Asessing the M&A landscape for law firms

Considering that at a macroeconomic level the demand for corporate law services is directly tied to the profits of corporate clients, it would stand to reason that as the economy rises, so too would the demand for legal services, which in turn would help ignite the flow of M&A deals. As the economy contracts, on the other hand, deal-making in corporate law firms tends to follow suit. Curiously, however, litigation, workout and bankruptcy practices seem to follow something of an inverse cycle—flourishing as the economy ebbs and tailing off as it accelerates.

There’s also an interesting accordion effect that seems to take place. During periods of growth, you tend to see more partners breaking away to form their own boutique practices. In the aftermath of a recession, however, there’s often a measurable uptick in activity involving firms coming back together to gain economies of scale.

As a result, since the aftermath of the 2008 global financial crisis, there’s been a steady increase in M&A activity amongst larger law firms. Many of these transactions are driven by middle-market firms looking to combine resources to create scale so they can better compete with the AMLAW 200. Less frequently, a seismic pairing will occur within the AMLAW 200, as large national players seek additional scale and expertise to better compete with the Global 100 firms.

Looking across our clients in the large firm space, we’re seeing on average a 5-7% increase in billable rates over the past three years. Firms are feeling compression on their billables, compression on their fees, and steady but relatively flat demand. Yet at a firm management level, there’s an expectation to grow and continue driving the profit-per-partner metric in order to attract skilled attorneys from competitors because clients are still willing to pay premium fees for premium expertise.

Not surprisingly, given the ongoing pandemic and lingering recession (despite the U-shaped recovery of financial markets), 2020 saw a precipitous drop in deal activity: a mere 65 total acquisitions, with more than half of those deals (58%) involving very small firms with five or fewer attorneys.

Even in less extraordinary times, though, smaller targeted acquisitions make up the lion’s share of legal M&A. While large firm mergers of equals can be game-changers, more than 75% of consummated deals over the past decade have involved small firm (2-20 attorney) acquisitions. This makes sense, considering these deals involve far less complexity, are much less likely to derail, and often provide the acquirer with sought-after specialty expertise.

In addition to scale and resources, many middle-market firms turn to M&A as a way to broaden and deepen their platform. They’ve identified client areas of need where they could provide expanded services and they want to capitalize on those opportunities. Adding a specific niche practice group to generate additional organic growth is therefore both attractive and accretive.

Filling a Next Generation Leadership Gap

For small to mid-sized firms (up to 200 lawyers), a merger may offer the most viable succession planning solution. Many firms grew rapidly throughout the 1990s and 2000s, adding a lot of partners during that period who are now thinking about retiring. Unfortunately, this can create a significant next-generation leadership gap that can’t quickly or easily be bridged. A strategic merger, however, affords an opportunity to instantly “up-tier” your firm’s talent.

M&A Success Drivers for Large and Mid-Size Firms

Aside from some clear upfront deal-breakers such as large conflicts around how two potential deal partners position themselves or who they currently represent, a successful merger of larger equals must first focus on the financials and then work its way through geography, approach, practice group capabilities, culture and conflicts.

1. Assessing financial similarities and differences – there are three financial variables (debt, capital and partner compensation structure) that have probably blown up more potential firm mergers than all other factors combined. Make sure you conduct thorough due diligence on how each of the firms manage debt and capital, and how they manage partner compensation. Do pay structures match up closely enough? For example, does one firm adopt an “eat what you kill” partner mentality while the other firm pools income to create a more even distribution? If you try to merge two vastly different partner payment methodologies, it’s going to be a difficult (if not insurmountable) hurdle.
2. Aligning your goals – why are you looking to merge or acquire in the first place? Before you go looking for a dance partner, you need to clearly understand what you’re hoping to accomplish. What particular areas of your practice are you seeking to enhance? What efficiencies do you hope to achieve when it comes to your three biggest expense levers: real estate, technology and people? For instance, do you and a potential partner have overlapping office space in a major metro market, or are there multiple offices within a single “coverable” area that could be consolidated?
3. Ensuring cultural compatibility – before you go out into the market, make sure you have a clear understanding of your firm’s culture so that when you look to identify a potential partner, you’ll be better able to assess whether they’re a suitable cultural fit. Regardless of any other business, operational or client synergies that may exist, if the cultures don’t gel, practice groups will soon start splintering off and the merger will begin to unravel.
4. Committing to flexibility – your goal is to build a firm that will seamlessly weave into a single cohesive entity. So, you can’t be inflexible and firmly entrenched in your processes and procedures with a long list of “taboo” areas that aren’t on the table for discussion. Both firms need to be open and willing to change. Know where the key differences are, and engage in an open and candid conversation about how best to address and blend those issues. “Hey, we really like the way you guys do this and we’d be willing to adopt that practice although perhaps we could slightly modify it to include X?”
5. Gauging partner commitment – it’s important early on to get a handle on how many partners you anticipate losing, as well as ensuring that the partners you most need to keep are all firmly committed to the merger. If either firm is not cohesive and susceptible to losing some of its key partners or practice groups, then there’s a real problem and the likelihood of success will be compromised.

A trusted partner to help bring it all together

Every potential deal involves marrying two distinct businesses that have each been functioning independently for years. That’s going to necessitate a lot of conversations around technology, process and cash management, specifically from a treasury perspective. At Truist, our Legal Specialty Group is adept at helping you take a deep dive into your cash processes from both an Accounts Receivable and an Accounts Payable standpoint, as well as a funds flow perspective.

If there is a difference between capital structures and/or partner capital valuation, do we need to think about enhancing any partner capital lending resources for the combined entity, or is there going to be a capital call that takes place?

Is there new debt that needs to be assumed? Perhaps over the years you’ve built your firm in a very debt-averse way and are now considering a merger with a firm that carries a significant debt load. You’ll need to figure out how to structure that debt and how to recapitalize partners coming in to reflect the considerable debt they’re bringing into the business. Depending on the interest rate environment, you may want to consider hedging interest rate risk when taking on new merger-related debt. The Financial Risk Management group within Truist Securities can assist with that analysis.

From a benefits design perspective, how do you go about consolidating two disparate programs into something that meets the vision for the combined entity? Benefits are very important to all employees.  Make sure to connect your organization to knowledgeable resources in the areas of health insurance and retirement benefits. Find consultative resources to work with you to review current benefits. At Truist, our Retirement Institutional Services team is always ready to work with your benefits professionals to evaluate your retirement plan design and costs. 

Your merger team should be in place very early on in the process, and needs to be able to rely on specialized expertise to help manage the process of combining everything that needs to be combined— from conflict resolution to cybersecurity protocols—so that the new entity leverages the best of both firms. Even if there’s a huge disparity between the size of acquirer and acquiree, every merger presents an opportunity to identify new best practices.