One thing you can count on when two law firms merge is that neither one buys the other. I use “buy” in its simple and core sense: Nothing is obtained in exchange for payment.
No cash changes hands; no stock is exchanged, no assets are purchased or liabilities retired. Viewed by anyone used to dealing with the mainstream for-profit economy and not Law Land’s isolated Galapagos Islands ecosystem, this is simply weird. Now, having trained in mainstream economics, we have marveled at this for many years and we finally decided to ask some of the smartest people we know what’s going on.
By the way, we specify “smartest” not because we don’t as a core belief subscribe to the notion that all lawyers are smart simply by virtue of their stipulated membership in the “lawyer” set, but because we knew we would need to talk to people who could get beyond retorts like “it doesn’t happen” or “it isn’t done” or “things don’t work that way.” We know that, thanks. Those are restatements of the question, not tentative probes toward an answer.
My own favorite explanation, produced by an extraordinarily creative and hard-working corporate and securities lawyer who was for an all-too-brief period in my associate youth my mentor and rabbi, was this hypothesis (I paraphrase): “There actually is an exchange of stock; the equity partners in the acquired firm trade their ownership interest [points] for ownership in the other/resulting firm. I think that’s it.”
This is actually the strongest answer we got. My only reservation about it comes from the economist and not the securities lawyer in me: “Equity” in a law firm has no tradable or market value; it’s the consummate illiquid asset and even saying it represents an “ownership” interest is mostly, to my mind, a metaphor. At least it’s unlike any common form of ownership we’re familiar with in our day to day lives.
Yes, I hasten to agree with you that the voting rights that all but universally accompany equity-partner status are quite tangible, but even that indisputable feature cannot, as they recite, be sold, lent, mortgaged, pledged, assigned, hypothecated, etc. If this is “equity,” it’s the strangest kind of equity I’ve ever seen.
Three perspectives – McKinsey drilled it into me…
1. A very practical answer – the traditional law firm has no retained earnings, nor appetite for major borrowing. They don’t have the cash to purchase another firm, it has to be a share sale, which is exactly what does happen.
The price paid is usually in the rem bands that partners move across at, sometimes with a time guarantee. This is effectively giving the the acquired firm a greater proportion of the shares than a straight merger, so there is an acknowledgement of value implied.
2. Even if there were an appetite to borrow and pay cash, the future firm – ie the acquired partners – would be liable, and hence be taking reduced earnings until it is paid off. (This does happen in corporates, but there is no-one left to complain apart from the creditors/staff if it goes wrong).
If you carve out the loan so only pre-acquisition partners are liable, you create a powerful incentive to exit the firm, moving to one where your income is not reduced by loan payments, leaving a few to bear the brunt of the payments and go bankrupt.
3. Looking at it another way, the Big 4 buy consulting firms all the time. They are never accretive – and cannot be – on a pure financial basis. One in Australia was very acquisitive and was paying around 70c per $1 of revenue. When you look at what is being bought, it is rarely IP that cannot be replicated, clients can move, brand is generally lost – it is really the people – who will expect their income to remain at least flat in their new home.
To be accretive, paying $7m for a $10m firm, would require $7m of cost synergies, or (at 30% margin), $23m of *incremental* revenue.
I have been responsible for some of these acquisitions, and I would not give my support for a cash payment based on a typical financial business case – it cannot add up. There needed to be another source of value, such as driving internal culture change, changing market perception, closing a specific gap in a longer value chain etc. I think most law firms would balk at this sort of justification for a cash payment Vs an equity swap.
The worst answer I heard from a Big 4 CEO was that these mergers were accretive to the future partnership, and that was his responsibility. That is true, but the future partnership includes the acquired group, who have a disproportionate share, so the former “shareholder group” are worse off. I’m not sure how long a corporate CEO would be able to run that argument!
Chris:
Deeply knowing and a large contribution to the discussion; thanks!
The (lack of) retained earnings is an issue we’ve touched on with some regularity here at ASE; when management has no viable choice other than dividend’ing out essentially the entirety of earnings each fiscal year, this a fortiori is the result.
On a somewhat related note, I’m sometimes asked why a P/E firm wouldn’t entertain acquiring a major law firm for its portfolio when the day comes that they could do that in the US (as it surely will); the questioner always adds that the inefficiencies in law firms are so great that surely a competent P/E firm could make short work of increasing margins sufficiently to continue paying the pre-acquisition partners what they had become used to and earn returns of their own.
While this might be feasible from a financial engineering perspective, at least until a new generation of partners (one that we’ve never seen before) with a different self-image around the holy grail of “professionalism” comes along, I can’t imagine any outcome other than all the marketable talent fleeing shortly after the deal closed.
Not a deep dive here but any combination of future opportunity cost with property rights and performance expectations will create a relative economic value that will be as legitimate for use as is for example a share price of something on the stock market, or the competitive price of a house for sale or the next first round draft pick. I leave the formulae to the professionals, but I think it is easier to understand without using “equity” as the first point of reference.
Isn’t the typical equity interest in a large law firm really akin to a preferred equity position with some voting rights over major decisions? Or maybe just a naked profits interest in some firms. Adjustable year to year by the compensation committee of course. I agree, “equity” is a misnomer of almost laughable proportions. And don’t think the younger generation at most firms hasn’t caught on to this. You are going to see real talent leave the law firm rat race when it comes time to decide whether they want to buy their job. No brainer at Cravath. AmLaw 50-100? Depends on the play, but firms are going to have to do a better job selling it than they have in the past.
I would argue the collective action problem you touched on in the second to last paragraph is the real stumbling block. Too many voices in the room to get to anywhere near a conclusive judgment of value. If a law firm really wanted to sell itself, the target would need some sort special committee mechanism in its partnership agreement that could do the normal “fairness” analysis that we see in corporate transactions, no? And it would need to have all of the bells and whistles of impartiality that a corporate special committee has to have to really serve shareholders instead of management (which is usually who stands to benefit the most from a large law firm merger). And still there are major disputes. On the acquirer side, you alluded to the aversion to debt, a common tool in the corporate M&A realm. If you can’t lever the returns, will most deals be able to pencil?
In short, law firm partnerships just aren’t structured to be acquired or acquire.
Maybe a small breach in the wall here in the UK?
Around 5 years ago, Gordon Dadds was a very small London law firm (turnover <$10m). In the meantime they have acquired several other small firms, to take their turnover up towards $50m and got a stock market listing.
Yesterday they announced the acquisition of Ince & Co- a UK Top 100 firm, to take them into the UK top 50. They will not be stopping there.
They have a very carefully created business model – and as per your more recent article, they are definitely "Playing to Win"
Maybe worth you calling in on your next UK visit?