Key Challenges facing the UK Legal Market

Transcription

1 Key Challenges facing the UK Legal Market Key challenges to the current business model of law firms The strategic challenge of market segmentation Managing successfully in a buyer driven market September 2014

2 The UK a hub of the global legal market faces a post-crisis restructuring of the industry With competition in the global legal market intensifying in all regions and areas of business, and with the rapid development of emerging legal markets, the mature UK legal market is facing some severe strategic challenges. The market is dividing into clearly defined segments, each having a different core client focus or core practice-line focus, and therefore experiencing different competitive pressures. Despite this, many firms continue to proclaim full service as a key element of their strategic focus, while market changes make this increasingly redundant as a strategic concept. We see few firms that have recognised the part of the market in which they are equipped to compete and have then set out to build the competitive advantages applicable to that market segment. Firms of all sizes and shapes continue to market themselves as a leading full service firm even though this phrase has little meaning in a rapidly segmenting market. The challenge facing the majority of UK law firms is to define clearly where they can compete and then to set out to build the competitive advantages applicable to this market segment, rather than trying to cater to a wide range of client types across a wide range of practice lines. Failure to do so will result in a market position being forced on a firm, and it might be one in which it struggles to be competitive. A key feature of the last five years has been the worldwide economic downturn and its impact on the legal market. It was inevitable that an industry as fragmented as the legal services industry was likely to face a significant restructuring in a downturn, more so than in other professional services markets that were already much less fragmented. Industry restructurings tend to occur in downturns, not upturns, and the legal market was no exception. This restructuring was due primarily to a sharp decline in demand that created an oversupply of lawyers, resulting in the passing of market power to buyers. A number of sizeable firms in the US and UK have collapsed in this period, and a significant number of firms, both small and large, have merged to avoid a similar fate. Our view is very clear given the trends we set out below: without a significant shift in strategic thinking in law firms worldwide, leading to a change in their business model, we will see more firms struggling to maintain position, more collapses and more forced mergers. 42% of UK law firms, surveyed by Thomson Reuters in 2014, look set to cut unprofitable services in the coming year Firms that lose competitiveness and are forced out of their present market position will realize that survival does indeed require a significant overhaul of their business model and a re-assessment of their strategic positioning, requiring a major restructuring. All of this will, however, be very painful; whereas addressing the issues ahead of crisis can result in change occurring with much less pain and urgency. Report on the State of the UK Legal Market Page 1

3 The structure of the UK legal market has to adapt to new market realities The UK legal market is worth 28bn a year. It accounts for 7% of the global industry, and includes almost 12,000 law firms and 127,000 practicing solicitors Two thirds of these solicitors work in private practice, and the remainder in commerce, industry and the public sector. Based on our analyses of the UK market, we have identified four strategic segments within the market. While some firms straddle more than one segment, it is nevertheless possible to identify the segment in which they compete primarily. All of the segments, even the Magic Circle to some extent, are under increasingly strong pressure to adapt to the new market realities within the next five to seven years, leading to a reshaping of the profession. Alongside the structure of four strategic segments is a fifth, being a generalist, non-strategic and unfocused position. A significant number of firms, while being partly in one of the four strategic segments, are primarily in this fifth, non strategic segment. The four segments described below are the Global Elite; Business Law firms (broken down by geographical focus into International, London, National and Regional); Retail; and Specialist. We comment on the fifth unfocused position as well. 1. The Global Elite These firms are generally regarded as the most prestigious law firms headquartered in the UK and US, and, as a group, consistently have the highest earnings per partner and earnings per lawyer. This group includes the five Magic Circle firms from the UK and eight to ten Wall Street firms from the US (such as Sullivan & Cromwell and Skadden). This segment is heavily focused on major transactions and capital markets work as well as on litigation. They provide a range of other services primarily to support their core work, and they tend to focus the marketing of these other services to their core clients. They are located in capital market centres and emerging markets and are able to compete on a fly in/fly out basis in many other jurisdictions. Mostly they are focused on the Global 250 to 500 companies and related businesses (including leading investment banks and other institutions). 2. Business Law firms, comprising four geographical sub-segments a. International Business Law firms (IBLs). IBL firms focus on the Global 500 to 1000 and equivalent clients for transactions mainly just under the radar of the Global Elite, as well as litigation, real estate and higher-value commercial work. They sell on the basis of relationships and local capability, and build strong domestic businesses, often with industry expertise, across the globe. These firms are focused on all major markets building both a leading local capability and a global network. They increasingly provide the greatest competitive challenge to the leading domestic firms in any market, as the IBLs offer a strong local capability coupled with a global capability. b. London Business Law firms. London-based firms are focused on the same range of work for their key clients as the IBLs, but have a more limited international capability. Most of the firms have some international capability, often through best friends alliances, although this capability is in most cases insufficient to put them into the international group. In general the members of this group are competing for similar work with similar clients as the members of the IBL group, but the London-based firms tend to get a smaller share of cross border work because of their weaker international offering. While many of these firms have developed specialisms, they still appear to serve too wide a range of clients and practice lines, and they are insufficiently focused. Report on the State of the UK Legal Market Page 2

