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Twenty years of mergers have transformed the American legal industry into a market characterized by very large national firms and smaller regional firms. The evolution of local legal markets in major U.S. cities affords some opportunities, particularly for large national firms, to continue this consolidation. Economic principles are the driving forces of most law firm merger activity. Most major law firm growth in the last generation has occurred not due to associate-driven leveraged growth, but to the phenomenon of branching, carried out mainly through mergers and acquisitions. As the supply of large, successful national firms increases, it is evident that the merger and acquisition activity in major markets also increases. Law firms merge for different reasons. An economic analysis of each city’s legal market is necessary to evaluate merger and acquisition opportunities. For acquirers, client development and synergies involving geographic and specialization diversification provide major incentives to merge. For acquirees, the prospect of increased profitability and economic stability provides compelling reasons to merge. Overall, successful law firm combinations result in competitive advantages such as maximized profitability, increased opportunities for high-performance partners, accelerated client development, optimum synergies, geographic expansion and long-term stability through diversification. Where do national law firms tend to branch? The evidence shows that in the United States, new office creation occurs mostly in New York, Washington, the San Francisco Bay area and Los Angeles. San Diego, Chicago, Miami and Boston have also seen significant merger activity. Cities such as Seattle, Houston, Dallas, Denver, Detroit and Philadelphia have less merger activity because of their markets’ oligopolistic configurations, dominated by fewer major firms. These regional markets may not sustain the economics of national firms, whose relatively high partner profits must be met to justify branching through acquisition. Whereas the branching phenomenon in the United States has created distinctly U.S. law firms, the last 10 years have also witnessed an attempt by major U.S. firms to expand into international markets. London is the most popular destination among overseas cities, while Hong Kong and Shanghai are increasingly attractive gateways to the burgeoning Chinese economy. U.S. firms move into Europe and Asia to remain competitive; top London-based firms are growing worldwide as well, typically through merger. A brief review of the structure of the California markets illustrates the effects of rapid structural transformation facilitated by mergers. In California, the largest indigenous firms typically have grown through development of branch offices nationally and worldwide, including acquisition of smaller firms. Midsize and small California firms have been acquired at high rates by national firms headquartered in other cities, thereby allowing the larger firms to grow through branching. Waves of mergers occurred in Los Angeles in the 1980s, San Diego in the 1990s and the San Francisco Bay area in the early 2000s. These waves have transformed mature markets because more national firms have become eligible acquirers, while the economically accelerated California markets allow them to implement a key part of their growth strategies. The consequence of this merger phenomenon has been a “hollowing out” of key markets and creation of market configurations in the largest U.S. cities of very large indigenous firms and branch offices of large nonindigenous firms, with very few profitable midsize or small firms remaining. Midsize firms find themselves at a disadvantage in competing for quality clients, partners and associates, and therefore have relatively noncompetitive profitability compared to larger rivals. Industry consolidation tends to amplify these disadvantages. An unusual amount of merger activity has occurred in the last five years, since the recession of the early 2000s forced vulnerable firms to merge or disband. Historical evidence shows that an increasing number of distressed law firm targets merge primarily during phases of decline in the business cycle, while acquirers are ripe to pick up smaller firms during boom phases. The economic challenges for midsize firms during the early 2000s encouraged wholesale acquisition of distressed firms in key markets. For acquirers, mergers have proved an ideal means of penetrating key markets. Branch offices in New York Global economic forces have made New York and the San Francisco Bay area markets particularly active recently, as a number of midsize or small firms have been acquired by national firms intending to establish beachheads and promote quick growth. In fact, the biggest trend in New York law firm market economics in the last decade has been the growth of national law firm branch offices. This trend has been fueled by the ample supply of excellent small and midsize New York firms. As a result, most movement into New York and the San Francisco Bay area by way of mergers has been in the so-called middle market, by firms of moderate profitability. Expansion options are limited for top-tier indigenous New York firms because not many local economies can support their extraordinary profitability. With one exception, the 15 most profitable firms, according to a 2005 American Lawyer survey, are from New York. Ironically, this profitability restricts their growth. The consequence of this law firm merger wave has been the development of mature oligopolistic markets in the top cities. Since national firms have entered local markets to compete with large indigenous rivals, a greater number of firms now perform work for corporate clients, thereby creating more competition. As the rivalry in top markets has intensified, regional firms have been required to develop growth strategies to remain competitive. This pressure has forced regional firms to grow, often through merger, or to be acquired. Given the oligopolistic configurations of most local markets, the competition for the remaining pool of eligible merger candidates is increasingly aggressive among national firms. Because of the difficulty of identifying suitable law firm departments or small groups of partners in the most competitive markets (New York, Washington, Los Angeles