Partners in Germany remain upbeat about the economic slowdown but, says Richard Tromans, exposure to the unpredictable local legal market could still turn out to be a powder keg powerful enough to damage the strongest of firms
“We are hitting a recession and it does not look good,” says one German partner from a US firm with a significant presence in Frankfurt.
A fairly self-evident comment you would think given the stream of depressing statistics coming out of the country in recent months, but the amount of straw-polling that Legal Week had to carry out before finding even one partner willing to make such an uncontroversial statement is telling.
Given the rapid expansion of City and US firms in Europe’s largest economy, it
is not a message that many corporate partners, whose economic literacy usually stretches only to predicting a never-ending boom, want to admit. But the signs from Germany’s economy circa August 2001, while still a long way from anything that could be called a true recession, look distinctly less than healthy.
With an ailing Japan and North America also teetering on the brink of a recession, Germany, still reliant on its export-driven manufacturing base, has already proved the hardest hit of the Eurozone’s major economies.
Predictions of economic growth this year running at close to 3% have been officially downgraded to 2%.
However, the consensus view among independent commentators is that the German economy, which is believed to have contracted in the second quarter, will be lucky to see expansion in 2001 much in excess of 1%. Industrial production has fallen this year while unemployment, the bane of post-unification Germany, has been rising for seven months to edge towards 9.5%. Likewise, the country’s property and construction sector, the most important element of its industrial base, is choked with over-capacity and falling investment returns.
Such a scenario would have seemed unthinkable 12 months ago from an economy that last year grew 3%, Germany’s best performance for a decade. According to the theory, that strong performance was supposed to be further boosted by the centre left Social Democrat Government’s ambitious free market reforms.
It goes without saying that the latter scenario had been accepted by the City’s top firms with the last 12 months seeing a wave of expansion in the wake of Freshfields’ market-shaking tie-up with Bruckhaus Westrick Heller Loeber in August.
The German M&A market was booming and Anglo-Saxon corporate lawyers were sure they were onto a good thing.
The result is nearly 20 international firms now in Germany with local law capability; and the short- term pressures for City and US firms to produce returns on their expensively won local arms will be intense if the corporate and capital markets do not produce the expected boom in the next two years.
And yet it would be wrong to overstate the gloominess of the situation, as the strategic reason for a sizeable German arm still makes obvious sense. As the world’s third largest economy, Germany’s attraction to banks and law firms is obvious. The combination of a high skills base and a key position in the economic convergence of the Continent together with under-developed capital markets and investment industry remains a heady mix for international companies and their advisers.
Likewise, the consensus view is that the economy will yet scrape past recession: boosted by the flight of capital from the slowing US, an administration that remains popular with international investors, and, if it is lucky, a positive realignment of the euro against the US dollar. Other causes for optimism include the record-breaking run for European M&A in 1999-2000, of which Vodafone’s successful bid for Mannesmann has been held as the defining symbol.
Add to that the wall of private equity funds that have been built
up to invest in the country, together with the hopes that Germany’s long-promised funded pensions sector, a key component of any healthy capital market, will finally be legislated for as promised next year.
And the optimists also point out, with some justification, there is an even bigger silver lining on the immediate horizon: the implementation next January of drastic cuts to Germany’s punitive capital gains tax on disposal of assets.
This is meant to free up billions of dollars of capital and allow German businesses to unwind their tortuous web of cross-holdings. The theory, according to the banks and law firms, is that an M&A and capital markets bonzana will ensue.
Nevertheless, a growing band of partners are conceding that the current economic climate is hardly an environment conducive to such wholesale restructuring.
Firstly, the current valuations on German stocks – the blue chip Dax index remains 20% below its 12 month high – will do little to convince Germany’s band of proud family-owned companies to go public.
Secondly, corporate unwinding, while a positive move for Germany’s overburdened banks still holding massive stock portfolios, looks equally unlikely to begin in earnest without a major rise in German stock prices.
As it is, banks will have to overcome strong resistance from their biggest corporate clients to aggressive disposals, as witnessed by the public spat between Deutsche Bank and Deutsche Telecom this month over the bank’s third party disposal of 44 million shares in the telecoms giant. Without the juicy carrot of premium valuations it will be many years before that mountain of capital is released.