4 c. National Business Lawfirms. These are mostly broad corporate and commercial law firms, usually headquartered outside London, with significant geographical coverage across the UK. The development of these firms is focused mainly on local markets rather than on London, and they seek only limited international expansion. Many aspire to compete in London but find this difficult given the competitive nature of that market. Many of their clients are the major corporates who also use firms in the first two segments, but this group tend to operate at a lower value level than that of those firms. They also have a strong client base in mid-cap and smaller companies and tend to provide a wide range of services to these clients. d. Regional Business Law firms. These are the firms that compete more as leaders within a specific region. These firms view local expertise and connections as key strengths, along with more competitive cost structures to enable more aggressive pricing. Although often unplanned, their very position in the market tends to define the type of clients with whom they work and the services they provide to those clients. Many of these firms are more focused than the London- or Nationally-based firms, although this focus has been created more by market forces than strategic design. 3. Retail law firms. The firms in this group differ quite widely but focus mainly on private clients and small businesses, either as High Street firms or in areas such as personal injury insurance claims. The former are numerous smaller firms dotted all over the country, while the latter are represented by some quite large firms who have specialised in insurance claims. Both groups are in very fragmented segments although consolidation is underway. 4. Specialist focus law firms. This segment represents the firms with the most distinctive specification of the scope of their activities. They concentrate and specialise in a very narrow part of the market, often with broad national reputations. This segment includes such firms as pension specialists, litigation boutiques and Corporate-focused boutiques. UK legal market: key segments Depth / Focus Specialist Magic Circle/ Global Elite International Business Law London Business Regional National Other Retail Size Low High Report on the State of the UK Legal Market Page 3

5 5. The Generalist. This is an on-going segment comprising numerous firms lacking a clear market position and focus in their business. Some of the firms classed as High Street firms would also fit here as their market position is less one of choice and more a consequence of where they have been forced to compete. These firms will increasingly be less competitive and effective since they lack focus and tend to be resistant to change: their future is highly likely to be difficult. These firms are typically undifferentiated in skills and type of work. In size they range from some mid-sized firms in both London and the regions to the very small, mainly regional. They tend be full service firms that compete for all values of work and client types, and have an economic structure that is not geared to any particular sector. This makes them too expensive to win lower value work, and they often lack the capability and reputation to win higher value work. 6. There are of course a number of firms which do not quite fit the segments specified above Travers Smith and Macfarlanes are examples of firms which are clearly London Business Law firms at one level, but which compete somewhat differently to many of the others in this segment. While the two firms differ significantly in many ways, there are some broad generalisations that can be made. Both firms have a higher level of profitability than others in this group and are also significantly smaller than most of the firms in the London group as well as the Magic Circle and IBL groups. They tend to be more focused on the higher value end of the market than others and do not present themselves quite as widely spread in terms of practice line focus as others in the group. It is this clearer focus on the type of work they can excel in that drives their above-average profitability. Both firms exercise considerable discipline in not pursuing work where their size and the lack of their own global network count against them, a discipline missing from many of the more generalist firms. Report on the State of the UK Legal Market Page 4

6 Get strategic or face gradual decline From our analysis and consulting experience we forecast a high level of consolidation in the market, which is already fairly consolidated at the top end. The UK legal market grew at 1.1% in 2013 and is expected to grow by 1.9% and 2.8% in 2014 and 2015, according to research by the Average growth of UK 200 firms in Law Society. The top 200 firms claim two thirds of private 10% practice revenues, and those 8% firms in the top 200 have 6% experienced different growth rates at its ends: the top 30 4% firms grew revenues at around 2% an average of 7% (1-10: 5.8%, 11-20: 7.6%, 21-30: 10.7%); 0% firms 31 to 100 grew at -2% slightly less than 2%, and firms declined at 0.06% in Additional evidence for market consolidation is in the decrease in the number of very small practices in the UK. The number of practices with five partners or fewer fell by 2% in 2012, whereas there was a 5.3 per cent increase in the number of firms with five to ten partners, further increases Number of lawyers per 10k population in those with 11 to 80 partners 60 and a 16 per cent increase in the number of firms with 81 or 50 more partners. Alongside this, 40 the UK market, as a whole, is 30 close to saturation. Only six countries in the world have 20 more lawyers relative to their 10 population, and only three 0 significantly more. We expect the market to consolidate further, with specialisation being the key focus and challenge within that process. We see the number of local mergers increasing, particularly in the business law segments of London, National and Regional, some of these mergers being forced to avert collapse, others having a reasonable strategic logic, and, unfortunately, some with no apparent strategic logic at all: driven by the desire for scale but little else. We also see international mergers in the IBL segment and also in the London business law segment, with US firms being the likely partners for these mergers. The number of firms with a transatlantic capability will increase over the next five years as an increasing number of US firms respond to pressures in their home market by seeking a strong capability in London, the world s second largest legal market. 1 to 10 China Japan 11 to 20 Sweden 21 to 30 Russia France 31 to 40 India 41 to 50 Germany 51 to 60 Australia UK 61 to 70 Spain 71 to 80 Italy 81 to 90 New Zealand Brazil 91 to 100 US 101 to 200 Israel Report on the State of the UK Legal Market Page 5

