To merge or not to merge?

Navigating the path to a successful merger is never easy. It is a route that demands careful negotiation underpinned by a realistic appraisal of strategic aims. And once merger terms are agreed, firms are only at the beginning of a difficult integration process, the failure of which will dissipate all potential benefits of a union. With so many possible pitfalls, many firms avoid mergers and instead choose an alliance or network to develop their firms and gain competitive capability. Alan Hodgart, an independent consultant, assesses the strategic case for mergers and asks whether alliances and networks can really be credible alternatives.

The legal profession is entering a new phase of its strategic development, one where critical mass by practice area and location will become important competitive capabilities. This development is occurring throughout many jurisdictions and it marks a new challenge for managers of law firms.

Competition has escalated across the legal profession over the last decade or more and, as a consequence, there has been increasing segmentation of law firms based on their competitive strengths in particular markets. The trend first appeared in the high-value transactions market: the large M&A and financings market, where the main clients are FTSE/Fortune 500 companies, similar institutions and major investment banks. The work is high-margin but, to be successful, it also requires a very complex and demanding set of competitive capabilities.

In countries around the world, this part of the market has become dominated by a small number of firms, primarily an elite group out of the UK (mostly new global competitors) and Wall Street. In all major jurisdictions, a small number of domestic leaders also compete in this area, but rarely on a regular basis. (For example, in European M&A work, from 1998-2002, the five UK global firms plus three Wall Street firms had a market share in excess of 55 per cent for the whole market. It increased to over 65 per cent as the deal size rose).

As firms get squeezed out of high-value segments such as this, they search out other practice areas and clients where they can achieve above-average returns. Some go for a greater litigation focus across a range of commercial-practice areas, others seek to build their market share in secondary transactions (mid-market deals) and in a small range of higher-value commercial services (for example, labour law and anti-trust). Others opt for a more niche-specialist position focusing on a narrow range of client types and a strong focus on specific client types.

As a consequence of this, the legal market is breaking into geographical groups (or segments) focused on particular client types and practice areas. Each segment has a somewhat different focus to others. The goal for firms in each group is to develop a strong position through building up its market share of clients and work. There is greater competition within each segment and firms see the need to develop capabilities where there are perceived weaknesses.

While there are mergers that lack a strategic basis, it is in the issues above that the rationale for sensible mergers can be found. Put another way, the best mergers are simply a quicker way of achieving what the firm’s strategy demands. A firm can, over time, go out and recruit more people, seek to pitch to new clients, open Greenfield sites in new locations – or find a merger partner where these are achieved immediately.

The issue of critical mass is one of the most misused rationales for merger and it is worth mentioning in this context. Merger simply to be a bigger firm is not a particularly sensible idea, nor is it strategic. The important issue is the required competitive size and depth in core-practice areas. Building up critical mass in three major practice areas will, in the absence of cuts elsewhere, increase the overall size of a firm, but this is a consequence of a clear strategy, not a strategy in itself. Firms pursuing an effective strategy might choose to merge because it:

Secures a larger base of the type of clients on which the firm’s strategy is focused;
Adds critical mass in one or more practice areas;
Provides skills that allow the firms to better develop existing clients and to attract new clients of the type being pursued;
Provides a competitive capability in another location, which is essential to the firm’s strategy.

Merger discussions should not proceed unless one or more of these reasons can be identified clearly and early in the discussions. The only possible exception is where an early discussion indicates that a merger would enable the combined firm to pursue an entirely different strategy than either firm envisaged pre-merger.

Second, “critical mass” is a relative term and covers sheer size (number of fee earners) and depth (number of people at the same level with the required expertise). A firm’s critical mass in any area can be compared with direct competitors and will impact client perceptions. For example, a client might only need two or three lawyers for a project but prefers a firm with 20 lawyers in that particular area rather than a firm with five. There are several reasons for this, even where the technical expertise between the two firms is comparable:

Clients perceive the larger group as having more collective experience between them, thereby bringing more value to clients;
There is a perception that the large group must be more successful than the small group, which is why it is larger;
There is security in numbers in that two or three lawyers make a small proportion of a 20-person team whereas they make up a major part of a five-person team. In the event that the smaller firm is busy, clients worry that their work will suffer because of reduced flexibility;
The “under-the-bus” syndrome – In a small team there are usually one or two really good people and, if one goes under a bus, there will be a problem. In a larger group there is likely to be a number of stars who could step in if one “disappears”.

