LB100 2012 – Future Proof

From merger mania to profit manipulation – the LB100 in 2012 draws on familiar themes from 20 years of law firm financials.

If there’s one thing the last 20 years have taught us at LB, it’s that the legal profession carries on regardless. The UK may have entered into a  double-dip recession despite quantitative easing; the US and a number of European countries may have seen their credit ratings downgraded; M&A may have dried up and the global debt markets may be in stasis, but the UK’s top 100 law firms continue to post record growth and trend-busting profits. The industry has again showed its remarkable resilience and stability.

This should come as no surprise to anyone who has monitored the fortunes of the profession since we began publishing the gross fees of the leading UK firms 20 years ago. While we may have embraced the information age, as technology has changed the way we do business beyond recognition and the global economy has dipped and swerved countless times since 1992, the industry has more or less maintained its inexorable rise (for more, see our 20-year review, ‘LB 100 Retrospective – All Grown Up’).

This year is no exception. LB100 firms have increased turnover by a scarcely believable 17% this year to achieve total revenues of £17.67bn – the highest since the LB100 began. Profitability has reached record levels as well, breaking the £5bn barrier for the first time to stand at £5.39bn, an average net income increase of 8% on last year.

But before we get carried away, confidently praising the staying power of a seemingly impervious profession that accounts for roughly 2% of UK GDP, it’s worth putting some of these headline figures into perspective.

The 17% growth in total revenues is skewed significantly by a massive wave of consolidation by LB100 firms over the past two years. LB100 firms on average have become considerably larger, many of them by acquiring large chunks of revenue by merging or taking on teams. Some of the biggest double-digit leaps in turnover this year are due to consolidation. Norton Rose’s 69% leap in turnover is the result of the combined revenues of its Canadian and African acquisitions coming on line. Clyde & Co’s revenues are up 35% after taking on Barlow Lyde & Gilbert in 2011, while DAC Beachcroft is showing a 22% increase in turnover following the merger of the two insurance giants last year.

In fact, removing any firm that has achieved significant leaps in turnover through consolidation means that average revenue growth across 91 firms is down to a more modest 6%. Proof that all is not what it seems and that despite the tough talk, there’s an even tougher market out there. The general consensus is that the legal market became rather excited during the first six months of 2011/12, only for those hopes to be dashed as the eurozone crisis hit and the dealflow started to dry up once more.

‘Despite having recovered markedly from the decline in the demand for legal services since 2008/09, we expect the currently depressed levels of transactional activity and revenue growth to be a feature of the market for the medium term,’ says James Tsolakis, head of legal services – corporate and institutional banking at The Royal Bank of Scotland (RBS). ‘This position is unlikely to alter until the UK and major global economies recover by demonstrating long-term sustainable growth. However, our research and evidence also suggest that the market for legal services is no longer in decline but has stabilised, albeit at levels up to 10% lower than the same period last year.’

‘It’s been a very attritional year,’ says Ian Metcalfe, managing partner at Wragge & Co, which posted a 4% increase in turnover to £118m and a 3% drop in net income. ‘I think the last four months of the previous financial year were quite strong and we went into the new financial year with quite a good start. Then August arrived and we all know what happened in Greece. That threw the market into turmoil again and made people think: “I guess I better sit on my money and sit on my hands”. While corporates have got record amounts of money on their balance sheets they’re not spending it. A number of transactions slowed down or stopped altogether.’ Metcalfe says he believes that his firm’s modest gain in revenue is actually fairly good when compared against the market as a whole.

Eversheds chief executive Bryan Hughes sums up the outlook for the profession at a macro level. ‘It’s a massively challenging market,’ he says. ‘There’s no real growth in the economy therefore there’s no growth to latch on to, so what you’re looking for is increased market share or increased shares from your existing clients. There is an incredible amount of pricing pressure out there. It’s a capacity market: there are too many lawyers and not enough work.’ This comes from a firm that has performed better than most: revenues have increased in real terms by 3% while careful management of the purse strings has seen net income rise by 11%.

