The growth imperative: Positioning in a dividing market

The 2014/15 financial year was 'a good year' for many law firms in the UK and certainly better than for many years since the financial crisis. But, was growth universal among commercial law firms? The short answer is: no.

Underlying conditions have not substantively changed for the UK legal market as a whole. Some firms are doing very well, that is certain, but unlike previous positive market periods there is no rising tide that is lifting everyone up. Only half the firms are being fully lifted up. The other half are experiencing slow growth as well as in some cases a contraction in total revenue, revenue per lawyer and/or profits per equity partner.

What is also clear is that the market within which the main UK law firms operate is dividing more distinctly than ever before. The reality is that the legal market, which to some extent has for many years accepted that a few 'mega-firms' at the top will be much larger is now changing into a market with many more larger firms. There are now ten £0.5bn-plus UK-based firms, fifteen £150m to £499m firms and twenty firms between £80m and £149m. Large-scale UK firms are more prevalent than ever before and clients no doubt can see the difference.

After these larger firms, mostly in the Top 50, the scale of firms rapidly drops, giving the UK 100 over forty firms with revenues in the £21m and £49m bracket. Meanwhile what were once small revenue gaps between peers that were one side or the other of the mid-point in the UK 100 have now grown into gaps worth tens of millions of pounds. And those gaps will be increasingly difficult to bridge organically.

Splitting apart

The UK market is now seeing a bifurcation: two groups of market constituents are being driven apart in quite different directions. In turn, this is altering market perception and perhaps more importantly client perception of law firm scale.

As seen in Table 1, a client of a firm that had around £40m revenues in 2008 may not be that surprised to find that in 2015 the firm was still at this size, that it still had a limited number of partners to choose from, or that it still hadn't really changed its overall offering even though the world had moved on significantly since then. But the same cannot be said for the firm in 25th place - things there have had a scale change.

When it was only the Magic Circle and a handful of other proto-global firms rapidly building scale, it perhaps did not seem that relevant to many UK firms that they were being left behind. 'Who cares? Let them grow abroad, it doesn't really affect many of our clients,' some firms said.

Now, however, things have changed. Many law firms that would be regarded as having a more national focus have built outwards in scale and reach across the UK and also into the City. Some regional firms have also gone national, others have built up in London and several more have also become international. Significant growth, expansion into new, often larger markets and wide scale geographical coverage has now been taken up as a strategy by far more firms than ever before.

Of course, even now some firms may say: 'So what? What other firms are doing doesn't affect us directly.' But the problem is that unless you are a very niche firm and truly have very little competition, then these changes do affect you.

The reality is for most of the firms in the UK 100 and many in the next 100, having to compete with firms with greater scale does really matter, especially now. Scale translates into an expression of several important factors:

• The breadth and depth of partner teams across core practice areas and main sector specialisms.

• Geographical reach, whether in the UK or beyond.

• The ability to project a firm's brand across the market.

• The ability to invest in the future of the firm and its service level to clients, ranging from better IT to overall investment in facilities.

Scale also to some extent provides an IBM factor. No one will criticise a general counsel or a company owner for choosing what is perceived as a 'large' firm with sufficient expertise in that area, whether for a panel place, or for a specific major/high stakes matter. The assumption, rightly or wrongly, is that larger firms must be doing something better than smaller firms. It is intrinsic to human nature to think this way and very hard to defeat.

However, it is not logical to then say: 'Smaller firms have all had it.' Clients will, of course, come to smaller firms and most likely always will. But the clients that feel most comfortable with such firms may not always be the clients you want occupying your lawyers' time, nor will they pay the highest fees your firm is capable of achieving.

Smaller SMEs and less wealthy private clients seek out smaller firms in part because of price. If such clients become your mainstay then unless you can increase volume and address margin issues you are using your lawyers' time to conduct work that may see little price improvement in the years ahead. It could even face decline. Which in turn means you cannot easily grow organically. And that, as shown above, can lead to an increasing gap between you and other firms.

What can then happen is a vicious circle where smaller firms generate less fees per matter, cannot grow and so 'tread water'. Such firms then cannot always afford sufficient pay rises for key associates, risking their departure. They cannot invest enough in business development to grow the client base. They cannot invest in the latest IT. Year by year, the position gets worse. Yet, they still keep going. Unlike the prognosis seen in many books on management, such hamstrung legal businesses don't go extinct overnight, instead they experience a long-term decline.

If they have not been unwise in their property decisions or borrowing, this decline can go on for many years. Some partners may even be relatively happy with their remuneration, even if it is a far cry from where it once was. But, is this the kind of firm you want? Is this the kind of firm your top clients, or the clients you aspire to have, want to give their work to? Does a firm like that provide a future for its talent? If not, then time is of the essence.

The growing gap

The gap between the faster growing firms and the slower growing firms is getting larger. For example, the gap between a firm in 25th place and 50th in 2000 was just £24.3m. The gap has now increased to £91.1m, or a size difference of 156 per cent of revenues.

In this kind of market there is no way that most firms can organically 'home grow' so many millions of pounds in revenues in terms of bridging the scale gap with their larger rivals without merger, at least not in a timescale that would matter strategically.