7 International activity will be a highly important area of potential growth for UK law firms, and we already see this fuelling the demand for mergers between UK and US or European law firms. According to Acritas Sharplegal research, 71% of UK general counsel have international legal needs and spend significantly more on external counsel than those with a purely domestic focus. From the supply side, net exports of legal services from the UK have increased substantially since 1995 and have been growing faster than those in other professional services. The PwC Annual Law Firms Survey 2013 indicates that international expansion continues to be a strategic priority for many firms including those outside the Top 25. Australia, the USA and Africa are the key regions for growth for Top 25 firms, with the Top firms seeking to establish presence in the Middle East, China and the rest of Asia. Net exports of legal services from the UK have increased substantially since 1995 and have been growing faster than those in other professional services. Real net exports of UK legal services are expected to grow by 6% per year by 2015 and by 6.5% per year by 2025 (twice the overall UK legal market growth rate). The IBLs and London-based business law firms will continue their expansion into key markets (approximately 30 jurisdictions worldwide) and will do so via merger and lateral hire. As noted above, we see more transatlantic expansion within this group as well. The Magic Circle will continue to build depth in Asia and also develop into Latin America, taking on more of a business law model in these regions, following trends in demand. They will also continue to grow in the US and it is likely that two will achieve very strong mergers in the US over the next three years, making them truly global leaders. The international expansion among these firms will put pressure on the present London-based firms either to follow internationally or to focus on work that is primarily domestic. If the London firms decide to expand internationally through organic growth, the process of catching up with their peers will be very expensive and will impact negatively on profits for some years: merger is a more likely route by which to catch up. If they retain their domestic focus, they will still face tough competition for the better value work, from the IBL group in particular, who also have strong domestic practices. They will need to convince clients to favour them over the IBLs even though many clients will be using the IBLs outside the UK: as clients rationalise their list of suppliers the more domestic firms will need to fight hard to retain market share with clients who are tempted to consolidate their work with a group of IBLs. (As clients have said to us many times, why would they use a domestic firm for local work and an international firm for work in other jurisdictions, when the international firms are also strong in the local market? Report on the State of the UK Legal Market Page 6

8 Clients perceive a firm to have real strength in only a few areas The picture below illustrates our reputation analysis of the overall UK legal market, based on the evaluations law firms receive from the international legal directories, client feedback and our proprietary research. The top end of the market (tier 1) is occupied by the Magic Circle, with only Herbert Smith Freehills close by. Slaughter and May is placed within a second part of the top tier (tier 2) due to the more specialised nature of its practice offering. A number of the more successful International Business Law firms in London CMS, Norton Rose Fulbright and Hogan Lovells to name a few are also in this segment. Overall UK market: law firm reputation vs. size Cleary Gottlieb Steen & Hamilton Dechert Field Fisher Waterhouse Holman Fenwick Willan Howard Kennedy Fsi K&L Gates Kirkland & Ellis Lawrence Graham Lewis Silkin Olswang Sidley Austin Skadden, Arps, Slate, Meagher & Flom Stephenson Harwood Weil, Gotshal & Manges Reputation Index 80% Average: 392 Allen & Overy 75% Linklaters Freshfield Bruckhaus Deringer 70% 65% Herbert Smith Freehills 60% Ashurst Hogan Lovells 55% Simmons & Simmons Norton Rose Fulbright 50% Slaughter and May CMS Berwin Leighton Paisner 45% Mayer Brown White & Case 40% DLA Piper Baker & McKenzie King & Wood Mallesons 35% Dentons Mayer Brown Latham & Watkins Travers 30% 25% Smith Shearman & Sterling Macfarlanes Reed Smith Addleshaw Goddard Pinsent Masons Jones Day Nabarro 20% Bird & Bird RPC Wragge & Co Clyde & Co Osborne Clarke Mishcon de Reya 15% Speechly Bircham 10% Squire Sanders DAC Beachcroft Sullivan & Cromwell Clifford Chance Average: 33% Eversheds Lawyers within jurisdiction The rest of the market divides into an additional three tiers: (3)the upper mid market occupied by another group of International Business Law firms, many US based, such as Mayer Brown, White & Case and Baker & McKenzie; (4)the lower mid market occupied by firms large in size, but doing comparatively lower value work (Eversheds, Addleshaw Goddard and Clyde & Co); and (5)the largest part of the market, comprising a diverse range of firms, some that are seeking to compete across a broad range but have below average reputation index scores and below average size. The UK-based firms in this tier tend to be competing at a lower value end than firms in higher tiers. Some US firms appear in tier 5 simply because they do not as yet have the scale and the breadth of practice lines to be in a higher tier, even though they are competing in the higher value end of the market in what they do. The same point applies to some UK firms such as Macfarlanes and Travers Smith who are in the higher value end of the market, but whose strategic focus leads them to a tier 5 grouping. Report on the State of the UK Legal Market Page 7