Over time, if the size difference becomes too large, the smaller group may disappear off the client radar and work move progressively to the larger firm. Hence, critical mass is an important competitive capability between peer-group firms and can support an appropriate merger.

The other issue with critical mass is depth. A firm wishing to build critical mass in, say, mid-market corporate work should not merge with another firm simply because it doubles the size of the corporate group. The crucial issue is whether there are sufficient people with the required expertise and experience in the specific area of corporate work on which the firm is focusing.

One example of this is where one firm is partner-heavy in a practice group and the other is partner-light. A merger could provide the right balance. In another case, a firm might need to build up its heavy hitters in a particular practice area, in which case, there is little point merging with a firm where its people are young and inexperienced. Similarly, a firm wishing to develop particular types of clients might merge with a firm where there is a depth of experience in working with such clients. Provided the clients follow the merger and there are opportunities to build the business further, it could be an effective merger. In another case, two firms were competing for a larger number of corporate transactions. Interviews with clients indicated that both firms were seen as too small, but a doubling of the size with a consistent quality would encourage clients to award larger transactions. The two firms merged and, over a two-year period, the merged firm doubled the size of transactions that it handled.

Of course, in any merger there will be downsides. The critical issue is whether the strategic benefits outweigh the pitfalls. In any merger, there is almost always at least one part of one firm’s business that the other would prefer not to have.

Alternatively, there might be some people that do not provide any strategic benefit or there might be some clients who do not fit within the strategy.

In a merger, it is generally not easy to be selective and say “we’ll have this but not that”. It might be possible where the firm has been weakened and is not in a strong bargaining position or where it has already reached a strategic decision about disposing of parts of the business. However, partners will usually only vote to merge if they see all or most of the firm merging, not parts of it.

What this means is that even where a merger meets the strategic aims set out earlier, the merger itself does not necessarily make the new firm more competitive initially. It might, on the surface, double the strength of a core-practice area. However, if there is no plan to bring everybody together so that there is a one-firm image projected on the market, clients will not necessarily see the merger as providing a significant enhancement of competitive capabilities.

Likewise, any downsides taken on as a part of a merger need to be managed away as quickly as possible in the post-merger phase. Unprofitable clients, taken on as part of the overall package, should be made profitable quickly or asked to go elsewhere. Under-performing fee earners should be given a timetable to improve, along with help and support, but asked to leave if performance does not improve quickly.

Even soundly based strategic mergers can fail to deliver the potential benefits because, once the papers are signed, everybody goes back to working exactly as they did before. Integration is essential and this is not just about getting people under one roof. Integration applies to every system, process and work style, so that clients see a one-firm approach to everything. Only then will clients start to use the wider services or the greater depth, knowing that there is a guarantee of consistency as they use more of the firm. Integrating two firms of any size is a very complex, time-consuming job that must be done with speed. Where integration drags out, clients continue to see gaps in consistency and form a view that the firm is not as strong as its size suggests. Even when integration is finally achieved, many of the potential benefits of merger have already been lost.

This raises a crucial issue, which is the need to develop certain integrated systems and structures prior to the merger so that they operate effectively on day one. At the top of the list of these are the organisation and management structure (including who will fill what roles), partner and staff-remuneration systems, partner capital and drawings, performance-management systems, financial reporting, key human-resource processes, and marketing. This is not an inclusive list but covers those areas that almost always need to be negotiated and agreed prior to any merger vote. Failure to successfully negotiate such challenges explains why many potential mergers do not proceed.

The three most notorious deal stoppers (other than name) are management structures, partner remuneration and structuring the economics to reflect profitability differences. Even if lawyers believe they can negotiate their own merger, it is in areas such as these that they should seek expert advice even if, on paper, there appear to be no problems. Partners have an uncanny habit of perceiving unfairness in any proposal put forward and those negotiating the merger are not always alert to the signals. Corporate clients use advisers on their mergers and lawyers should always do the same. Remember, mergers are never easy even when they initially appear to be made in heaven.

