Growth metrics: How scale and geographic spread affect law firm profitability

When is geographic expansion an appropriate strategy for a law firm? How much does scale really matter? How large does a law firm really need to be? Opening new offices in new markets makes for good press. So too do big mergers or signature lateral hires. But, does simply increasing scale or spread really deliver enhanced economic performance? As growth returns to western legal services markets, and law firms think about how they should respond to their changed world, these questions are becoming increasingly important.

Driven partly by the 'big four' accounting firms ramping up their legal advisory businesses, a view has emerged that somewhere around 20 law firms in a market would be sufficient to create competition and service most clients' needs. Of itself, increased scale seldom delivers better performance unless it corrects a lack of critical mass. Size does matter in law firms, though. Compared to smaller law firms, bigger law firms are usually perceived to be:

• more capable of handling more difficult, important, larger legal matters;

• more attractive to large corporates and financial institutions;

• more likely to have stronger brands and better name recognition;

• more able to invest in new systems, offices and other initiatives;

• more attractive to the best legal talent; and

• more profitable and liquid.

Being one of the top-20 grossing firms can therefore be of significant advantage. Small wonder, then, that so many law
firms falling below the number 20 talk
of bulking up.

Geographic reach can also be valuable in today's hypercompetitive market, but only if driven by the correct strategy. The costs of establishing and doing business in new markets are often underestimated. All too frequently, hindsight reveals that assumptions upon which new offices were established were flawed.

Technical analysis

Does a causal relationship exist between scale, geographic spread and profitability, though? It depends.

Figure 1 shows growth in revenues among the top-50 UK law firms as a whole over roughly the past two decades, corrected for inflation by using constant 2010 pounds, plotted against the UK gross domestic product (GDP), both reduced to an index, with 1996 = 100.

Law firms at the top end of the UK's top 50 have been growing revenues faster than those further down, and profits per equity partner (PEP) in this group has improved significantly over the years. Excepting the period immediately following the global financial crisis, the top-50 law firms have clearly and consistently increased the size of their businesses, and revenue growth is back onto the trend line from 1996 to 2009. Consolidation (largely through mergers) and an increase in revenues from international business (largely through international offices) are the only reasonable explanations.

As to international expansion, if we can better understand what specifically drives success, then law firms can craft better strategies to draw the greatest value from their new international offices.

Building on research published in the American Lawyer in 2012, we studied large UK and US law firms that have more than 20 per cent of their partners outside of their firms' home countries. Figures 2 and 3 show the market positioning of those firms in terms of the percentage of their partners outside of the firms' home countries versus PEP and revenues per lawyer (RPL), respectively.

In the two diagrams, the size of the 'bubbles' indicates the number of fee earners globally; the colour indicates the firm's home country, based upon where the majority of lawyers are based in 2014. By this logic, Herbert Smith Freehills and Ashurst should be classified as Australian law firms but, to keep things simple, we have kept to just two country variables and classified them under the UK.

The RPL graphic in particular suggests that a gentle decline in economic performance occurs as the number of partners outside of the firm's home country increases much beyond 33 to 50 per cent.

These graphs should not simply be taken at face value, though - they represent just two perspectives from a complex network of variables. If the percentage of partners outside of the home market is a legitimate driver of RPL, then it is only one of them, and its relationship with other drivers is non-linear.

 

Key findings

We can draw the following observations from our work, thus far.

• The most profitable firms with up to 20 per cent of partners outside of their home country are generally US-based. Several of these are firms that are focused on capital markets as opposed to broader corporate and commercial practices, so their work mix is inherently higher priced.

• Dollar strength is to the disadvantage of the UK-based firms, but correcting for that would not radically change their relative positioning on the chart.

• Of the six US-based law firms with up to 50 per cent of partners outside of the USA, White & Case has a profile most like the magic-circle firms. It is also, by a significant margin, the most geographically diverse of the premium New York law firms.

• Besides Baker & McKenzie, the US-based global law firms are products of transatlantic mergers in the past decade, with significant UK components.

• The verein firms may be amongst the least profitable overall but, as several have pointed out in recent years, this is irrelevant because the separate profit pools allow partners to be compensated not only commensurately with performance but also competitively in their markets, relative to other economic options that they may have. This is the same strategy as that adopted by the 'big four' accounting firms and allows for far greater compensation spread across the partnership. Some partners in verein firms may earn more than their counterparts in premium firms.

The diagrams show that UK law firms are far more amenable to international expansion. This is not surprising. The US legal services market, representing roughly 50 per cent of the global legal services market, is the most important market for US-based law firms in ways that the UK can never be for UK-based law firms. So, in order to expand significantly, large UK-based firms have always needed to look internationally.

