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| Peter Zeughauser |
There was speculation about which firms might fail and which might be the white knights saving crisis-stricken firms. Some even feared a legal sector remaking of "Barbarians at the Gates."
Now 2020 is in the history books. As it played out, there weren't any firm failures, white knights or barbarians at the gates.
2020 did end a multiyear streak of increasing law firm mergers. It is not that there weren't any merger talks. There were, even on Zoom. But for the first half of 2020, firm leaders were preoccupied with navigating the COVID-19 storm.
Very few firms, possibly save those with big bankruptcy practices, had a sense of how their year would turn out. Even at the end of the third quarter of 2020, when the year was panning out to potentially be another revenue and profitability record breaker for a surprising number of firms, many chairs were wary of how strong year-end collections would be.
Although economists will have a better sense of what 2021 will look like once the Georgia runoff election results are in, the BigLaw merger market seems poised for a return to normal in 2021. Indeed, by the end of January, it may feel like a snapback. By the end of 2021, last year's dip in the law firm merger market will be an anomaly, for a number of reasons.
First, the market remains unnaturally fragmented, with only one firm, Kirkland & Ellis LLP, having close to 5% market share in 2019.
Second, a long-building consensus is taking hold around the compelling case for scale, particularly to meet the needs of the biggest and best clients that pay the highest rates.
And third, because of the law of large numbers. The compounding of rate increases, revenue growth and net operating income, the latter especially so in an appropriately leveraged firm, has produced a Pac-Man effect in the lateral market, with giant superfirms growing faster, bigger and stronger by gobbling up the best talent.
However, these factors will likely not lead to an unusual number of blockbuster deals among billion-dollar or bigger firms. A normal merger market might instead include one big deal and about 100 deals with firms averaging five to 20 lawyers in size. Let's break down why this is and what we are likely to see in 2021.
Acquisitions of Smaller Firms by Large Firms and Mergers Between Small Firms
If you are a small firm — with under 400 lawyers and as few as four — you are hot in today's market, and only getting hotter. If I had a dollar for every large firm that asked if I could find them a small firm to acquire in an attractive market, i.e., location, practice area or sector, I would not be writing this column. Instead, I would be drinking banana daiquiris on my private getaway island in the Caribbean.
This is because firms are increasingly wary of the lateral market. Yes, there are a few very rich, magnetic firms that can dip into the lateral barrel and pluck out a whopper anytime they like. And they do. But a growing number of firms have concluded the lateral market is an expanding no man's land.
Sure, firm chairs won't sneeze at a bona fide performer. Usually someone they know well. But much of the market seems to be approaching burnout on laterals.
Too many laterals looking for a home have five "priors" — i.e., they have been a partner at five prior firms. There are precious few good reasons for having five priors. And chairs of billion-dollar firms with about 40% margins are starting to think that the opportunity cost of reeling in a solo lateral with a $5 million book of business doesn't merit the $2 million that drops to the bottom line once the recruiting and onboarding expenses burn off.
In my experience, increasingly, firm chairs would rather spend their time hunting for a small firm, even a very small firm of 10 to 20 lawyers, that fits a strategic need. Attractive targets are in a city, sector or practice area that correlates with the acquirer's growth strategy.
The suitor gets complete visibility into the target's financial performance and client base. The target's lawyers tend to stick well to, and perform well on, their new platform. These deals sell like hot dogs at a ballgame.
There are several reasons small firms choose to be acquired. Poor leadership and rainmaker succession planning are two. Not infrequently, they find themselves on the short end of a convergence, lacking the breadth and depth big clients need when they shrink their outside counsel lists.
For small firms, having a few big rainmakers can present a single-point-of-failure risk. The partnership may be uncomfortable or incapable of shelling out the big dollars needed to keep up with new technology.
In addition, larger competitors' longer deal sheets and greater deal flow provide the most current knowledge of street terms for deal points, a big attraction to clients. And, again, there's the compounding effect on revenue and profit that comes along with size.
Does this mean the bell is tolling for small firms? Not at all. Increasingly, though, being small is the province of high-stakes trial firms, where it helps to reduce conflicts and provide high numbers of trials per partner. To be small and prosper otherwise means carving out a niche and sustaining a high-performance culture.
Although predictions are barely worth their bytes, I would say we will see 2021 close out picking up on 2019's trajectory, with about 115 firms small firms acquired, with the average target size being 18 lawyers and the average suitor size being 1,400 lawyers. But brace yourself for an uncharacteristically high volume in the first quarter.