In such a context, a quick return on law firms’ investment looks a pretty shaky bet.
An additional problem will be that a slack market, while reducing the amount of work in itself, will also frustrate City firms’ long-cherished ambition of importing City charge-out rates, which are often twice as high as the fees German companies are used to paying.
An additional point is sheer exposure. Clifford Chance, Freshfields, Linklaters and Lovells all have more than 70 equity partners in Germany, roughly five times the number of senior local law lawyers they have in comparative nations such as France, whose economy is more than two thirds the size of Germany’s.
This expansion, having occurred in the vast majority over the last five years through merger rather than the more controllable process of organic growth and lateral hiring provides its own problems, not least the difficulty of management control in uncertain economic times.
For top City firms the expansion has produced unchartered areas of exposure to another economy, with upwards of 20% of their income now coming from a single international practice.
Consequently, any downturn in fee income will be felt directly by their London HQ at a time when US and mid tier rivals are producing profits close to or in excess of the magic circle.
It goes without saying that the pressure will also be keenly felt by US firms, that culturally, with a couple of honourable exceptions, do not have the best record for stomaching loss-leading international offices.
An additional fuel to the fire is the number of entrants to the market post Freshfields/Bruckhaus, further driving up the demand for German lawyers despite the slowdown in the work they are actually bringing in.
This year alone has seen Norton Rose, Latham & Watkins, Debevoise & Plimpton, Simmons & Simmons and Hammond Suddards Edge all open up German practices.
Others such as Linklaters have merged with their allies and Mayer Brown & Platt and Allen & Overy have grown their offices considerably. Meanwhile practices as varied as US firms Altheimer & Gray and Sullivan & Cromwell and the UK’s Eversheds and Bird & Bird have all promised to build a German practice in the next 12 months.
With so many competitors, the absence of a surging corporate market – and a trip round the offices of most firms Frankfurt and Munich offices makes that current absence clear – could yet prove an explosive combination.
Is such a risky scenario causing worry among German partners? Not at first glance, but dig a little deeper and it becomes clear that there are increasing signs of alarm. One partner at a magic circle firm with a large base in Germany goes as far as to say: “We are still working at around 100%.”
Yet when pressed, the same partner concedes that capital markets work is sharply down, corporate activity is slower than expected and the media sector is taking a beating. Others, meanwhile, claim that broad-based practices will have greater capability to refocus their business to cope with the shifts in the market. Such a strategy would at least be aided by the generalised nature of German practice, a tendency many international firms have ironically been trying to wean their local law offices off.
Peter King, a Linklaters partner and German specialist, falls into this category, pointing out the capacity of his firm to refocus its practice if necessary. Certainly it is a strategy the magic circle firm has been committed to, with Linklaters having already hired 60 German law associates this year.
“There is a lot of industrial consolidation and private equity investments are increasing,” he says.
He adds that there is an increasing market for debt and securitisation is growing in popularity. “This will not be desperately bad,” says Christoph von Teichman, the German head of Latham & Watkins. He adds that during a downturn M&A lawyers convert to restructuring lawyers and equity capital markets experts start working on bonds.
A fair point, but post-war Germany has long had a developed debt capital market. The driving force behind German expansion was the expectation of a comparable equity culture, with plenty of capital for new young businesses and a healthy corporate restructuring market for public companies. The relatively low margins
on bond issuance and corporate restructuring are certainly not what drove City firms to build up massive German capability.
Other partners are less forcibly upbeat, with one forthright German partner with a US firm conceding: “There is a general feeling that there are less deals and not many big ones.” This feeling is borne out by the figures.
According to Thomson Financial, the first half M&A rankings for 2000 saw a record $245.5bn (£171.1bn) worth of completed M&A deals with a German target. The same period for 2001 saw $61.35bn (£43.51bn) by value. Before you press the panic button consider that more than half the 2000 figure is due to Vodafone’s Mannesmann takeover. But excluding headline deals from both periods reveals a clear underlying slowdown on value and volume, if admittedly against the context of a record-breaking 1999-2000.
