According to the self-assured analysis of McKinsey, there are only six types of successful acquisitions. Cutting directly to the chase, they are:
- Improving the target firm’s performance;
- Removing industry excess capacity;
- Creating market access for services;
- Acquiring skills faster or cheaper than they could be developed internally;
- Exploiting economies of scale; and
- Picking winners early.
We’ll get to these momentarily but first McKinsey volunteers a few harsh words on how most acquisition “strategies” are mere cosmetic puffery, including “growth” per se, They also voice skepticism about the strategy “of record:” “the stated strategy may not even be the real one: companies typically talk up all kinds of strategic benefits from acquisitions that are really entirely about cost cutting.” A more recent column asserts that “at least 60% [of mergers/acquisitions] are expected to fail” and provides the author’s own analysis of our Six Type taxonomy.
But shall we look at each of these categories and map whether it does or even can make sense in Law Land?
- Improving target performance: This is what private equity does at its best (what it does at its worst is topic for another day), but consider how exactly they often go about it: They find firms operating with low profit margins and high cost bases, where even small improvements in efficiency can provide an outsize boost to profit margins. A firm with a 6% margin (94% of revenue going to costs) can enhance its return by 50% simply by cutting costs to 91% of revenue (a 9% profit margin). But a firm with, say, a 35% margin going in–far more representative of Law Land–would need to cut costs by 22% percentage points (from 65% to 43%) to score a 50% gain in margins (35% to 52%). As McKinsey drily observes of an example close to this latter scenario, “That might not be reasonable to expect.”So we can file #1 as “not applicable,” or “not realistically available,” to us.
- Consolidating to remove excess capacity: Completely surreal in our world. A manufacturing or extraction company can buy plants or mines and shut them down and they obligingly stay shut down. A law firm that acquires another firm’s lawyers in order to RIF them finds those people back gainfully employed in very short order indeed.This would be a delightful approach, by the way, were it feasible: We are suffering from a long-term surfeit of excess capacity.
- Accelerating market access for services. Here the prototypical examples are Big Pharma acquiring a boutique drug company and giving it access to a monstrous sales force, or IBM scooping up software and hardware companies (43 for an average of $350-million apiece from 2010 to 2013 alone) to push their wares through IBM’s global sales force.Not really the way we do things. To be sure, headhunters and some consultants will happily talk about access to a superior “platform,” but in our experience that’s exactly what it is about 95% of the time: Happy talk. Very rarely are clients seriously stymied at finding the truly talented lawyers in the sub-specialty of legal expertise they have a need for again and again. The exceptions are typically lateral moves of superstar individuals or tiny groups who for reasons of compensation firepower, cultural tension, or simple wanderlust no longer feel they belonged at their original firm. But thinking you can acquire 100 or 400 perfectly competent lawyers and materially increase their visibility and productivity by having them on your website and with your business cards is nonsense.
- Buy skills faster than you could build them. Finally here we have a strategy with teeth for Law Land. It can take forever and be excruciating, house-by-house combat to build a greenfield practice by lateral ones and two’s. Small group moves are better, but if it’s a practice that requires a critical mass of adjacent and supportive expertise, why not acquire the whole shebang and be done with it? Not only is it faster, it’s safer, inasmuch as the people at the acquired firm have demonstrated that they can actually work together for an extended period of time (no guarantees–your firm’s mindset, unspoken assumptions and priorities, and technology-finance-marketing-operational infrastructure is going to be very different, no matter how hard you try).
- Exploit scale. Great idea, if there were such a thing, but there aren’t “economies of scale” in the true sense in Law Land, so this is alas not available. Doubt me? The proper definition of scale economies is that average costs fall as output increases, but since when was that true with highly skilled professionals still (largely) billing by the hour?
This point is a bit subtle, and bears some elaboration. Economies of scale typically arise when fixed costs–which don’t vary with output–can be spread over more production. But a law firm’s fixed costs are not large, with the arguable exception of office space, and that of course isn’t really “fixed” at all as you substantially add more professionals and staff. Similarly, “economies of scale” can come into play when there is some fairly hard minimum scale of output before having a going business is even feasible at all. No car company, for example, could exist economically on production runs of a few hundred or thousand cars per year. (Don’t get cute and argue that Ferrari and Aston Martin, for example, do that very thing; we’re talking about economies of scale, not minimum conceivable scale if price is no real object.) Finally, many scale economies arise from physical realities or engineering; for example, it really only takes two to three pilots to fly a commercial airliner, whether it’s an Embraer regional jet or an A380 double-decker.
The final point is one that can also be confused with scale economies, and it’s the simple but hard reality that even in law firms, with more you can do more: Larger firms with more lawyers and higher revenue can hire more business professionals, or more sophisticated ones, or invest in purpose-built technologies more cost-effectively, or profit from word of mouth and brand name awareness simply by virtue of their sheer size.
