The evidence is unambiguous: mergers increase profitability. The merged entities resulting from intra-Am Law 200 combinations climb an average of 23 places in the profit per equity partner (PPP) rankings from the five-years before to the five years after the merger. Average compensation for all partners rises by a comparable amount—18 places over the same time period.
Conventional wisdom has it that mergers enhance profitability through increased revenues and reduced costs: more cross selling across practice areas and offices increases revenues; greater leveraging of scale economies reduces costs per lawyer. However, the numbers contradict this view: post-merger revenues are lower relative to competitor firms than are the sum of the predecessor firms’ revenues, and costs per lawyer increase markedly.
So how is profitability increasing? Mergers seem to act as a catalyst for strategic repositioning, particularly a sharpened focus on the most profitable parts of the new entity’s business. That the firm’s focus is sharpened is evidenced by declines in the number of both total partners and equity partners; that this sharpened focus is on the more profitable parts of the business is evidenced by growth in leverage, (higher leverage broadly equates to higher profitability).
This repositioning is wise. The decade ahead will be turbulent for Big Law. As profits weaken and some firms unravel, high-performing partners will look for stronger platforms. They will be attracted to (and retained by) firms that provide the stability afforded by strong fundamentals (as reflected in high average compensation for all partners) and that possess the ability to pay their high-performing partners competitively (as reflected in high PPP rankings). Where high-performing partners go, attractive clients follow. Thus, while some will chide the leaders of merged firms for consolidating their partner ranks, it is unarguable that they are strengthening their firms for the testing times ahead.
It’s important to recognize that the strengthening doesn’t come about by simply bringing together two firms under a common brand. Rather, the numbers show that the strengthening comes about when the occasion of the merger is used to refocus and restructure the firms. Thus, leaders of merged firms need not just the strategic insight to see the potential value of a merger but, more importantly, they must have the managerial resolve to make the requisite restructuring happen.
The forgoing is based on an examination of the five mergers between Am Law 200 firms that took place between 2007 and 2011, see Table 1. Thus, the analysis is only of mergers of comparable firms, as distinct from tuck-in acquisitions or international roll-ups. This time frame was chosen to enable review of five years of post-merger performance, as is appropriate given that mergers are undertaken with long-term strategic benefits in mind. For symmetry, the analysis contrasts performance in the five years before the merger with that of the five years after the merger. The comparisons are based on rankings relative to other Am Law 200 firms rather than on absolute metrics. This rankings approach has many benefits: it automatically adjusts for inflation and timing in the business cycle and, most importantly, it focuses attention on performance relative to other firms, the litmus test for initiatives aimed at garnering strategic advantage.
As an example of the approach, Figure 1 shows the analysis for one of the mergers examined, that which created FaegreBD. It shows rankings among the Am Law 200 for profit per equity partner (PPP) and average compensation for all partners (ACAP) for the five-year periods before and after the combination. For the five years beforehand, the charts show the rankings of the predecessor entities and also of a pro forma of the combination generated by summing the two firms’ profits and then dividing by the sum of their number of partners. Naturally, for the five years after the merger the charts show only the performance of the combined entity. For each measure, the five-year average rank is noted on the chart for the pro forma and combined entity. In this case, the analysis shows the combined entity’s PPP ranking rose from an average of 167th for the five years pre-merger to an average of 131st for the five years post-merger, a climb of 36 places. Similarly, the firm’s average comp for all partners (ACAP) ranking rose from 147th to 114th, a climb of 33 places.
The changes in profitability rankings shown in Figure 1 for FaegreBD are mirrored in the data for the other mergers examined, see Figure 2. The merged firms’ rankings by both profit per equity partner (PPP) and average comp for all partners (ACAP) rose for all firms from the pre-merger to the post-merger 5-year periods. The average PPP ranking climbed 23 places while that for ACAP climbed 18 places.