and the San Francisco Bay area), higher threshold whole law firm acquisition has become a more thinkable opportunity, although a more costly one. Merger strategies should be evaluated according to key economic factors such as optimal size, profitability, specialization and culture of each candidate firm. Optimum strategies should be developed for both acquirers and acquirees. A merger of two large national firms that leads to diverse yet complementary geographic practices and varied specialties may be successful for some firms. But bigger mergers mean bigger potential risks. The data on post-merger experience reveal frequent attorney attrition, particularly where incompatible cultures are involved. For example, in a case where one firm demands that attorneys carry higher work loads than another, lawyers from the firm with the lower expectations will tend to be demoralized and attrition enhanced. In general, national firms that seek to set up a branch office in a new city will acquire a small firm as a beachhead upon which to build. Although in concentrated or mature markets, growth through lateral partner or small group acquisition may prove more difficult than expected, most of the movement of partners between firms occur in smaller groups. Particularly at the top of a market, many prospective acquirers seek to cherry-pick whole departments of indigenous law firms as their main tactic for market entry or supplementing an existing office. This approach can be an efficient model for whole law firm acquisition. Because small firms often originate via the departure of a group of partners from a large firm, acquisition of a smaller firm follows the same model as an acquisition of a group of partners from a department of a major indigenous firm. However, a successful growth strategy depends upon parity being realized between partner revenue and partner profits of the smaller group of attorneys and the larger firm. In successful combinations, target firms’ profitability must generally satisfy the acquirers’ economic thresholds of comparable partner profitability and associate leverage. Because of the diminished pool of possible targets in a mature market, too few firms might satisfy the economic criteria of highly profitable potential acquirers. On the other hand, a target that is highly profitable as a stand-alone firm has little reason to merge with a larger firm. This is why elite boutiques continually repel merger opportunities. More moderately profitable firms, though, may need to restructure their partnerships, by stripping less profitable partners of their equity or fully vesting partner retirement plans, to appear more successful to possible acquirers. Cultural incompatibility between law firms in a proposed combination, with the smaller firm craving independence and the larger firm requiring increased bureaucracy, is the most important noneconomic issue that arises in merger discussions. One solution is for a larger firm to allow a local office to maintain a degree of autonomy while simultaneously allowing its partners to pursue opportunities to enhance national reputation and clientele. Compatibility along various economic and cultural criteria leads to more successful mergers. Because law firm mergers involve professionals with diverse personalities, they require the application of management art as much as the hard science of economics. In analyzing local markets, larger acquirers initially identify prospective targets and evaluate them primarily on the basis of economic compatibility. Yet in competitive markets, relatively few target candidates will meet the high thresholds necessary to satisfy an acquisition, particularly in the middle market where marginally lower economic conditions may not allow larger, more successful, acquirers to complete merger deals. Moreover, the competition for the few suitable acquirees will be intense, since there are many prospective acquirers. Perspective of target firms Target law firms in turn must evaluate prospective rival acquirers based on economic factors, such as average partner revenues, partner profits and associate leverage, as well as geographic complementariness, potential for specialization synergies and, finally, cultural compatibility. Firms need to weigh the comparative factors of prospective matches against their managers’ preferences and goals. A midsize firm may be compelled to merge in a competitive market or risk losing its most productive partners to rivals; yet loss of rainmakers can threaten the firm’s survival. In the best-case scenario, two or more rivals will provide the target with offers in a competitive bidding war that maximizes the target’s opportunities. Preferably, this negotiation process, whether bilateral or multilateral, will involve the advice of an intermediary agent who provides economic analysis to, and evaluates optimal offers for, prospective merger partners. As the structure of many U.S. industries has become oligopolistic, large corporations have fueled a winner-take-all competition among the law firms that serve them, which is reflected in the structure of major U.S. law firm market configurations. The consolidation wave of the last 20 years has produced a new class of national and global firms, measured by size, profitability and market power. Though the markets in major cities are relatively concentrated, there is still room for more mergers and acquisitions, including the cannibalization of branches as weaker firms give way to stronger ones. With the lucrative U.S. markets becoming increasingly saturated, top foreign markets are expected to be viewed as prime locations for mergers. Major U.S. firms have not yet fully activated their globalization strategies. The structure of major city law firm markets does not preclude the possibility of a merger wave between firms of equivalent large size, as has occurred in other industries. Once this process begins, it tends to feed itself, with firms competing to be bigger, ubiquitous and more profitable. Given these conditions, it is possible to predict the emergence of a national market consisting of a few dozen law firms commanding disproportionate market power. Neal Solomon, a consultant with California Legal Search in San Francisco, has written books and articles on the economics of the legal profession. He can be reached at [email protected].

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