While some firms see the need to enhance their competitive capabilities and understand that a merger might achieve this, they often shy away because of the time, problems and potential downsides. Some adapt their strategy so as to compete in a market position that obviates the need to enhance competitive capabilities. Others seek to achieve the initial competitive position through alliances or networks.

The most obvious situation where firms have turned to alliances and networks is in developing their international capabilities. This has also been done in a number of situations within the domestic market. The most publicised version of the latter is Lovells and its Mexican wave network in real estate. It would clearly not be a strategic move to merge with a London firm simply to be able to handle lower-value, real-estate work profitably. Developing a network of good-quality firms that are prepared to undertake the work at an agreed quality standard is a better solution than merger and allows Lovells to meet the needs of its core clients.

Others have taken a similar approach internationally, particularly, but not only, in regard to Europe. The difficulties of merging within one jurisdiction are significant, but they multiply when it becomes multi-jurisdictional. Hence, a large number of firms have resorted to alliances and networks.

Given the problems and risks of merger, is this a better approach? The answer depends on both a firm’s strategy and how an alliance is structured. There are many situations where a firm needs to be able to refer a client to a firm in another jurisdiction but where the client is not looking for a one-firm service, nor for any particular consistency other than they want a respected competent firm in the other location. In these situations, a well managed alliance or network is perfectly adequate. What a member firm must not present to clients is that:

It can guarantee a service quality comparable to the referring firm;
That it is an across-the-board alternative to truly international firms with their own offices.

A general alliance will never be able to present the same consistency of quality that an international firm has the capability of achieving or what a more integrated alliance can achieve.

There are situations where the competitive capability in another location must be able to demonstrate a high level of consistency in strategic focus, service-delivery quality and working style. High-value, cross-border transactions are one area where these are essential capabilities. Lovells’s Mexican wave is another example where these conditions apply, at least in part.

In these situations, general alliances tend to suffer against the alternatives. No matter how good the member firms are in each location, they will have their own set of strengths and styles that will differ to those of other member firms. While neither one is good nor bad, clients who prefer one approach in all of their work will find the different approaches disturbing.

Hence, where the work and client requires high levels of consistency, the situation is either merger or very tight alliances. Examples of the latter include the Slaughter and May best-friends approach and that of Herbert Smith/Stibbe/Gleiss Lutz. In these alliances, there is a high degree of integration in areas that matter and there is only independence in areas of management and profitability. While arrangements vary in these tight-knit alliances, the aim is to create a sense of a seamless, one-firm, cross-jurisdictional service without actually merging. To that extent, they require much of the integration that would be required in a merger and raise their own issues, given that the firms retain their independence.

There is little doubt that we will see an increase in mergers over the next few years. The strategic focus of many firms requires them to significantly enhance their strategic capabilities and the organic route will not enable them to do so quickly enough. Mergers will only be successful if they are seen as a means of implementing a sound strategy and no firm should contemplate a merger or alliance without being able to identify how it will move them forward in their strategic development.

Furthermore, the rationale for merger should be based on hard, objective analysis. Given a firm’s strategic goals, who are its real competitors, how does the firm rate against these, what are the identified competitive capabilities that it has to enhance, how does a particular merger opportunity achieve this, and is there a better opportunity available?

Not all sound, strategic merger opportunities will be exciting. Many people feel that unless it is love at first sight, with all sorts of bells, whistles and lightning bolts, then it is a doomed romance. The fact is that most mergers, like most romances, have their highs and lows, but the parties concerned see that they can build a better life together than apart. There may be no thunderbolt of lightning on day one or even day two but sometimes there are good, solid, sound and sensible reasons for getting hitched rather than continuing life alone.

The possibility that a merger could be a small move in implementing a strategy should always be on the table. An emotional rejection of merger is not a wise way to run a business. This does not mean that management should become merger-discussion junkies as has happened with some. Rather, it is wise to ensure partners see that, given the firm’s strategy, there is the possibility that a certain type of merger might be more beneficial than remaining independent.

In today’s competitive climate, no responsible firm that wishes to sustain success should turn its face resolutely against merger (or an integrated alliance). Problems are raised under either approach but strategic success might come to depend on it.

Alan Hodgart is an independent consultant. He can be contacted at: mail@alanhodgart.com.