‘What’s particularly pleasing in terms of the turnover is that we didn’t have an acquisition this year,’ says Peter Jackson, managing partner of Hill Dickinson. ‘You’ve seen some big numbers in some of our competitor firms but of course they acquired this year – we haven’t.’ Hill Dickinson made its investment in 2010 when it acquired the Liverpool and Sheffield offices of Halliwells. 2011/12 is the first full year since the acquisition and turnover is up 10% to £110.1m and net income has swelled by 32%.

The Liverpool-based Major UK firm is one of the strongest performers this year but the true success stories are those that haven’t bolted on teams or made mergers but have grown market share and picked the right horse to back in terms of practice areas.

Profit for sanity

This year’s 16% rise in total profits doesn’t tell the real story either. While the total profit garnered by our top 100 is at an all-time high, profit as a percentage of turnover is not at its highest level ever. In 1992 total profit was 33% of total revenues, while in 2002 it was down to 30%. In 2012 total profit is 30% of total revenues – four percentage points down on the biggest margin so far when it was 34% in 2008.

And while we’re not seeing the widespread artificial inflation in PEP against declining revenues that we saw at many firms two years ago, there’s still room for firms to produce some odd numbers, with some posting significant increases in net income despite static or even declining revenues. A change in business climate has put cost efficiency even more at the top of the agenda but average cost per lawyer is up 4% on last year and £25,000 higher than in the boom year of 2008/09.

The arrival of alternative business structures (ABS) this year means licensed UK law firms can accept external equity investment from non-lawyers as part of the financing for their future growth. Russell Jones & Walker (RJW) was the most notable first mover, becoming part of Australian law firm Slater & Gordon, the world’s first publicly listed law firm, in a £54m deal. All of this has served to make firms more aware of their investment potential and sweat their assets much harder against static real term growth. This cost reduction has been achieved by cutting non-fee-earning staff and lawyers in unprofitable practice areas. RJW has reduced its fee-earning ranks by 9%, an inevitable consequence of getting leaner for the Australian deal.

Despite the mass redundancy rounds of 2008 and 2009, it seems firms can still find ways to cut costs to make profit. Overall, the total lawyer headcount of the LB100 is up 6%, so the answer is not cutting back on lawyers as a whole. It would appear that non-fee-earning staff have been affected and while firms have got larger on average through consolidation, fee-earners in less profitable areas have also suffered.

Mark Brandwood, managing partner of Brabners Chaffe Street says that over the last few years the number of lawyers hasn’t reduced but the amount of work has. ‘There are more lawyers fighting over a smaller pool of work,’ he says. ‘There is increased competitive pressure. You have to fight harder and provide a more cost-effective service to keep your clients happy.’

This point is echoed by Tsolakis at RBS. In his report, A perspective on the legal market, released earlier this year, Tsolakis said that overcapacity was damaging the profession.

‘The level of fee-earner resources, notwithstanding the restructuring that has already been done, continues to exceed the volume of work that is available,’ Tsolakis tells LB. ‘I can see at least 5% of capacity being taken out of the market.’

But Chris Osborne, a senior managing director in FTI Consulting’s economic and financial consulting practice warns that cutting back on associates could cause problems in the longer term. ‘It’s an easy decision to prop up earnings by not taking on young lawyers,’ he says, ‘but in a few years’ time the profession will end up with a demographic weakness – at some point there’s going to be excess demand for experienced associates and they simply won’t exist in the right numbers.’

Not every firm has had to trim the fat though. Lewis Silkin managed double digit increases in both revenue and net income and has not needed to do any significant culling to enhance profitability. In fact, fee-earner and non-lawyer staff numbers are slightly up on last year. ‘“Steps to increase profitability” can sometimes be used as a euphemism for the deliberate managing of the equity and so on,’ says managing partner Ian Jeffery. ‘We haven’t had a particularly aggressive redundancy programme at any point over the past few years. To the extent there’s been any headcount shrinkage it’s been very limited. So in terms of managing the profitability it’s just as it’s always been, which is a reasonably careful eye on the way we manage our instructions and trying to manage expectations of clients on the project and I suppose just a careful eye across the whole cost base as we go along. We certainly haven’t gone through a deliberate or aggressive profit enhancement exercise.’