9 It is worth noting that a number of US based IBLs have been moving up the rankings steadily over the last seven or eight years and, as noted above, are now well ranked in the market. On the other hand there are many US firms in London with the same problems as many UK firms: they lack a strategic focus, are trying to cover too many practice areas with too few fee earners (so lack any depth) and struggle to convert US clients who are in the UK because the clients are using firms with more scale and depth. The best performing US firms in the UK market either have focused on a narrow range of practices and built depth behind those or have merged so achieving some scale and depth in the process. This chart indicates something of very real strategic importance. The more sophisticated clients increasingly see many firms as having real strength only in a few areas and not across a wide range of practices. The chart above demonstrates that while many firms listed are full service in a business law sense, some have a higher reputation across a wider range of practices than others. (We exclude from this comment firms such as Macfarlanes and Travers Smith who, as we noted previously, because of their strategy are ranked in fewer practices than their peer group. Slaughter and May within the Magic Circle has the same issue on the chart. Nevertheless these firms have a level of profitability equal to or above their larger peers.) What is clear in many of the firms outside the very top level is that they are too broadly spread in terms of client types and practices: they have too many practices that are not ranked highly by clients and are below the firm s average profitability (and significantly so in many cases) and too many clients that are not profitable (or with low profitability). This is linked to a lower level of competitiveness and profitability relative to their higher ranked peers. The belief in the redundant notion of full service along with partnership constraints, leads them to retain these practices in the belief that they will lose clients if they cannot offer them a wide range of options. This belief is not borne out by client surveys, which regularly and clearly show that clients buy only the practices that they perceive as strong from a firm, not everything, and the success of the more focused firms is further evidence of this. Firms also hold onto clients that are not strategic (and unlikely ever to be) and which generate lowto no profit in the belief that one day one of them will become another Google. As a consequence a considerable amount of time and effort is spent on non-strategic work and clients, taking partners away from deepening their relationships with strategic clients and building more competitive practices where it really matters. A major challenge for many firms is to clarify their strategic position in terms of the types of clients on which to focus and then the core practice range in which they need to compete in order to build a strong profit stream from these clients. The remaining practices fall into two groups: the practices that are necessary to support the core, and the nice to have but non-strategic practices. The support practices can then be restructured into a size that allows them to play the support role profitably; the nice to have practices will need to be disposed of over time as they are often lowprofit, and high-maintenance in terms of management time. The same tactic applies to clients. There is a need to reduce the client base and to focus attention on those with which the firm can really grow and develop its position. These are tough decisions to make within a partnership model, as the decisions mostly require partners to support a strategy that would see the role of many partners change within the firm, and would see other partners being asked to leave. This is not easy to achieve within a partnership as many firms have found and this raises questions about the decision-making processes in modern partnerships (see below). Nevertheless, the choice of focus is one of the most critical strategic decisions that many UK firms are still to take. Those that achieve this strategic shift, away from a full service business model, are far more likely to succeed than those who continue with the full service approach. Report on the State of the UK Legal Market Page 8

