Trouble in paradise?

Most law firms have maintained they are well equipped to withstand the current economic turbulence. But how is the offshore world, so closely linked to the financial markets, faring?

By Nicola Davies, CEO, Mourant Ltd, and Jonathan Rigby, managing partner, Mourant du Feu & Jeune

Over the past 12 months the press has been full of doom and gloom about the world’s financial markets. Given that offshore finance centres are almost entirely dependent on them for their life-blood, one might assume that they too are having a torrid time at present. But the picture is actually far more complex than one might expect.

Certainly there are areas that are struggling, but others are performing very strongly, and the challenge for the so-called ‘offshore’ firms is to adapt in order to thrive in this new environment. Those who are slow to do so are likely to face significant difficulties in maintaining earnings in the months to come.

Perhaps surprisingly, Jersey has seen the value of its funds under administration rise from £194bn in March 2007 to £246bn at the same point in 2008, and the number of funds has risen from 1,200 to 1,370 in the same period. The Cayman funds market is also strong. Fund-raising for the first half of 2008 was just three per cent down on the $137.2bn (£68.48bn) raised during the first half of 2007.

What is clear from these statistics is that there is still plenty of activity in the offshore funds market despite the global economic downturn. A number of private equity and hedge fund groups are taking advantage of the banks’ need to restore the strength of their balance sheets by setting up funds specifically to buy distressed debt. Hedge funds continue to explore a range of non-correlative asset classes such as life assurance policies, and a number of fund managers are aiming to exploit rising land and food prices through newly-launched agriculture funds. Infrastructure continues to attract considerable private equity investment, and it seems that many private equity houses still have plenty of cash available for these investments – and the ability to raise new offshore funds – despite the credit crunch.

But it would be wrong to suggest that the offshore funds market is entirely immune from the downturn. In the traditional private equity field, underlying transaction volume is down, as merger and acquisition activity is impacted by the general slowdown and, in particular, the difficulties in obtaining bank leverage. There appears to be a general consensus that this market – an important source of offshore business - will not return before the middle of 2009.

Structured finance, however - a key growth area for many offshore centres in the past 20 years – is also faring surprisingly well. While it is true that far fewer new securitisation vehicles are being established, the thousands of special purpose vehicles (SPVs) that have been set up over the years still need ongoing advice, and many of them are being restructured as a consequence of the current financial situation, which provides a steady stream of work for those firms that can offer expertise in this area. Workflows in other areas have been boosted by the credit crunch. For example, we have seen a marked increase in the number of offshore structured equity products, innovative debt securities (including commodity and oil-linked products) and bank tier I capital raisings. Demand for offshore shari’ah law structures also remains high.

The picture is less rosy in relation to traditional bank lending and security work - the ‘bread and butter’ instructions for offshore law firms over many years. This market has been hit hard by the credit crunch, and we are seeing far fewer instructions in the current climate. The same is true in relation to the establishment of offshore property holding structures. This market has been particularly buoyant in recent years, but the economic downturn has led to a significant reduction in the number of new structures being established and the number of transactions involving existing vehicles.

The market for offshore companies remains very strong in certain quarters and we continue to see a rise in the number of clients seeking to establish listed holding companies for foreign-domiciled trading businesses and asset-holding companies for resources and other businesses. Demand for listings on the Channel Islands Stock Exchange also remains strong, despite the difficult market conditions.

The current economic climate also looks set to trigger a sharp rise in the amount of offshore litigation. As credit lines dry up, some offshore vehicles have defaulted, leading to an increase in insolvency and restructuring work. Financial structures have become so complex over recent years that when they fail, unwinding them and dealing with the resultant litigation is often a complex and long-drawn-out affair, which should ensure that litigation teams are kept busy for many years to come.

Offshore litigators are also reporting a rise in the number of contentious trust cases, with more claims against trustees as portfolios fail to deliver the returns enjoyed in previous years. The offshore funds market also looks set to generate more work for litigators. Two types of scenario are emerging: investor claims for compensation where directors are alleged to have failed to observe proper principles of corporate governance and fund prices have fallen sharply; and regulatory intervention, taking place where weak financial and management systems are being maintained. The difficult economic conditions are also likely to see offshore litigators busy with applications for injunctions over assets held or controlled offshore.

Cost control

The firms that should fare best in the current market are those that have a reasonably good level of diversification and are not too reliant upon a high volume of bank lending and security, merger and acquisition, commercial property and non-essential legal work. Larger firms, with the ability and resources to adapt their teams and expertise to restructuring and refinancing, and to deal with complex innovative new structures under development rather than the high-volume plain-vanilla issuance of the past, should be better equipped to weather the conditions, provided that they can keep their costs under control. But cost control does not necessarily come easily to firms that have experienced relatively consistent year-on-year revenue growth for over 20 years.

