Game Changing Mergers

We have seen very few mergers in the U.S. that could be categorized as “game changers” — that is, a merger that dramatically changed the competitive landscape.  Sure, we see lots of mergers where two firms from contiguous states double their size through a merger; but, as the old horse racing saying goes, “You don’t make a fast horse by harnessing together two slow horses.”

By contrast, look at what has happened in the international marketplace over the past twelve months or so.  Norton Rose has tied together dominant firms in the UK, Europe, Canada, South Africa and Australia –- all with separate profit pools -– and they are rapidly moving toward gigantic mergers in the U.S. and China.  Malleson’s merger with China’s King & Wood instantly created a dominant Australasia competitive position; the new firm is likely to soon announce major American and British mergers through their multiple Swiss Vereins.

An equivalent “game-changer” within the United States would probably not be the creation of a giant firm with offices in every major city.  Instead, I suspect it will play out as the consolidation of large, respected firms in second- and third-tier markets consolidating with leading large regional firms in capital market centers.

Consider, for example, if Faegre Baker Daniels (the result of the recent merger of Faegre & Benson and Baker & Daniels) were to merge with Chicago’s McDermott Will or Jenner & Block.  The result would be a Midwestern powerhouse that serves a distinct regional client base.  It would immediately change the competitive marketplace in Minneapolis and Indianapolis and create a whole new level of marketplace dominance in which even other Chicago firms would have to scramble to keep up.  The problem, of course, is the firms’ difference in profitability.  In 2011, according to the AmLaw rankings, Faegre had PPEP of $530,000, while Baker & Daniels was at $520,000.  McDermott and Jenner, on the other hand, were both in the $1.4 to $1.5 million range.

It is worthy of not that, over the past several years, almost every major international merger has been accomplished through the use of a Swiss Verein.  These “partnerships of partnerships” permit firms to create a common operating and marketing platform without sharing profits or liability.  The argument against such mergers is that the resulting entities are not “proper” law firms.

A lot of the merger consulting I’m involved in has to do with helping firms create short lists of potential merger partners to meet their unique criteria.  We create all sorts of quantitative rating factors but one of the primary issues is always compatible profitability.  Now, I have always subscribed to the conventional wisdom that merging firms must have profits per partner within about 20 percent of each other if they want to have a prayer of getting a merger through.  The reason, quite simply, is that the partners in the firm with the higher profitability will fear that a merger with a less profitable firm will dilute their own compensation.

Applying such absolute tests for merger viability has resulted in a marketplace where a significant number of mergers make no strategic sense. They provide little value to the clients of the participating firms and solve none of either firm’s driving issues – except, perhaps, that the combined firm has more lawyers in more cities and can rank higher in the AmLaw listing.  Look at the announcement of any significant law firm merger.  The managing partners always talk about how similar the two firms are, which means that their lawyers seem to get along, they don’t have any big conflicts and…wait for it…they have similar profits per partner.

In fairness, this old-school criterion for mergers hasn’t worked out that badly.  It’s common for consultants and bloggers to talk about failed mergers, but in truth, most mergers have worked out pretty well.  Of course, we can’t speculate on the road not taken but merged firms have, by and large, survived and even prospered.  Okay, there was Dewey & LeBoeuf, but that merger actually made some strategic sense when it occurred — we’ll chalk that one up to an implementation failure.  Indeed, many merged firms have gone on to engage in multiple additional mergers.

Profit Pools

But if separate profit pools could facilitate competitively advantageous mergers, would the resulting firms function as collaborative organizations?  A number of U.S. law firm mergers started out with each firm maintaining its own pool of profits for the first several years of the merger, with the intention of converting to a single pool over time.  In some cases, that occurred; in others, the firms elected to remain as separate financial entities.

But the best experience base is in Canada, where until fairly recently, multi-provincial law firms were not permitted.  As a result, firms banded together to function under a single firm name, but otherwise remained independent.  Ever since a change in most Canadian law societies’ regulations permitted national law firms, most multi-provincial firms have fully merged; but a significant number continue to operate as separate profit centers.

From both the U.S. and Canadian experience with separate profit pools,  as well as the increasing number of international Swiss Vereins, there are several primary operational issues that are most often cited as problems with separate profit pools:

Practice Silos – If partners in one part of the law firm do not economically benefit from sharing work, there will be s tendency to create siloed practices in which individual lawyers function as free agents, do most of their work themselves, and only bring in other partners and associates when required by the need for specialized expertise or the volume of work.

Slower Revenue Growth – One of the principal advantages of a merger is the growth that is stimulated by the addition of new resources and client contacts.  This does not occur as naturally without a single profit pool.

Lack of Cross-selling – Introducing a client to a lawyer who is not economically tied to your practice represents a risk to the referring lawyer that the client could be lost if not well served by the referral.  Without justifying benefit opportunities, the risk is not worth taking and cross-selling is unlikely to occur.

Inconsistent Pricing – One of the primary reasons that firms have different levels of profitability is their pricing structures.  Typically, less profitable firms have lower hourly rates.  The use of separate profit pools eliminates the need to rationalize rates between merging firms, leaving differences to continue and often become exacerbated.

Inability to Exercise Firm-wide Management – The absence of a common compensation system makes it more difficult for a consolidated firm’s management to implement firm-wide consistency on such basic issues as administrative procedure, quality standards, work ethic, and client service.

Five Keys to Making Separate Profit Pools Work

Make no mistake, putting together a consolidated law firm with separate accounting systems is hard – but it’s not impossible.  Indeed, as we look at many national U.S. law firms, especially those with offices in vastly different economic markets, (e.g., New York City and St. Louis), we see completely different levels of profitability  driven largely by differences in work ethic and billing rates.  While operating as a single profit pool, the effective result of the way many of these firms view their compensation systems is to, at least subjectively, see different offices in separate pools.

Firms that actually operate with separate profit pools tell us five primary keys to making such systems work.

1. Complete consolidation as a goal.  Wanting to move toward single-firm status seems to be an important value.  Even if separate profit pools for compensation purposes is expected to be part of the long-term system, the firm must be committed to functioning as a single organization.  Failing this, the firms will naturally move farther apart in every way in which the separate units practice law and manage themselves.  One way to address this is to set a goal that when the comparative per-partner profits of the two pools come within a certain percentage of each other, the pools will be merged.
2. Two pools, one set of standards.  Simply because the firms maintain separate accounting systems for determining profit does not mean the compensation systems need to be different.  A single set of standards for working lawyer contribution, origination and client management will have the effect of drawing the firms together.  This includes common (or at least overlapping) compensation committee membership.
3. Compensation standards that stress collaboration.  The key to getting partners to use lawyers from different locations is to reward them for the effort, to the extent that it is more valuable to them to use someone in another office than a lawyer in their own profit pool.  As one managing partner of a recently merged firm said, “You have to remove any disincentive that partners can cling to as a justification for not collaborating, even if you have to overly reward them for cross-selling.”
4. Have a single firm-wide CFO.  Avoid dueling finance people, each trying to make their profit pool bigger at the expense of the other.  A good finance person will be able to build a fair expense allocation and financial report system that transparently reflect the operation of each profit pool.
5. Strong practice group management.  The real key to building a single collaborative law firm is making the practice group, rather than the office, the primary organizational component of the law firm.  Even with separate profit pools, strong practice groups (and practice group leaders) will drive collaboration in engagement, management and increased cross-selling, as well as greater uniformity in work ethic and pricing.

Without question, separate profit pools are awkward and make the consolidation of two law firms more difficult.  But if they can drive mergers to dramatically enhance their firms’ market positions into higher levels of dominance, I believe it is worth the effort.