10 Buying power shifts to General Counsel and to the Head of Finance General Counsel and their teams in major companies and institutions have long moved away from using a single law firm as the sole legal adviser for their business. Many in the past went too far the other way and appointed numerous panels of firms. The move more recently has been back towards a limited range of firms appointed for their specific strengths. General Counsel, often having worked within law firms, see private practices generally as inefficient. This is based largely on their experience in moving to an inhouse position and seeing how efficiently a business can be run. GCs are looking to firms to improve their efficiencies and, as a result, reduce prices; and are forcing firms to accept increasing discounts to achieve this. (Procurement staff in many companies are also active in connection with this.) The Law Society reported that in 2013, on average, FTSE 100 companies conducted business with six solicitor firms ranging from one firm to 23. In-house legal departments have faced budgetary restrictions in recent years and this is another powerful driver in their quest to reduce the cost of legal services. Given the business model of most law firms, fee negotiations usually take place after the work has been done and the cost incurred, so any discounting of standard rates directly reduces the firm s profit: an unsustainable position for any business in the medium term. There is an increasing move towards fixed prices, or estimates based on a few key assumptions, although this is not yet dominant in the market. Many clients are still trying to ascertain what the market price of many services should be, and law firms are struggling to provide accurate estimates and then to manage the work so that it produces the required profit margin at the quoted price. In our view, however, this will be the long term pricing model for the provision of most legal services, and firms need to understand the changes required in their business model if they are going to have a profitable business. At present too many firms are providing fixed prices but then managing the work as if under an hourly-rate contract and this is a sure way to lose profit. Internationally, a few companies have already chosen a way to outsource all or most of their legal work to a panel of firms, each firm being present for only one or two practice areas. For example, Pfizer allocates firms on its panel a fixed annual budget: each firm is paid one twelfth of that budget each month. In return, the firm must accept what ever work is given to them within their area of focus: if the work in a year at standard rates is less than the budget then they are in front, but, if it is more, then that is the law firm s problem not Pfizer s. In this way the client knows in advance what its legal spend will be each year, and it is up to the law firms to implement changes in their business model so as to increase the value they add for the client but also make a profit for themselves. A number of companies are implementing variations on this model. Report on the State of the UK Legal Market Page 9

11 Another type of client power shift lies in how quickly lawyers invoices are paid. Delays in payment are caused not only by the General Counsel in a client organisation, who challenges the invoices (and hence the underlying pricing of the law firm a top priority area for development), but also then by the Head of Finance: invoices which have been disputed by the GC, and which have therefore not been paid within standard term deadlines are increasingly likely to fall foul of evermore aggressive cash management practices. Add to this a law firm s inability to invoice their work promptly, and there is a risk of lock-up times growing significantly. According to PwC s 2013 survey of UK firms, the average lockup time (unbilled work in progress plus debtors) increased from 107 to 111 days the power and pressure continues to grow on the client s side. It is not unknown for firms to invoice 25% of their annual fee income in the last month of the financial year. Is it any wonder that disputes over charges occur given the time between doing the work and invoicing for it? Hence law firms face three challenges around profitability in a demand-driven market. One is to match the price to the value perception of the client ahead of doing the work rather than discounting after doing the work. Having done this, the second challenge is to manage the cost of doing the work so that it meets the price for the client and the target profit margin for the firm. The third challenge is to develop cost structures that differentiate the cost base of work types given the perceived value of each work type in the firm s market. The critical challenge in all of this is for lawyers to understand the client s price range before starting the work, and to then ensure the process for doing the work is as efficient as possible without reducing the quality and value to the client below what is required. On top of all this, there is then the challenge of invoicing clients promptly and speeding up payment. Implementing actions to address these issues will require major changes in the business model of a law firm. Who has disappeared from the Top 200 in the last two years? Only six firms in the last two years have managed to climb into the UK 200 without a merger. Six names have disappeared from the UK top 100 since 2011, all of them through mergers while regional firm Cobbetts entered administration and their assets were acquired by rival Manchesterbased law firm DWF. (Halliwells collapsed in 2010 and numerous smaller firms outside the top 200 have either collapsed or been forced to merge over recent years.) Six firms dropped out of the UK Top 200 in 2012, although another nine firms disappeared but effectively stayed in the Top 200 as a part of a merger. Clearly the pressure is on many firms to hold their position at the larger end of the market and a number are doing so only through merger. This points to further consolidation at the upper end of the market. If firms seek to compete across a relatively wide range of clients and practices they will only be able to do so if they retain scale in core practices, and this will require a constant addition to overall size unless they cut back in noncore practices. Report on the State of the UK Legal Market Page 10