While they offer a low tax environment, offshore finance centres are expensive places in which to conduct business with high commercial rents and support staff salaries. Associate remuneration is often close to that offered by the leading onshore firms, but offshore charge-out rates are lower, and the nature of offshore work makes it harder to maintain the leverage that would be typical at an onshore firm. These factors present a formidable challenge to offshore firms when it comes to managing costs.

Recruitment is particularly difficult in most offshore finance centres. With tiny local populations and strict work permit or housing licence requirements for non-locals, the competition for good lawyers can be fierce. This means that firms will be reluctant to reduce headcount aggressively, for fear of not being able to hire sufficient numbers of strong lawyers when markets return. As a consequence, the focus is more likely to be on redeploying lawyers from the quieter areas to those that are busier, and investing time in important non-chargeable projects such as the development of know-how.

Although it is difficult to get
reliable data on the subject, the cooling of parts of the offshore market may also have a welcome knock-on effect for some of the firms, in that it may well serve to slow down the degree of ‘job hopping’ that has plagued the industry for many years. In boom times, lawyers will often move from one firm to another as they try to manage the progression of their careers. In the downturn they are less likely to do so, valuing job security more highly. This can only be a bonus for clients, who will benefit from greater continuity – and for employers, who need to spend less on recruitment and training.

Expansion plans

If it is difficult for offshore firms to make significant savings on their salary bill, they will undoubtedly look to cut costs in other areas. Over the past five years or so, many of the leading offshore firms have expanded their jurisdictional reach by establishing a presence in competitor jurisdictions. In some cases this has been achieved through organic growth, but most firms have done so through merger and acquisition. Both are expensive, requiring the recruitment of senior lawyers ahead of revenue, or significant acquisition and integration costs. Law firms, generally being businesses that distribute all or the vast majority of their profits annually and which do not typically build up large cash reserves, have to finance capital expenditure from borrowings (difficult in the current credit markets) or from revenues. In times when profits may be flat, partners will be reluctant to further sacrifice income for the sake of investment projects with a payback period of many years. We are therefore likely to see a slowdown in the rate of jurisdictional expansion, as firms become increasingly reluctant to make heavy capital commitments at a time when early deal-flow cannot be assured. It is also likely that the offshore world will see more best-friend relationships, such as that announced this year between Maples and Calder and Carey Olsen in Jersey coinciding with the closure of Maples’ own Jersey office, either as a long-term arrangement or as a precursor to a merger or formal alliance when the markets recover.

Nevertheless, the multi-jurisdictional strategy is now such an established feature of the offshore legal world, the activity in that field is unlikely to cease altogether, and one of the most interesting areas to watch will be developments in some of the ‘quasi offshore’ jurisdictions. Against an ever-changing regulatory and fiscal backdrop, although many jurisdictions seek to avoid the offshore label - preferring instead to refer to themselves as ‘financial hubs’ – it is becoming increasingly difficult to distinguish between the traditional offshore locations and their supposedly onshore competitors. Ireland, Luxembourg, Dubai, Hong Kong and Singapore are all interesting cases in point. Every one of these jurisdictions has numerous characteristics that are shared with the traditional offshore jurisdictions, and each now contains an office of one or more of the big Channel Islands or Caribbean-based law firm groups. Although in the majority of cases they have so far established their associated trust company businesses in those locations, rather than choosing to offer domestic law services, there are signs that this is changing – and if the administration businesses in those jurisdictions are a major success, it is inevitable that some firms will start to consider whether they should be offering the legal services alongside administration.

So far, most firms have resisted the temptation to offer legal services in these jurisdictions for fear of biting the hand that feeds them. Those firms who do have a law firm office located there tend only to use them as representative offices to refer work into the Cayman Islands, British Virgin Islands (BVI) or the Channel Islands. In Dublin, however, one Cayman firm has now broken this mould, choosing to try and beat the incumbent Irish law firms at their own game by establishing its own Irish law capability and picking off a number of high-profile lawyers from the established firms. There are many people closely watching the outcome of that development, what the response of the Irish firms will be, and whether they join forces with any of the offshore groupings, or continue to plough their own single-jurisdiction furrow.

In the past 20 years the offshore territories have enjoyed a phenomenal period of growth in revenues and profits, and in recent years the market has been characterised by increasingly ambitious geographical expansion, and tentative moves to push the ‘offshore’ boundaries. The challenge now is for management teams that have probably never before faced significant market turmoil to adapt their strategies and operational priorities to a more difficult market environment. This is likely to lead to a slowdown in the previous rush for international growth, while firms focus on the more prosaic task of maintaining margins from their core jurisdictions - a management discipline that should stand those who rise to the challenge in good stead for when more buoyant markets return.

Nicola Davies is the CEO of Mourant Ltd and a member of the Managing Partner editorial board. She can be contacted at: nicola.davies@mourant.com. Jonathan Rigby is managing partner of law firm Mourant du Feu & Jeune.