But if the cooler than expected winds moving through Europe are hitting short-term gains, perhaps the more significant impact of the slowdown has been the damage it has inflicted to the Social Democrats’ attempts to inject openness and flexibility into the economy.
Having pushed through many contentious reforms in the early part of its administration, including sweeping cuts in capital gains and corporate tax, the signature economic reforms of Chancellor Gerhard Schroeder’s administration looks secure. The same cannot be said for other promised reforms, notably to Germany’s rigid labour market and weak policing of competition policy. An alliance between Germany’s blue chips and MEPs has already scuppered the European Union’s long awaited common takeover code, which had been held up for the 12 years the code was developed as a key stride along the road to cross border competition.
Germany has since unveiled its own proposed takeover code, which, while believed to be an improvement on the current situation, still allows plenty of scope for national companies to frustrate merger bids with little recourse to shareholders.
Coming within weeks of the European Commission’s rejection of the Honeywell/General Electric merger, it would be an understatement to say the move has been badly received by international investors, particularly in the US.
Von Teichman for one concedes that loss of the takeover code has been damaging to the standing of German business and a sharp reminder to the world of the protectionist instincts of the nation’s business community.
“I am extremely unhappy about what happened with the takeover code. It is a big mistake and sends out the wrong message,” he says.
Without scope for stronger shareholder protection, pessimists fear that the nation’s chances of building an entrepreneurial culture in the next decade look distinctly shaky.
Indeed, the virtual collapse and surrounding controversy of the growth exchange Neuer Markt is further evidence of the rocky road for Germany innovators.
Having been hyped to the hills in the middle of the technology bubble, Neuer has this year been widely accepted by Frankfurt’s business community to have let in more dogs than Crufts.
Particularly hard hit by the crisis in confidence in growth companies has been the media industry. According to German insiders, a number of domestic media groups are close to going under after making bad investments in Hollywood.
Echoing King’s warning that niche practices are particularly ill-equipped to cope with a slower German market, new entrants to the market targeting the technology, media and telecoms (TMT) and growth companies have been among the worst hit.
The Munich office of US joint venture Brobeck Hale and Dorr can already testify to that. The office, which is focused on taking growing companies to their first flotations,
has already recognised that it could be 30% below planned turnover, and Brobecks’ situation is by no means unique. Facing this tougher business environment and the prospect of a general election next summer, the Social Democrats’ likelihood of securing further economic liberalisation before the next Parliament look remote. Indeed, there is already talk of raising business taxes and curbs to the announced tax cuts, while the aforementioned pension reform will be difficult to implement before the next election.
None of which undermines the rationale for German expansion among the world’s leading law firms.
What has been delivered is a sharp reminder that the economic integration and liberation of Continental Europe has for 50 years been a case of three steps forward and two steps back. In short, this is a game for firms that have the stamina to ride out short-term dips in the market, or the magic circle as they are known for short. Likewise, the position of Linklaters and, to a lesser extent,Clifford Chance, which have been willing to make tough decisions in terms of the reshaping their newly- acquired German practices, look considerably more secure than some rivals.
Freshfields, for its part, has a cushion against leaner times in its brand recognition and all-round quality of Bruckhaus, despite the hands-off style of its marriage, while Allen & Overy’s focused office and banking connections will do much to limit its exposure.
But firms such as Lovells, Norton Rose, White & Case, Simmons & Simmons and Lathams will inevitably find their already rather-thin margin for error in Germany getting a whole lot thinner should the market fail to pick up.
For New York firms, with the honourable exception of Shearman & Sterling, Germany has many of the signs of turning into a poisoned chalice. With US firms pulled in one direction by their Wall Street banking clients’ push into Europe and pulled in another by domestically focused partners in New York, a test of nerve will be required.
Meanwhile, magic circle firms look best placed to pull through, and could even benefit from the shakedown of potential challengers.
But this benign analysis relies rather heavily on competition for German lawyers easing, if Frankfurt is not to face the similar kind of salary bubble that has burst so spectacularly in the faces of Silicon Valley law firms this year. As it stands, exposure to the unpredictable German legal market could yet prove to be a powder keg powerful enough to severely damage the strongest of firms, let alone the also-rans.