12 Market dynamics are driving changes in profitability in the Top 100 The profit per partner dynamics of the UK Top 100 firms from 2011 to 2013 illustrate essential changes within specific segments post-financial crisis. While the average PEP (excluding Magic Circle, IBL and Specialist firms) remained constant at around 350,000, different segments of the industry have shown distinct trends. As can be seen in the graphs below, a significant upward trend in PEP is maintained within the Magic Circle, London Business law firms, Retail, and Specialist I firms (the latter being the most successful focused specialists). From our strategic work with some of the top City law firms, we know that a number of London Business law firms have worked on profitability improvement in recent years. This is an example of these market players reacting within a static market to address market-driven pressures. Conversely, National law firms, Regional law firms including (for these purposes) Scottish law firms saw slight decreases in PEP over , with International Business Law firms and a second group of specialists (Specialist II) maintaining stable profitability. This again illustrates the pressure on the middle market: the IBLs managed to keep their PEP stable while the more local mid-market players faced reductions in PEP due to their limited ability to bring in higher value work and/or due to their cost structures being out of line with their pricing , , , London Business National Regional Regional Scottish Regional Insurance Pl Specialist II Grand Total 400 IBL Magic Circle Specialist 1 Average of PEP-2011 Average of PEP-2012 Average of PEP-2013 Average of PEP-2011 Average of PEP-2012 Average of PEP-2013 These changes in PEP are the outcome of a number of factors and actions, including market competitiveness, strategic market positioning decisions, reviews of management models, and international capabilities, to name a few. Indeed, leverage (the number of associates per equity partner) is one of the factors, illustrated by the measurable data and this factor speaks for some fundamental changes taking place. Average Leverage IBL London Business Magic Circle National Regional Regional Scottish Retail, Insurance, Pl Specialist I Specialist II Grand Total Although the total average leverage rose slightly from 5.84 to 5.97, the graph below illustrates much more significant changes in leverage within individual segments. Almost no segment kept leverage constant over the last two years, suggesting that law firm management teams are active in making significant changes in staffing and legal operations (with the Magic Circle being the segment with the least change in their leverage). With the legal market reaching maturity in a period of limited economic growth, many firms appear to have returned to operational and economic restructuring to maintain their desired profit margins under conditions of harsh price competition. Report on the State of the UK Legal Market Page 11

13 Analysing the correlation between changes in leverage and changes in PEP (2013 vs 2011) reveals a positive relationship overall (see the graph below) as would be expected. Only the IBLs (-6%) and National law firms show a negative relationship between profitability and leverage perhaps indicative of the pace of expansion within those segments. Correlation: changes in leverage vs changes in PEP (UK 100) 80% 60% 51% 63% 40% 20% 0-20% -40% -6% IBL London Business Magic Circle National 24% Regional 6% Regional Scottish 29% 29% Retail, Insurance, Pl Specialist I 35% Specialist II Grand Total 24% -60% -48% To understand better the middle market, it helps to look at a more detailed graphical analysis of Leverage vs PEP for its three key segments: London Business law firms, IBLs and National law firms. The chart below illustrates that the majority of these firms appear to be underweight in profitability and leverage. Leverage London Business, IBL, National Law Firms DWF leverage PEP Bond Pearce Hill Dickinson Bevan Brittan Average: 454 Forsters Field Fisher Waterhouse BLP Dickinson Dees Charles Russell Farrer & Co Addleshaw Goddard Lawrence Graham Gateley Trowers & Hamlins KWMSJB Osborne Clarke Stephenson Harwood Speechly Bircham Mills & Reeve Lewis Silkin Nabarro Simmons & Simmons Bircham Dyson Bell Wedlake Bell Fladgate HowardKennedyFsi Pinsent Masons Kingsley Napley Taylor Wessing Winckworth Sherwood Olswang Eversheds Herbert Smith Freehills Bird & Bird Clyde & Co Ashurst Hogan Lovells CMS Norton Rose Fulbright DLA Piper Mishcon de Reya Travers Smith Average: 7.7 Macfarlanes Profit per equity partner ( k) Report on the State of the UK Legal Market Page 12