The interesting statistic is how little the fee-earning structure at top law firms has changed over time. Equity and non-equity partner numbers are both up again this year to 8,352 and 6,651 respectively. This puts paid to the theory that equity partner numbers are being slashed to simply enhance PEP. The number of partners as a percentage of total lawyers is relatively unchanged in 20 years – it is around a quarter of all lawyers.

However, cutting costs by reducing headcount doesn’t always have the desired effect: just ask LG, Howard Kennedy and Manches. All three have seen fee-earner numbers fall, and all three have posted alarming dips in net income.

Top performers

Three firms in particular stand out as leading the pack this year: Bristows, Mishcon de Reya and Stewarts Law. Indeed, Mishcons and Stewarts Law were both singled out for their stellar performance in last year’s LB100 report and were shortlisted for Law Firm of the Year at this year’s Legal Business Awards, with Mishcons named as the winner. Mishcons has consolidated its terrific year in 2011 by posting a 12% revenue increase to £73.1m and a 42% increase in net income to £19.6m, meaning that profit per lawyer (PPL) at the firm has leapt by 21% to £81,000.

Stewarts Law has built on its LB100 debut in 2011 with another outstanding year: turnover is up another 22% to £34.9m, which means that revenues at the firm have grown 75% since 2010; while profits have soared 34% this year to £15.5m. Bristows has managed to increase turnover by 27% to £32.9m and increased its net income by a whopping 53% to £13.8m. As a result, PPL is up 40% to £113,000. This is a stark contrast to 2008, when the firm fell out of the LB100 when revenues fell 8% to £18.5m. Turnover has increased 78% since those dark days.

As is explained in our analysis of our new City Domestic peer group (see ‘A tale of two cities’, page 88), the recipe for success for all three firms is sticking to what they do well. They have the fortune of being strong either in a practice area that is doing very well or having a client base that is particularly active. Bristows has leveraged off its strength in TMT, particularly IP, which appears to be unaffected by the downturn. ‘We’re busier than we’ve ever been,’ Bristows head of IP Edward Nodder told LB in our IP special in June (see ‘IP review: No quarter given’, LB225). ‘That suggests client requirements for IP advice have held up pretty well and are not significantly affected by cutbacks.’

Stewarts Law has continued to make the very most of its position as a leading independent disputes firm, unfettered by banks or other cloying relationships with financial institutions. It has added to the core commercial disputes practice by bringing skill sets such as employment and divorce law. Mishcons meanwhile is clearly reaping the benefits of seeing earlier than most that you can build a very successful firm around servicing a specific and lucrative client base – namely its Mishcon Private offering to high-net-worth individuals and wealthy families. It’s clear that private client has enjoyed a renaissance in recent years and those that eschewed their private client practices for not being core to their businesses must be eyeing Mishcons’ performance with more than a hint of jealousy.

‘I’m not that interested in what other people do. I think our alignment two years ago of “private” as a concept that went beyond old-fashioned private client, which was purely trusts and estates, into this holistic area has been a successful move,’ says Mishcons managing partner Kevin Gold. ‘For us, “private” encompasses individuals and families and businesses and their life and their reputations and we try to package that all together into a single offering. That offering could be in the investment space, it could be in the property space it could be a reputation issue but actually dealing with people’s families and their businesses in a sympathetic way I think is just getting traction – I think it is getting us market share.’

Technical glitches

On the flip side, there are those firms that have really had a terrible year. 13% of firms posted a revenue decrease, while 25% of firms showed a fall in net income. Worse still, nine firms had a fall in both revenue and net income: Shoosmiths, Gateley, Speechly Bircham, LG, Dundas & Wilson, Clarke Willmott, Bevan Brittan, Manches and Howard Kennedy.