International expansion exposes a firm to a wider range of risks. Currency risk is one of these. Since the global economic crisis, the euro has been depressed and emerging market currencies have been variable, to say the least. Given the macroeconomic dynamics at play, especially the strength and likely sustainability of the US economic recovery, we think most US-based law firms will remain primarily focused on their own market. Their international growth will be very selective, focusing on high potential areas in the most promising markets that best support their US practices.

UK-based firms have struggled to win market share in the USA, so are unlikely to significantly access the US market except through major transatlantic mergers. More of these are expected, but divergence in profitability between the premium US-based law firms and the magic circle would seem to make this more likely in the mid-market. Premium US-based law firms are more likely to be able to secure the talent that they need through lateral hires and organic growth. For the premium UK law firms, options for growth in the USA may largely be limited to laterals hires and organic growth; hence, very tightly focused.

What of following clients, though? American corporations and financial institutions are expanding their businesses across the globe. Is there not a strong imperative for US-based law firms to follow those clients, or risk losing their business to competitors that do? This would have been true a decade or more ago. Today, client-buying behaviour is more sophisticated. Clients no longer typically use a small number of law firms 'from home' to service all of their global needs. There is also greater churn between law firms and their clients.

It used to be that law firms entering a new market had, as their ideal, to structure their new office with a smaller 'mini-me' version of the main office. Today, law firms need to be far more thoughtful about the best strategy to adopt in each market. They need to play carefully to their strengths, taking account of local competitive conditions. As a general
rule, a firm:

• should not have a full-service office if an office focused on selected niche practices will do;

• should not have an office if an alliance with a local firm will do; and

• should not have an alliance if a 'best friend' relationship will do.

The aim should be to achieve the level of presence that clients require in a market at the lowest sustainable cost. This mitigates against entering a market through a significant merger unless a compelling strategic rationale exists for the combined firm and the risks are well understood.

Fee-earner performance certainly affects RPL and demand for legal service has remained depressed in many markets, as their economies have continued to languish. Complexity costs also increase as organisations become more diverse and geographically spread, but this would have more of an impact on profitability than on RPL. Also, economies of scale may balance this through elimination of duplication, investment in more efficient systems and centralisation of business service and other functions.

Drivers of RPL

So, where does that leave us? Clearly there is more research to be done in this area, but it would seem that the most important drivers of the decline in RPL as the percentage of a firm's business outside its home market increases are:

• strategy creep, especially where this translates into partners cutting prices to significantly below what would be paid for similar work in London or New York in order to win work from more competitive, local firms;

• lower fees in markets with depressed currencies, especially the Eurozone and emerging markets, even in
  areas which are strategically core
  (for instance, where doing that
  work in that market protects an important client relationship in a
  more important market);

• lower productivity generally in Europe and some emerging markets, as a result of depressed economic activity in those markets (largely but not always a consequence of the lingering effects of the global financial crisis); and

• poor integration of far-flung offices into firmwide networks, silos, internal competitiveness and other factors which hinder collaboration across geographies.

Expansion considerations

What do law firms need to do when contemplating a move into a new market?

The quick answer is to effectively address the drivers outlined above. One frequently hears the words "the benefits do not necessarily show up in the numbers". For instance, it may be that, while a particular office is itself unprofitable, revenues are earned elsewhere in the network because of it. That can and should be measured. There are very few issues that cannot be reduced to quantifiable metrics, although innovative thinking may be needed to find the linkages. Besides that, the following approaches should be used.

• Rigorously test assumptions and think through scenarios.

• Develop a strategy that aligns well with local market realities, with measurable objectives and defined key performance indicators (KPIs). Many markets (including London) are littered with offices of international law firms that are unprofitable, and that unpalatable reality is hidden by sloppy KPIs.

• Start small, with a focused team addressing a real client need, and expand gradually as the partners in the office understand the market better and new opportunities emerge that warrant growth.

• Over-invest in integrating lateral hires from the local market into the firmwide network. Unless their focus is on local law, they may need to radically retool their competencies and develop new client relationships.

• Especially if the firm is ramping up its international expansion, pay specific attention to proactively driving inter-office collaboration. Firms that have run global strategies for a long time will attest to this. In today's globalised world, it is pointless to build a network of international offices if the firmwide whole is not well knitted together.

• International expansion is not going to cure poor performance caused by the wrong strategy in one's home market. That needs to be fixed first.

Rob Millard is a law firm strategy
and management consultant based
in Cambridge and London (robertfmillard@mac.com)