14 The firms on the top right of the chart, e.g., Mishcon de Reya and Eversheds, use their leverage to generate above average profitability. The firms on the bottom right, e.g. Macfarlanes, Travers Smith and Ashurst, have below average leverage but above average profitability because of their higher value mix of work. Firms in the top left of the graph, such as Bond Pearce and Pinsent Masons, clearly have sufficient leverage but have yet been unable to generate above-average profitability. Indeed, a number of high leverage firms need to review their cost structures, because high leverage itself is only part of the answer to achieving competitive profitability. (Firms with high leverage but lower profitability need to either reduce unit costs, raise revenue per lawyer or both.) The bottom left of the graph on page twelve holds the majority of firms: they face the challenge of how to develop a more competitive position either through higher leverage with maintained profitability per lawyer or with the same leverage but aiming to get higher value work from the upper mid-market, or combination of both. The indisputable fact is that some law firms are making a number of significant changes and decisions and that, for any firm, aiming simply to maintain the status quo is no longer a feasible way to stay competitive, maintain accustomed levels of PEP and attract good quality legal talent. What to do? Consider your business model Outside of international growth (as noted before), law firms that seek to grow above the market rate can only fight for and take market share from other law firms. Locally, there will be a significant reshaping of markets, with few firms remaining full-service as that term is currently understood. The apparent current overcapacity in the sector will be addressed through restructuring. There will still be a place for smaller local firms, but these will need to offer distinctive quality in service delivery and in client relationships. Firms will focus on specific practices and client types, and many will have a strong industry focus. Opportunities to practice under new business models, the arrival of multidisciplinary practices and Alternative Business Structures (ABSs) will change the middle and high-street markets. These issues illustrate both the arrival (new entrants) and evolution (existing firms) of a new business model. As clients became educated enough to negotiate fixed pricing by each value category relevant to them, so new business models become necessary to adjust for the transfer of business risk from client to firm. Clients are creating an environment in which law firms are under pressure to provide more certainty about the end price of the work they carry out for clients, and that means firms accepting some of the risk in terms of profitability. More international players are expected to build presence in London, more likely through transatlantic merger than through significant local investment. More specialist firms will emerge, and some will have a global capability in their specialism. Report on the State of the UK Legal Market Page 13

15 An effective business model thus sets out in detail the way in which the firm intends to deliver value to its clients, and in such a way (a predefined process) that each client is prepared to pay the price that provides the firm with its targeted profit margin, given the anticipated cost of doing the work. Hence the new business model must be based on the demand side of the business: on what clients want and value, how they want it delivered, and how the firm can organize itself to meet those needs better than its competitors could. Because of an (almost) inevitable segmentation, firms which seek to be full service will become increasingly uncompetitive across a range of practices, and this will depress overall profitability with a consequent negative effect on investment and growth. Firms will continue expanding their core practices: client interviews and buying patterns demonstrate clearly that in choosing between peer firms where there is a significant difference in the size of a practice area, a client tends to favour the firm with more depth in a practice. In the context of globalisation, firms that wish to remain domestic need to re-think their strategy and either focus on a smaller range of practices, in which they can match or outperform any competitor, or retain a broad base of practices but move their client focus to more domesticallyfocused client types (and this is likely to mean smaller clients). Many firms will decide to shrink rather than grow, abandoning unprofitable and unaligned practices, moving away from a full service approach. Successful firms will have implemented efficient work processes and will be able to meet the rising pressures on pricing while maintaining healthy profit margins. Many other firms will disappear, either through merger or, unfortunately, collapse. Within all of this there will be a drive to reduce the cost of doing the work, allowing a firm to meet the client expectation of value while remaining profitable. Work processes will be more standardised and will utilise technology to be so. Standard templates for carrying out the majority of work types will become the norm even in higher value work. These templates will be capable of adaption to suit specific circumstances but will provide an efficient basis for carrying out the work. In the new business model, the role of a partner will change and new skills will be required. Pricing and cost issues make it uneconomic for much of the work to be done by partners, and the partner role will focus more on managing the quality and profitability of the work and the people, as well as business development and client relationship activities. Leverage will increase for most firms, as fewer partners will be required to generate a given revenue, given the change in their role. Firms that succeed will be bold and guided by a clear strategy of targeting a specific value segment of the market. They will develop themselves in one of four directions (two of which result in growth, two in contraction): 1. Grow organically, through lateral hiring, and/ or acquiring entire specialist teams; 2. Merge with another firm where there are clear strategic benefits to both parties; 3. Focus the business on several core areas, abandon unaligned practices and those which cannot generate the targeted profit margin, and provide the remaining practices as support to the core; 4. Specialise narrowly by type of work, client and/or industry. Every other profession has had to come to terms with the above choices, and many law firms will need to adopt fundamentally new ways of thinking. This process will start with partners, who need to deliver on a strategic agenda which will be difficult, but which can be managed if addressed systematically and rigorously. Report on the State of the UK Legal Market Page 14