The Prize: Midsize Targets Sought by Larger Firms
Notwithstanding that larger firms are increasingly giving up on lateral hiring as a viable tactic for achieving scale — as opposed to filling gaps — in favor of small-firm acquisitions, the real prize is to acquire a midsize firm ranging in size from 150 lawyers all the way up to about 600 lawyers.
An acquisition of a high-performing midsize firm can move the needle for even a billion-dollar-revenue firm. The best targets offer true breadth and depth in several markets, often a combination of a city, a practice area and a sector.
COVID-19 has clearly accelerated change in BigLaw, but it has not had a big enough impact to bring about a material rise in the number of these deals. Better-performing midsize firms are managing the profitability gap by increasing compensation ratios to compensate their top performers at levels within spitting distance of their larger suitors.
Enough of these top performers enjoy the benefits of being a big fish in a small pond to keep them in their chairs. And if the past is prologue, partners writ large at underperforming firms will give their firms at least two years of poor performance before breaking rank.
Finally, these firms tend to like their midsize cultures. Often, the partners know and respect each other.
What might tip the scale and cause this dynamic to change at some of these firm is the growing performance gap between these firms and the superperforming large firms. Eventually, swelling compensation ratios at small and midsize firms will challenge prized firm cultures.
High-performing partners will be lured away by better brands and compensation that is two or three times what their firms can afford. Ironically, for the partners to stay together these firms will have to merge. This phenomenon has been slowly gaining momentum over the last decade. It will undoubtedly continue in 2021. But it is not yet set to cascade.
At lower-performing midsize firms, the work-life balance can be more attractive. Firm leaders are loathe to do a deal that requires outplacing partners who perform at an acceptable, albeit subpar, level. These subpar performers frequently comprise a substantial voting block at the firm.
It won't be surprising if less than a handful of these firms are backed into deals as their more productive partners are picked off by firms a tier or two above them. Successful mergers among these firms will be those led by chairs who can build a consensus to deftly sculpt a higher-performing whole from the best of what comes together in the merger.
The Billion-Dollar Blockbusters
For years, the legal media salivated every time merger talks between two large firms were leaked. Then, reporters learned that these talks happen all the time. They usually never went anyplace.
In their fiscal 2019, 29 firms reported between $1 billion and $2 billion in revenue, with the top 10 firms having over $2 billion. Twenty-five firms reported over $3 million in profits per equity partner. The next 27 firms reported between $2 million and $3 million in profits per equity partner.
In my experience, the leadership of the 25 to 30 firms comprising the second tier is becoming acutely aware of the reason the first tier is pulling away: greater scale, compounding and the rule of large numbers. Many of them dream of doing a big merger of equals. Some feel impelled.
So are we going to see a 2021 tidal wave of these deals, shrinking this second tier by half or one-third? Unlikely. We may see one or two, and I say this more to hedge my bets than to predict the likelihood of a deal between two billion-dollar behemoths.
Why no tidal wave? Because very few of these firms have not already had a meet-and-greet and concluded a deal wouldn't work.
Under the hood, there is a social hierarchy. Status is important to BigLaw partners. While the compensation hierarchy can be addressed in a deal, partners who rank high in the social hierarchy fear a loss or dilution of status. Then, there are the inevitable conflicts under codes of ethics and within industry sectors.
Having predicted few deals will occur, it is important to note that this second tier is under pressure to grow materially larger. These firms' top talent is increasingly succumbing to the financial siren of the titans at the top, not to mention the increasing dominance of the top tier in certain markets, and moving to bigger firms.
This keeps many of the second-tier firm chairs awake at night. With only a few exceptions, these firms don't have the breadth and depth of talent to withstand the assault on their talent.
On top of the top-performer mindset, consumer markets are exploding around the world — including Asia and Africa. Multinational companies of all sizes are chasing these markets around the globe. Even with Brexit and the European Union in chaos, the flow of money and trade across borders is inexorable.
Multinational companies are concerned about China's internal politics, growing surveillance technology and militarism, but they recognize the need to do business there, and their law firms must either expand globally or recede in importance.
The pace of global expansion of law firms is slow, but the risks and costs are great. A big cross-border merger may help, but will the dam break in 2021? No.
For trans-Atlantic deals, culture, governance, compensation systems, cash versus accrual accounting conflicts, and tax issues continue to break the back of all but a few fortunate enough to push a deal across the finish line. Even then, it takes years to reap the rewards. However, deals in the Shanghai Free Trade-Zone, particularly between U.K. and Chinese firms, had picked up steam prepandemic.
So, might a domestic or transcontinental deal or two occur between two behemoths when travel resumes? It is possible. There is nearly a year ahead. Plenty of time to get one done.
Peter Zeughauser is chairman at Zeughauser Group.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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