Key Challenges - UK Law 2014

Key Challengesfacing the UKLegal Market

September 2014

• Key challenges to thecurrent business modelof law firms

• The strategic challengeof market segmentation

• Managing successfullyin a buyer driven market

Report on the State of the UK Legal Market Page 1

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 regionsand areas of business, and with the rapid development of emerginglegal markets, the mature UK legal market is facing some severestrategic 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.

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.

42% of UK law firms,surveyed byThomsonReuters in 2014, look set to cutunprofitableservices in thecoming year

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Page 1


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 theglobal industry, and includes almost 12,000 law firms and 127,000practicing 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.


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 butfind this difficult given the competitive nature of that market. Many of their clients are themajor corporates who also use firms in the first two segments, but this group tend to operateat a lower value level than that of those firms. They also have a strong client base in mid-capand 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 aspecific region. These firms view local expertise and connections as key strengths, along withmore competitive cost structures to enable more aggressive pricing. Although oftenunplanned, their very position in the market tends to define the type of clients with whomthey work and the services they provide to those clients. Many of these firms are morefocused than the London- or Nationally-based firms, although this focus has been createdmore 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 smallbusinesses, either as High Street firms or in areas such as personal injury insurance claims. Theformer are numerous smaller firms dotted all over the country, while the latter are representedby some quite large firms who have specialised in insurance claims. Both groups are in veryfragmented segments although consolidation is underway.

4. Specialist focus law firms.

This segment represents the firms with the most distinctive specification of the scope of theiractivities. They concentrate and specialise in a very narrow part of the market, often with broadnational reputations. This segment includes such firms as pension specialists, litigationboutiques and Corporate-focused boutiques.

SpecialistMagic Circle/Global Elite

InternationalBusiness Law

LondonBusiness

NationalRegional

Retail

Other

Depth / Focus

Low High

Size

UK legal market: key segments


5. The Generalist.

This is an “on-going” segment comprising numerous firms lacking a clear market position andfocus in their business. Some of the firms classed as High Street firms would also fit here as theirmarket position is less one of choice and more a consequence of where they have been forced tocompete. These firms will increasingly be less competitive and effective since they lack focus andtend to be resistant to change: their future is highly likely to be difficult. These firms are typicallyundifferentiated in skills and type of work. In size they range from some mid-sized firms in bothLondon and the regions to the very small, mainly regional. They tend be “full service” firms thatcompete for all values of work and client types, and have an economic structure that is notgeared to any particular sector. This makes them too expensive to win lower value work, andthey 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 segmentsspecified above

Travers Smith and Macfarlanes are examples of firms which are clearly London Business Lawfirms at one level, but which compete somewhat differently to many of the others in thissegment. While the two firms differ significantly in many ways, there are some broadgeneralisations that can be made. Both firms have a higher level of profitability than others inthis group and are also significantly smaller than most of the firms in the London group as wellas the Magic Circle and IBL groups. They tend to be more focused on the higher value end of themarket than others and do not present themselves quite as widely spread in terms of practiceline 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 notpursuing work where their size and the lack of their own global network count against them, adiscipline missing from many of the more generalist firms.


“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

Law Society. The top 200 firms

claim two thirds of private

practice revenues, and those

firms in the top 200 have

experienced different growth

rates at its ends: the top 30

firms grew revenues at around

an average of 7% (1-10: 5.8%,

11-20: 7.6%, 21-30: 10.7%);

firms 31 to 100 grew at

slightly less than 2%, and

firms 101-200 declined at

0.06% in 2012-2013.

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

in those with 11 to 80 partners

and a 16 per cent increase in

the number of firms with 81 or

more partners. Alongside this,

the UK market, as a whole, is

close to saturation. Only six

countries in the world have

more lawyers relative to their

population, and only three

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.

Average growth of UK 200 firms in 2012-13

10%

8%

6%

4%

2%

0%

-2% 1 to

10

11 to

20

21 to

30

31 to

40

41 to

50

51 to

60

61 to

70

71 to

80

81 to

90

91 to

100

101

to 2

00

1 to

10

11 to

20

21 to

30

31 to

40

41 to

50

51 to

60

61 to

70

71 to

80

81 to

90

91 to

100

101

to 2

00

Number of lawyers per 10k population

60

50

40

30

20

10

0

Chin

a

Japa

n

Swed

en

Russ

ia

Fran

ce

Indi

a

Germ

any

Aust

ralia UK

Spai

n

Italy

New

Zea

land

Braz

il

US

Isra

el


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 26-50 firms seeking to establish

presence in the Middle East, China and the rest of Asia.

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?