The last word from our McKinsey friends on this particular topic helps make my point:
Some economies of scale are found in purchasing, especially when there are a small number of buyers in a market with differentiated products. An example is the market for television programming in the United States. Only a handful of cable companies, satellite-television companies, and telephone companies purchase all the television programming. As a result, the largest purchasers have substantial bargaining power and can achieve the lowest prices.
While economies of scale can be a significant source of acquisition value creation, rarely are generic economies of scale, like back-office savings, significant enough to justify an acquisition. Economies of scale must be unique to be large enough to justify an acquisition.
Finally, picking winners early and helping them develop their business.
The number of law firms that actually do this as asymptotically close to zero, but we think it’s an unexploited opportunity.
Note that we are not talking about identifying other law firm winners; hundreds and hundreds of boutiques are started every year and picking winners early on in that area is a mug’s game. Once they succeed, then you might learn something from what they did, but otherwise you’re not only looking for the needle in the haystack, you don’t even know what color or how long the needle is. (What if it’s hay-colored and hay-length?)
What we are talking about is picking industry/sector winners (high potential growth areas) early and growing an expertise there to exploit them when they ripen–before they become obvious and the talent gets expensive and picked over.
In the course of a conversation with an AmLaw 100 partner in Asia the other morning, the question arose of how an outside firm decided to open a new office in a major US city about to experience a widespread wave of bankruptcies among a leading local industry. “How did they know to do that? What did they know that we didn’t know?” (It helps to know this is a city where my interlocutor’s firm has an established office.) “Business intelligence professionals,?” I hazarded a guess.
So how many business intelligence professionals are on your firm’s staff? Do they get the resources they need? Do you listen to them? Do your partners ask them probing questions? How much rope do they have?
Thinking about a merger or acquisition? Ruing a past one?
If your questions about the potential transaction have not focused on hard questions around business fit and business rationales, but on things like “would I want to have a beer with this crowd?”, we can only counsel realism. And taking a brief, instructive, tour of failed corporate mergers for pointers.
Bruce, a recent transaction in Seattle may be an example of a combination (not a merger) that is somewhere between 4 (buy skills) and 5 (exploit economies of scale). A real estate practice group of 13 lawyers left a smaller firm for a larger firm. The larger firm already has the capacity to serve that field. It picks up perhaps a few skills; more importantly, it acquires the ability to handle even larger transactions than those it already does. As for economy of scale, I wholeheartedly agree with you that there is no economy of scale in a law firm, at the macro level: i.e., the overhead per lawyer of a 500-lawyer firm is higher than the OPL of a 100-lawyer firm, which is higher than the OPL of a 50-lawyer firm, and so on. But for small changes in firm size there may well be an economy of scale: there may be sweet spots among the lemons. For example, I can expand my firm by 50% (going from 2 lawyers to 3) without renting more space or hiring more staff. My OPL will decrease by 30%. But if I hire a 4th lawyer I then do need to hire another staffer and rent more space; my OPL goes back up. It may be that some practice group acquisitions are small enough in relation to the acquiring firm that the acquiring firm’s OPL decreases, or at least doesn’t increase. The firm may be able to accommodate the practice group in its existing space. It may hire the legal assistants of the practice group, but not need to hire more accounting personnel, receptionists, file clerks, and other support staff. Those acquisitions may actually be accretive to earnings.
There’s another reason that McKinsey overlooked. As the marketing classic by Trout and Ries, “Positioning,” advises, perception vanquishes reality in the fight to get customer mind-share. Getting big to be seen as the elite or “nobody ever got fired for retaining” firm in your market can become a self-fulfilling prophecy.
Now, this strategy can get pathological — see Dreier LLP or Finley Kumble. But note how until their falls those firms were lionized by the legal press and attracted paying, if not the most blue chip clients. A rational AmLaw 200 firm or even AmLaw 50 firm could conclude that bulking up with marquee laterals and scrambling for mindshare, as long as costs are somewhat under control, is the only possible strategy.
Great contribution; thanks. Clearly you well understand the odd dynamics of the law firm market.
“Brand perception” studies a la BTI or Acritas will frankly tell you, if you ask (we have, trust me) that simple recognition is highly correlated with scale/global footprint and often not at all or only loosely with quality or sophistication of service delivery.
This is a type of market failure that (touche!) firms like Finley Kumble and Dreier (and surely others under our nose today) are hoping to exploit.
Without editorializing, I would venture that DLA has employed this strategy (grow big fast, then clean up quality) in a case study fashion. The second part is the one that requires business and cultural discipline, which is why you so rarely see it.
And DLA could still blow up!
Thanks again for writing,