In true LB100 fashion, you can often predict how the wind is blowing by how long it takes firms to provide information. For example Forsters, which posted a healthy 12% increase in revenues alongside a modest 2% rise in net income – not bad when the majority of your business is in real estate – was one of the first firms out of the blocks, announcing its 2011/12 results in early May. By contrast, LG took an inordinately long time to hand in its report card. Little wonder: with a 5% drop in revenues giving rise to a 45% plunge in net income, plus failed merger talks with City International rival Field Fisher Waterhouse (FFW), 2012 looks to be another year to forget for the beleaguered firm. In the end, the merger proposal was not even put to a partner vote. Both FFW and LG kept their counsel in the wake of failed merger talks but you suspect that LG’s erratic financial performance may have played a part.

Unlike many of its peers (and indeed the profession as a whole), LG is characterised by great highs and very low lows: in 2008/09 its profits tumbled for the third year in a row. Profits per equity partner (PEP) stood at £347,000 – pre-2002 levels – after a 32% fall in net income. Although the 2008 crash brought its finances to a head, there was no way to fudge the fact that the property specialist had been failing in a boom market. In 2010, managing partner Hugh Maule looked to have reversed the slide. The firm posted an 8% rise in revenues to £64.9m and transformed a 19% drop in partner profits to a 64% rise, seeing PEP climb from £347,000 to £568,000.

But then recovery stalled again last year. The firm dropped seven places in the LB100 after revenues fell by 9% to £59m and PEP was slashed by a quarter to £426,000. The latest results leave a firm that has seen revenue fall 17% from its 2008 peak of £67.5m while its net income has fallen 63% since 2006, despite a rally in 2010.

Another firm that has walked away from a merger and has generally had an awful year is Scottish blueblood Dundas & Wilson, historically one of the strongest performers in the LB100. Last September, in a move that had everyone – including Dundas partners – scratching their heads, the firm began merger discussions with Bircham Dyson Bell. Both firms walked away from the negotiations a few weeks later. After that, the firm went through a period of unrest that included partner dissent, redundancies and managing partner Donald Shaw stepping down midway through his second term. New co-managing partners Allan Wernham and Caryn Penley began their roles officially on 1 August, after acting on an interim basis since March, and have their work cut out: turnover is down 12% this year to £54.5m and has fallen 27% since 2008. Profitability continues to slide as well: net income has fallen 36% this year and the firm’s profit margin is 30%. Set against the rest of the LB100, Dundas remains a comparatively profitable firm: it currently ranks 63 in our ‘Behind the numbers: profitability revealed’ table. But when you consider its profit margin was 41% for the previous two years, it’s clear the crown has slipped a little.

One thing that all the firms that have struggled in both revenue and profit terms share in common is too much practice diversity. It seems that firms that are trying to be as many things as they can to clients (especially those in the mid-market) are suffering the most. Bevan Brittan, which posted only a slight dip in revenues (-2%) and net income (-3%) has been through a process of refocusing its service lines to what it is known for, ie public services. Managing partner Duncan Weir hopes that the strategic focus will start to pay dividends in 2012/13, when he predicts revenue growth for the first time in five years (see ‘Bevan Brittan – Don’t Look Back’, LB224).

‘The general sense among the firms that I speak to is that below the top ten firms, which all have different agendas, success is a question of focus,’ says Paul Roberts, managing partner of Forsters. ‘We’re probably more focused today than we have ever been in terms of where we see our opportunities and where we see the strength of the firm.’

‘In general, firms that entered the downturn with a clear strategic focus and a strong market position tended to suffer less in the recession,’ says John Cussons, director at consultants Huron. ‘They recovered faster than the firms that were undifferentiated in their approach to the market. Many of the latter have struggled to compete in the downturn and are still underperforming their peer group because they are seeking to compete across too wide a range of practices, too wide a range of clients and too wide a range of economic values.’