Conventional wisdom would suggest that enhanced profitability post-merger results from increased revenues and lowered operating costs: revenues grow as the combination enables each firm’s partners to cross-sell to the other firm’s clients, the broadened office footprint stems the flow of work to rival firms, and the combined firm integrates its broader range of specialties into more-differentiated client offerings with higher price realization; the larger combined firm achieves greater economies of scale thereby lowering costs per lawyer. However, the data stand in stark contrast to this expectation. As Table 2 shows, the average ranking by revenue fell 5 places, and that by cost per lawyer rose 17 places, for the five mergers examined. The shortfall in revenue growth relative to peers has been seen too in an ALM study of a broader set of mergers.
There’s a paradox in falling revenue and rising cost-per-lawyer linking with higher profit per partner—with revenue falling and costs rising, you’d expect profits to fall. It’s explained by looking at the linkage between the number of partners and profitability. Figure 3(a) shows the number of equity partners and PPP; Figure 3(b) shows the number of total partners and average compensation for all partners (“ACAP”). In each, the arrow connects the firm’s average ranking for the five years before the merger to that of the five years after the merger. What we see is that the rise in profitability ranking (upward movement on the chart) is accompanied by a decline in ranking by the relevant number of partners (leftward movement) for all firms.
It is telling that there are declines in the rankings by both number of total partners and number of equity partners. A decline in equity partners and a rise in total partners would have suggested PPP was being artificially sustained through displacement of partners from the equity to the income ranks. The decline of both is evidence of a sharpening of focus—not all partners, equity or income, who fitted with the strategy of the predecessor firms fit with the strategy of the merged firm. Given how firms have a tendency to grow without an especially sharp focus in good times, and that it can be hard to cut off such initiatives as they are invariably someone’s pet project, what we’re probably seeing here is an intensification of leaders’ resolve to deal with sacred cows as part of a renewed commitment to a sharpened strategic focus.
The sharpened focus appears to be on the high-leverage practices within the new firms. Table 3 shows the leverage profiles for the five mergers examined. Four of the five firms show significant increases in leverage, with an average increase of almost 20 percent. Because higher leverage practices are also more profitable practices, what we are seeing is that the sharpened focus is on the higher-profitability practices.
This sharpened focused is having the intended effects. Because average comp for all partners (ACAP) strips away the effects of policy changes regarding income partners it tells us about a firm’s underlying financial performance. Thus, the mergers are being managed to bring about a strengthening of the fundamentals. Because PPP tells us how well a firm can compete to attract and retain top partner talent, we see that the mergers are being managed to enhanced their competitiveness on this dimension.
As a whole, Big Law has partner capacity in excess of client demand, as evidenced by still low levels of utilization eight years into an economic expansion; a shakeout is coming. Partners will get nervous as many firms see precipitous declines in profits and some firms unravel. Partners will want to practice on strong, stable, platforms. As strength and stability come with sustained higher profitability, firms that can offer such will have a distinct advantage in retaining and attracting the strongest partner talent. The most attractive clients to serve follow the best partners. Thus, it behooves firm leaders to enhance firm profitability.
The analysis here shows that mergers among similarly-positioned firms are a viable means to enhance profitability and hence competitive strength in preparation for the turbulence ahead. However, the analysis also shows that these benefits come not from revenue growth and cost management but from consolidation around the strongest parts of the merged firm. This consolidation requires robust, activist, management to make happen. In principle, such could happen without a merger. However, law firms are intensely-human creatures; the social costs attendant on such restructuring are just too daunting without an event to precipitate the changes. A merger acts as such a precipitating event. Leaders need to have more than a clear strategic vision to effectuate a successful merger; they need too the managerial resolve to seize the moment to refocus and restructure the combined entity around its areas of greatest strength.
Hugh A. Simons, Ph.D., is and ALM Intelligence Fellow and formerly a senior partner and executive committee member at The Boston Consulting Group and chief operating officer at Ropes & Gray. PowerPoint versions of the charts are available upon request: Hugh@SimonsAdvisors.org.
Nicholas Bruch is a senior analyst at ALM Legal Intelligence. His experience includes advising law firms and law departments in developing and developed markets on issues related to strategy, business development, market intelligence, and operations. He can be reached by Email, Twitter, or LinkedIn.