Net exports of legal services from the UK haveincreased substantially since 1995 and have beengrowing faster than those in other professionalservices. Real net exports of UK legal services areexpected to grow by 6% per year by 2015 and by6.5% per year by 2025 (twice the overall UK legalmarket growth rate).

“

”


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.

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.

Overall UK market: law firm reputation vs. size

80%

75%

70%

65%

60%

55%

50%

45%

40%

35%

30%

25%

20%

15%

10%

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

0 200 400 600 800 1000 1200

Average: 392

Lawyers within jurisdiction

Repu

tatio

n In

dex

*****

****** *

*

***

*

**

***********

*** **** ** *** ** ***

****

** DLA Piper

Average: 33%

Allen & Overy Linklaters

Freshfield BruckhausDeringer

Herbert Smith Freehills

Hogan LovellsAshurst

Simmons & Simmons

CMS Berwin Leighton Paisner

Slaughter and May

Norton Rose Fulbright

Clifford Chance

DLA Piper

EvershedsPinsent MasonsAddleshaw Goddard

Latham & Watkins

Shearman & Sterling

Jones DayBird & Bird

NabarroReed Smith

MacfarlanesTravers Smith

Wragge & CoOsborne Clarke

RPC

Mishcon de Reya

Speechly BirchamSullivan & Cromwell

Squire Sanders

Clyde & Co

DAC Beachcroft

Mayer Brown White & Case

Baker & McKenzieDentons

Mayer Brown

King & Wood Mallesons

Allen & Overy Linklaters

Freshfield BruckhausDeringer


Hogan LovellsAshurst

Simmons & Simmons

CMS Berwin Leighton Paisner

Slaughter and May


Clifford Chance

DLA Piper

EvershedsPinsent MasonsAddleshaw Goddard

Latham & Watkins

Shearman & Sterling

Jones DayBird & Bird

NabarroReed Smith

MacfarlanesTravers Smith

Wragge & CoOsborne Clarke

RPC

Mishcon de Reya

Speechly BirchamSullivan & Cromwell

Squire Sanders

Clyde & Co

DAC Beachcroft

Mayer Brown White & Case

Baker & McKenzieDentons

Mayer Brown

King & Wood Mallesons


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 low-

to 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 low-

profit, 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.


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 in-

house 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.)

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.

The Law Society

reported that

in 2013, on

average, FTSE

100 companies

conducted

business with six

solicitor firms –

ranging from one

firm to 23.

“

”


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 ever-

more 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 Manchester-

based 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 non-

core practices.


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 essentialchanges within specific segments post-financial crisis. While the average PEP (excluding MagicCircle, IBL and Specialist firms) remained constant at around £350,000, different segments of theindustry have shown distinct trends. As can be seen in the graphs below, a significant upward trendin PEP is maintained within the Magic Circle, London Business law firms, Retail, and Specialist Ifirms (the latter being the most successful focused specialists). From our strategic work with someof the top City law firms, we know that a number of London Business law firms have worked onprofitability improvement in recent years. This is an example of these market players reactingwithin a static market to address market-driven pressures.

Conversely, National law firms, Regional law firms including (for these purposes) Scottish law firmssaw slight decreases in PEP over 2011-2013, with International Business Law firms and a secondgroup of specialists (Specialist II) maintaining stable profitability. This again illustrates the pressureon the middle market: the IBLs managed to keep their PEP stable while the more local mid-marketplayers faced reductions in PEP due to their limited ability to bring in higher value work and/or dueto their cost structures being out of line with their pricing.

These changes in PEP are the outcome of a number of factors and actions, including marketcompetitiveness, strategic market positioning decisions, reviews of management models, andinternational capabilities, to name a few. Indeed, leverage (the number of associates per equitypartner) is one of the factors, illustrated by the measurable data and this factor speaks for somefundamental changes taking place.

Although the total average leverage rose slightlyfrom 5.84 to 5.97, the graph below illustratesmuch more significant changes in leveragewithin individual segments. Almost no segmentkept leverage constant over the last two years,suggesting that law firm management teams areactive in making significant changes in staffingand legal operations (with the Magic Circlebeing the segment with the least change in theirleverage). With the legal market reachingmaturity in a period of limited economic growth,many firms appear to have returned tooperational and economic restructuring tomaintain their desired profit margins underconditions of harsh price competition.