FTI’s Chris Osborne says classic management thinking says that firms need either to be large or to be focused. Firms that are not in the top tier will need increasingly to tailor their offering. ‘The middle ground will increasingly be unsustainable,’ he says. ‘The smaller firms that have identified a core area of focus are going to end up in a stronger position.’

UK and bust

There is some irony in the fact that our new City Domestic peer group is home to the most successful firms in the LB100 this year. All three firms have done well with largely UK-based businesses, which defies the current consensus that the UK market is as tough as ever.

‘I think things are a lot tougher in London comparatively than they were a few years ago,’ says Michael Greville, managing partner at Watson, Farley & Williams, which has had a strong year, posting 14% growth in revenues and a small rise in net income. ‘Asia is not easy but there is plenty of work out there. We’ve also had a very good year in Germany, and in other places in Europe. That’s a bit of a shift actually, that’s why the London mid-market may be having some trouble because I think the London market is actually pretty fierce.’

This point is echoed by Simon Beswick, managing partner of Osborne Clarke: ‘The profit margin on certain domestic work is reducing as clients want greater value for money, the prices are decreasing and most of your overheads are in London. It’s quite a challenging place to be.’

Last year we published the UK-only revenues of the top-50 firms for the first time, to enable a basic comparison between the domestic market performance of the top and bottom halves of the LB100. This year, we are able to compare UK-only performance of the top 50 firms with last year (see chart, ‘Which firms have the biggest UK business?’). Only five firms actually posted a decline in UK revenues on last year and only one was a UK-only firm (Shoosmiths (-6%)). The others – FFW (-4%), SNR Denton (-3%); SJ Berwin (-2%); and DLA Piper (-1%) – haven’t suffered meaningful reductions in UK revenues. Most of the significantly international firms recorded modest increases in UK revenues, which goes to show that either these firms have worked hard to maintain market share in the UK, or they’re fudging their figures.

As Allen & Overy managing partner Wim Dejonghe says, London is a static market, so it’s all about having ‘a leading position in a market that has very limited growth. Obviously growing from a leading position in a market that is not growing is an impossible task’.

In terms of practice area performance, the really strong areas are private client, TMT and litigation, as evidenced by Bristows, Mishcons and Stewarts Law. The transactional market remains as creaky as it has been for a few years but here are some positive signs. Osborne Clarke’s Beswick reports that the market has rebounded ‘only a bit but enough to give law firms a bit of growth’.

Beswick also notes resurgence in the leveraged finance market, something that James Collis, the recently installed managing partner of Ashurst has also observed. ‘You have a perfect storm for leveraged finance,’ he says. ‘The increased costs of lending that banks face as a result of tighter regulation, including Basel III, is driving them to be more selective as to whom they offer credit. As a result, for deals to be done, people are having to leverage their assets and find alternative sources of funding liquidity.’

Olswang’s chief executive David Stewart says his corporate practice exceeded expectations last year, something not many managing partners will be saying for a while. ‘Many people have reported that it was good for the first six months of last year and then slumped but we had a crackerjack year,’ he says. ‘The key reason is our sector focus on technology and media, where corporate activity has remained strong as the demand for technology and media hasn’t waned. TMT is one of our core strengths and tech has really taken off again in a substantive way.’

But overall, transactional activity remains depressed. ‘Revenue performance across practice areas is best summarised as patchy,’ says Tsolakis. ‘Unfortunately, there is a lack of continuity of transactional flow, transaction repetition and replication.’

One practice area that has polarised opinion among LB100 firms is real estate: while some firms are pointing to a depressed real estate market as the root cause of their meagre performance, others say deals are back if you’re in the right position to take advantage.

Mishcons picked up Real Estate Team of the Year at this year’s Legal Business Awards and Gold says that revenues from real estate are up 27% this year.

‘The boom in real estate has been largely fuelled by the flight of private money players coming into the market,’ he says. ‘We have also seen a reasonable flight in investment out of certain eurozone countries into the UK. London is being seen as the safe house of Europe.’ Meanwhile Wragges’ Metcalfe describes the 6% growth in his real estate practice, particularly in residential work, as being ‘remarkable in a very challenging market’.

