow as consolidators in the sector
  • Benefits of spreading back office and infrastructure costs across a larger population of fee-earners

James Tsolakis
  James Tsolakis is head of legal services within the corporate and institutional banking division at The Royal Bank of Scotland. As such, James has a wealth of experience in both the banking and legal sectors. He is a banker to the legal profession with more than 12 years' experience in both London and New York. In addition to his global responsibilities, James supports the legal profession `across the United Kingdom. His clients include a number of the United Kingdom's top 100 law firms. He works with product specialists to provide tailored solutions and best practices to the legal profession across applicable banking and financial products and services. James supports his clients through his understanding of the legal market, and they value him as a strategic business partner.

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