In Defence of the Merger?

I wrote recently about the problem of mergers in the legal market. My post seemed to resonate with a lot of people - it has been one of the most read articles on my blog with over 300 hits since it was published.

I have received a few comments about it too - most have been supportive, but a few have been critical - saying that I had underestimated the success of mergers and that I didn't quite understand the motivation behind firms merging.  In particular, it was suggested that I didn't understand the financial pressure to merge faced by smaller firms with no access to loan capital. So I have been reading around the subject today to see if I have been missing something.

I read a very interesting article from Syscap (see the article here), who are a 'provider of smart, cost-effective finance solutions' according to their web site. The article from Philip White, their CEO, suggests that since access to finance has become so difficult for smaller law firms, their only solution is a merger.

Even firms that can get offers of conventional bank loans are finding that those loans are too expensive. Bank of England data shows that lending margins for small businesses loans across all sectors are still on the rise.  Small businesses, such as sole practitioner law firms, are now paying the highest interest margins in three years on loans of less than £1 million. 

The law firms that Syscap speaks to about funding for tax payments, IT investment etc, leave us in little doubt that they are finding it almost impossible to get sensibly priced funding elsewhere in the market. 

Further evidence of how tough things are can be seen in the 17% jump, since the start of the year, in the number of funding requests that we have received from law firms to help pay their big semi-annual tax payments to HMRC.

The above quote form the article does demonstrate the difficulty of financing a firm - but I'm still not convinced that merging is the solution. Two smaller firms who can't finance a capital programme merge - and become a larger firm with the same problem.

Partnerships have always had some difficulty to get bank loans - there is almost no collateral for banks to lend against. The traditional answer to that problem has been the equity call - or rather the practice of retaining sufficient profit each year to fund capital projects, rather than returning as much as possible to the partners in order to boost that favourite measurement of Profit per Equity Partner (PEP). Recently, however the drive to show more profits being given to partners has meant that a smaller and smaller percentage has been retained within the firm.

I appreciate that the profits in small law firms are proportionately small - however their access to affordable finance is unlikely to improve in the near future (and I don't plan to get into the argument about non-partner equity here) and so partners will need to look at improving the profitability of the work that they do. Not so that they can take more out of the firm - but rather so that the partners can use the cash in the firm to fund efficiency projects and some real growth.

So - before you consider a merger consider this: look at the way that your firm works and the cases and matters it takes on. Increase the profitability of the work - don't just look for turnover. Talk with the partners about the large/capital projects required - whether that is investment in technology or a marketing push. Look to invest internally. Look to flatten out the peaks and troughs that normally categorise partner drawings by developing a long-term financing strategy based on internal investment and a longer equity return model.

It's not likely to be a particularly popular strategy (particularly with those senior partners about to retire and withdrawn their equity) - but it will provide some stability to the firm and a platform for growth.

Buying Turnover

Times are tough - and lawyers in England and Wales are certainly noticing.

In these straightened times, it seems that firms and chambers are reacting by wanting to appear successful and strong. I have discussed at length the difficulties of firms using the right measurement and the fascination that stills seems strong for the use of turnover as the primary measurement. Turnover is up and so we must be doing well - that seems to be the system in place.

Sadly, even though firms tend to use turnover because it is the easiest to understand and to feel that you are affecting, increasing turnover is not that simple.

Lawyers can't simply put their prices up. They are being squeezed in every area - and those involved in publicly-funded work and being squeezed more than any. Clients have a bit of an upper hand at the moment - meaning that prices are, if anything, going down or at least remaining constant. It is a brave client partner or senior clerk who discusses an increase in rates.

So where is this perceived success to come from. Where are firms and sets to find the increased turnover?

Simple - they are buying it. Much of the legal news at the moment is about mergers or acquisitions. Whether it is Herbert Smith Freehills, Norton Rose Fulbright, or Finers and Howard Kennedy, firms are looking to bring extra turnover into the firm by the simple expedient of merging with another firm. They're almost all at it - Field Fisher Waterhouse are still trying after a number of false starts.

This may well be a normal and even sensible reaction to a difficult market - but much like an endlessly-upward equity market, its not sustainable growth. In fact its not really growth at all. The market is, if anything shrinking and so the apparent growth gained from mergers is simple re-allocation of turnover within a market.

It is possible, in fact, that there will be a downward blip in turnover as the newly merged firm works out what it is doing and as it reassures clients from both firms. Profitability will certainly be affected, at least in the short term - there will be layoff costs, integration costs and, usually, there is a good deal of marketing and PR to be done, to explain to clients and the market why the merger has been a tremendous thing.

Perhaps a little more time spent on planning and implementing more profitable work would be a more efficient use of the time spent? I don't object to mergers - but let's not pretend that we are generating real  sustainable growth, or that we are doing anything that create a strategic advantage.