Moreover, it is worth considering that even under a determined growth drive rival firms that are already larger may still remain in a better position. For example. a £50m firm that grows an aggregate 20 per cent over four years is now £60m in revenues, but the rival firm, which let us say is £80m in turn reaches £96m in revenues if growing at the same rate. The gap now between the firms is actually greater, moving from £30m to £36m, even though the smaller firm has grown significantly.

In short, even if keeping pace with the growth rate of larger rivals, which takes quite some deliberate effort and planning, one's firm still remains relatively smaller. The only alternative is to grow even faster, in effect 'steal a march' on one's rivals.

Consolidate your position

One of the key factors that has contributed to the division of the legal market is consolidation. In 2015 there were 18 mergers involving at least one UK-based Top 100 firm, up by three on the year before and perhaps signalling a new period of higher levels of merger activity after the pause in 2014.

While we may not reach the peaks of 2012 and 2013, which were fairly termed the years of 'merger mania' with 26 deals apiece, the pressures of the UK legal market may well move many more firms to merge.?But, perhaps of more interest than the total numbers is the type of law firm merger that has taken place recently. There were several types of deal in 2015.

The largest group of mergers was of UK 100 firms combining with smaller firms, whether in the 200 to 100 group or even smaller. The second group was deals with international firms, though in most cases these were also relatively small deals with firms in Europe. Only one of the international deals was very large.

But, what does this tell us? First it says that many UK 100 firms are seeking to merge with smaller firms rather than look for mergers of equals. Such an approach makes perfect sense. A smaller firm that will help deliver key practice strengths and greater credibility in an important market can often be a very sensible strategic step.

However, what it may not do is radically change the firm's overall position, not unless the smaller deal is followed up by further growth. One might say a small deal is a sensible and solid growth step, but given the data seen earlier in this report, firms will need substantial momentum not to see those revenue and capability gains diminish relatively in the years ahead, i.e. a small combination is not the end of the process. In fact, it is really just the beginning of a project to build a better platform that will hopefully allow far greater growth in the future.

Fundamentally, one's firm is merging to help create more growth that will last into the future, not to achieve a one-off advancement. Although, of course, a merger will provide significant additional growth in the year the deal goes live. But, the year after one's firm will be judged on its growth following the combining of revenues. In which case deals that actually stimulate further growth are the real prize and have to be the highest strategic objective. We also saw several firms making small acquisitions of firms in Europe in 2015. This also made sense. Many of the firms doing this had already built out in the UK and in the City, and now they are looking to build into Europe and Asia using the same growth logic. Perhaps the most intriguing question is why there were not more mergers between UK 100 firms? After all, if growth is an imperative then why not find a merger partner that will really deliver this in one significant step? Aside from standard issues such as conflicts preventing deals, some possible reasons are discussed below.

Some management teams want to retain a high degree of power in any merger deal and can fear that the other firm's management will supplant them, which tends to make them focus on firms that have lower revenues. But, that then limits the choice of firms one can approach. Moreover, managing partners at other firms can be highly pragmatic and in fact may welcome the chance to be part of a broader management team without seeking to retain the same role. Many may welcome a merger as a chance to build a better management and support team in general.

The larger the other firm the more likely that it may have some practices and offices that are not essential to your firm's main strategic goals. But, in many cases the scale benefits gained through a large merger will outweigh the challenge of having one or two offices one doesn't need. Those offices can also be restructured at a later date. Moreover, additional practice areas, as long as not too detached from your main offering, may provide some useful diversification of revenue.

An influx of new partners may perhaps scare some lawyers who fear they will see greater internal competition. But, what is the alternative? It is true that bringing aboard a large number of partners via merger will be a significant integration project, but many businesses manage to do this. And, as to the risk of competition between partners, in part that can be influenced by the remuneration system, but also by instilling a culture of collaboration and cross-selling that makes 2 + 2 = 5 out of the merger, rather than having a large number of disparate partners competing unhelpfully against each other. In short, the success of a large merger (in fact, any merger) is very much down to how management promotes the right incentives and culture to support integration.

Ultimately partnerships have to vote for what they feel is the right thing to do. The more they feel there is a strong need to do something, even if it challenges them, then the greater chance they will support it. Although it can be tempting to avoid hard discussions with the board or partnership in general over more ambitious merger plans, management should also be wary of letting good opportunities slip away.

Usually a balance can be struck between some partners' hopes for inaction and taking the partnership too far outside their comfort zone. Though, any merger is always a step to some degree into new territory.

Partners understandably want to see solid evidence as to why something as bold as a merger is necessary and how it may be beneficial to them and the firm as a whole. It is also helpful for managing partners to gain a clear picture of what will and what won't be acceptable to the partnership. Very often a strategic analysis from a third party can be useful in providing this evidence as well as an understanding of the support level for different types of merger.

In conclusion, the UK legal market is now changing rapidly and the gap between those firms that are growing and those that are stalling is getting larger. Now is the time to confront the wider changes in the legal market and consider pragmatically how one's firm may need to respond. In some cases organic growth may bridge the gap to where you need to get to, but for many law firms it will not. In which case, managing partners may well need to consider merger as the best strategic path in order to build sustainable growth for the future.

Richard Tromans is founder of TromansConsulting (www.tromansconsulting.com)