450

400

350

300

250

200London

BusinessNational Regional Regional

ScottishRegional

Insurance PlSpecialist

IIGrandTotal

Average of PEP-2011 Average of PEP-2012 Average of PEP-2013

1,400

1,200

1,000

800

600

400IBL Magic Circle Specialist 1

Average of PEP-2011 Average of PEP-2012 Average of PEP-2013

10

9

8

7

6

5

4

3

IBL

Lond

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2011 2012 2013

Average Leverage


Analysing the correlation between changes in leverage and changes in PEP (2013 vs 2011) reveals apositive relationship overall (see the graph below) as would be expected. Only the IBLs (-6%) andNational law firms show a negative relationship between profitability and leverage – perhapsindicative of the pace of expansion within those segments.

To understand better the middle market, it helps to look at a more detailed graphical analysis ofLeverage 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 profitabilityand leverage.

80%

60%

40%

20%

0

-20%

-40%

-60%

Correlation: changes in leverage vs changes in PEP (UK 100)IB

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-6%

51%

63%

-48%

24%

6%

29% 29%

35%

24%

London Business, IBL, National Law Firms*DWF leverage – 29.6. PEP – 429

15

14

13

12

11

10

9

8

7

6

5

4

3

2

100 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950 1000

Average: 454

Profit per equity partner (£k)

Leve

rage

Average: 7.7

Stephenson Harwood

Ashurst

BLP

Bevan Brittan

Bircham Dyson Bell

Bird & Bird Bond Pearce

Addleshaw Goddard

Clyde & Co

Charles Russell

CMS

DLA Piper

Eversheds

Farrer & Co


Fladgate

Forsters

Gateley


Hill Dickinson

Hogan Lovells

HowardKennedyFsi

Dickinson Dees

Kingsley Napley

Lawrence Graham

Lewis Silkin Macfarlanes Mills & Reeve

Mishcon de Reya

Nabarro


Olswang

Osborne Clarke

Pinsent Masons

Simmons & Simmons

KWMSJB

Speechly Bircham

Taylor Wessing

Travers Smith Trowers & Hamlins

Wedlake Bell

Winckworth Sherwood

Stephenson Harwood

Ashurst

BLP

Bevan Brittan

Bircham Dyson Bell

Bird & Bird Bond Pearce

Addleshaw Goddard

Clyde & Co

Charles Russell

CMS

DLA Piper

Eversheds

Farrer & Co


Fladgate

Forsters

Gateley


Hill Dickinson

Hogan Lovells

HowardKennedyFsi

Dickinson Dees

Kingsley Napley

Lawrence Graham

Lewis Silkin Macfarlanes Mills & Reeve

Mishcon de Reya

Nabarro


Olswang

Osborne Clarke

Pinsent Masons

Simmons & Simmons

KWMSJB

Speechly Bircham

Taylor Wessing

Travers Smith Trowers & Hamlins

Wedlake Bell

Winckworth Sherwood

***

**

**

**

**

* * * ***

** *

******

*

** * *

***

* *

*

***

*


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.

“

”


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 domestically-

focused 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.


Who can achieve this by 2018?

Welcome “the new partners”“Law firms deciding and doing” actually means their partners deciding and doing somethingspecific. There seven areas on which partners need to focus and reach agreement amongthemselves 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 thespeed of arriving at decisions will be vital. Too many firms’ decision-making is constrained byfrequently needing to seek consensus across the entire partnership, thus unnecessarily delayingimportant decisions, and often resulting in compromises which may not be in the best interests of thefirm. 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 acorporate model, wherein shareholders are not involved in decision making, but rather delegate theirrights to an elected and trusted management body within a firm. This allows for constructive decisionmaking and saves time searching for common agreement and compromise. This also means thatpartners can only “fire” the decision making board if they are not happy with the results arising fromthe decisions of the main governing body in the firm. Whilemanagement 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, witha major change in the role of partners. As firms changetheir strategies from ‘full service’ to a more focusedapproach, much greater standardisation and delegation ofwork will be needed, utilising technology appropriatelyand most likely extensively. All partnership thinking willhave to be shifted to a demand- rather than a supply focusand 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 lawfirm – and most firms lack the decision-making processessuccessfully to reach agreement on the required changesthrough their partnerships at present. Partners’ naturalconservatism often leads them to opt for the status quountil such time that a crisis renders this impossible. Thismakes it difficult even to achieve a clear strategic focus, letalone 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.

“

”


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 2025. 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)


About Hodgart Associates

Hodgart Associates is a specialist consultancy offering strategic andorganisation development advice to professional service firms,primarily those in the legal, accounting, property advisory and fundsmanagement sectors. Alan Hodgart established the antecedent firmin 1990 and has continued within this specialist focus throughout theperiod since. The Firm is recognized by the market as one of only twoor 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:

www.hodgartassociates.com

Key Challenges - UK Law 2014

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