16 Who can achieve this by 2018? Welcome the new partners Law firms deciding and doing actually means their partners deciding and doing something specific. There seven areas on which partners need to focus and reach agreement among themselves to ensure the success of their firm in any market position: 1. Ensure there is clarity of strategic positioning and related strategy and its acceptance within the firm along with a supporting business model; 2. Achieve competitive levels of performance financial but also across a range of other key activities; 3. Implement processes to ensure work is done cost-effectively while meeting profit targets; 4. Develop effective, structured and disciplined business development and client relationship programs appropriate to the strategy; 5. Develop an economic structure for each practice group, directed to its role in the firm s strategy; 6. Articulate and manage a set of acceptable behavioural standards; 7. Implement lean and effective management structures and processes, and recognised these as part of the path to success. Any combination of the above will require rigorous decision-making in a tough environment, and the speed of arriving at decisions will be vital. Too many firms decision-making is constrained by frequently needing to seek consensus across the entire partnership, thus unnecessarily delaying important decisions, and often resulting in compromises which may not be in the best interests of the firm. Many firms have begun the process of changing their historical consensus management model (often in frustration derided as the lowest common denominator ) into something more akin to a corporate model, wherein shareholders are not involved in decision making, but rather delegate their rights to an elected and trusted management body within a firm. This allows for constructive decision making and saves time searching for common agreement and compromise. This also means that partners can only fire the decision making board if they are not happy with the results arising from the decisions of the main governing body in the firm. While management will need to consult about difficult decisions, they will have the power to move quickly when necessary. Law firms will become more akin to legal consultants, with a major change in the role of partners. As firms change their strategies from full service to a more focused approach, much greater standardisation and delegation of work will be needed, utilising technology appropriately and most likely extensively. All partnership thinking will have to be shifted to a demand- rather than a supply focus and demonstrate a number of New Law features. Finally, partner remuneration systems will need to be restructured, allowing greater retention of earnings for investment. All of this requires significant behavioural change in a law firm and most firms lack the decision-making processes successfully to reach agreement on the required changes through their partnerships at present. Partners natural conservatism often leads them to opt for the status quo until such time that a crisis renders this impossible. This makes it difficult even to achieve a clear strategic focus, let alone implement the many other changes required to pursue it. Firms will move to a situation where partners are more working shareholders with limited decision powers. Well trained management will be given the power to take key decisions without reverting to the partners. The management team will to some extent operate more as a board in a company elected for a period of time with extensive powers. Report on the State of the UK Legal Market Page 15

17 Key trends for the future The slow growth of the UK economy will drive more domestic consolidation as firms seek a stronger strategic position. International expansion will continue; More boutiques and niche firms will emerge; Law firms will increasingly seek to expand their geographical reach to mirror that of their existing clients, whether domestically or abroad; Clients business activity will be driven by the current generation of emerging economies, and the next generation: Indonesia, Mexico, Turkey, North Africa and South Africa; Real profits of UK businesses across the economy are predicted to grow by 1.6% per year by 2015, and by 3% per year until Real net exports of UK legal services are expected to grow by 6% per year by 2015 and by 6.5% per year by 2025; The successful firms in any market position will increasingly adapt to a new business model that reflects market demand more accurately; ABSs, public listing and private equity will drive the new delivery models; Firms that succeed will be bold and guided by a clear strategy. If we want things to remain as they are, things will need to change. Giuseppe di Lampedusa, Il Gattopardo (The Leopard) Report on the State of the UK Legal Market Page 16

18 About Hodgart Associates Hodgart Associates is a specialist consultancy offering strategic and organisation development advice to professional service firms, primarily those in the legal, accounting, property advisory and funds management sectors. Alan Hodgart established the antecedent firm in 1990 and has continued within this specialist focus throughout the period since. The Firm is recognized by the market as one of only two or three leaders in this segment globally. Our consultants bring a deep and insightful understanding of the trends and competitive forces in markets at all levels and are able to interpret these trends at a regional or local level. We also bring an understanding of existing and innovative business models currently under consideration by the market and are able to guide our clients through the necessary transitions. The approach taken is fact-based, drawing on evidence from our extensive, unique and proprietary databases, supplemented by specific data collections for each engagement. We have a proven capability and willingness to assist with the implementation of our advice, thereby enabling our clients to achieve their ultimate goals. We apply proven methodologies along with sound business principles and theories in coming to our conclusions and solutions. We are flexible in their application and recognize that these need to be tailored to the unique situation of every client. We do not repeat the results of one engagement for another. These factors have enabled us to build a long list of clients that have utilized our services over many years. While Alan Hodgart is a regular speaker at major conferences and the firm publishes a significant amount of material, over 60% of our new clients come via word of mouth. This includes new clients from all over the world. This demonstrates that we are able to build long term relationships with our clients and is also a testimony to the quality of our work. We exercise the utmost discretion and confidentiality with our clients. We only reveal the name of a client with their permission or where they have already and deliberately made our work with them public knowledge. We do not discuss any aspect of our work within a client other than with those people with whom our client has asked us to do so. We are happy to have a no-obligation, no charge initial discussion about issues of concern to firms. Please do not hesitate to contact us in the event you just wish to talk an issue through with an external source. For more information, or to subscribe to future newsletters, please visit: Report on the State of the UK Legal Market Page 17