‘Our real estate practice has held up extremely well,’ says Tim Eyles, managing partner of Taylor Wessing. ‘It’s focused on the right client base, it’s supported by the degree of foreign private capital investment that we are seeing.’ Burges Salmon, Fladgate and Olswang have also all reported positive news as far as their real estate practices are concerned.

Power in a union

The wave of merger activity between law firms that has been predicted since 2008 finally arrived in 2011/12. Consolidation accounts for the overwhelming surge in revenues across the LB100 and very few peer groups have been left unaffected by it, from all of the Major International firms to the Clyde & Co/Barlow Lyde & Gilbert tie-up in our new City International section. 68% of the firms in our Major UK category were directly involved in a merger or acquisition of some kind in the last two years, not least the Anglo-Scottish tie-up between Pinsent Masons and McGrigors that went live in May.

Expect the consolidation wave to intensify. Plenty of firms are making the right noises about a merger.

At Penningtons, which went through a double merger with Dawsons and Wedlake Saint last summer, marketing and development director Rolland Keane is keen to continue with the strategy. ‘We are fairly definite that we don’t want to stay as we are,’ he says. ‘We think our size makes us very vulnerable as changes such as ABS come on stream. We want to lay on more body mass but our mergers need to be strategic. We see future growth coming from international markets.’

But while a growing number of firms view getting bigger as getting better and buying revenue as the only way to secure a long-term future in a competitive market, others are not so sure.

‘It wouldn’t surprise me if we saw more consolidation but I suspect it would be for all the wrong reasons,’ says Watson Farley’s Greville. ‘I think people think there’s a certain safety in a difficult market in terms of size, but I’m not sure that’s necessarily the case. Whoever merges, there’s always going to be someone bigger than you so at the end of the day what do you think you’re trying to achieve through that merger?’

For Simon Hodson, senior partner of DAC Beachcroft, a merger was clearly right for his firm but he’s not sure it’s for everyone. ‘From a strategic point of view it was worthwhile and from an economic point of view it’s worthwhile because you can make cost savings. A number of firms may want to merge for cost reasons but I would suggest that there needs to be a more strategic underpin and there must be client reasons for doing it. Otherwise it shows that you don’t have a strategic vision so what’s the point?’

Magic solution

For some, the future lies in acquiring clients rather than competitors. The amount of work isn’t going to increase so firms need to take food from the mouths of their rivals. Easier said than done, so acquiring teams may be a means to an end.

‘You can’t depend on business growing because of the economy growing, that’s not going to happen,’ says Brandwood of Brabners Chaffe Street. ‘You’re looking to win market share off your competitors and you do that by competing for new clients. You look to make lateral hires for partners with client followings, new hires in niche areas where there are gaps in the market. If the opportunity came along to bolt on some nice smaller practices we would look at that opportunity as well.’

Others believe that the way lawyers deliver their service has changed and firms need to adapt to survive. ‘I’ve heard that clients are looking for flexible and straightforward advice,’ says Pannone managing partner Emma Holt. ‘It may be that we’re moving away from an era where people are super-specialised to where they have to understand every aspect of a client’s business. I think that’s a good thing – the legal sector is mirroring the economy. Clients are becoming more aware.’

For the next 12 months, expect more of the same: flat revenues, except for those that have taken the merger route.

‘This year firms are going to face the same challenges – they’re going to have increased salaries this year and the market will be flat,’ says Duncan Weston, managing partner of CMS Cameron McKenna. ‘Some people will grow the top line by merging or joining bits of the business on to them but at the end of the day profitability is going to swing on the cost base of the firms because the revenues organically are not going to go up significantly. Revenues are not going up more than salaries, put it that way, and that’s going to be the challenge.’

The last word belongs to a firm that has made great strides by remaining focused in what is a very difficult micro market: Scotland. Brodies has defied local trends by pushing revenues up 16% this year to £42.8m and achieving a 30% leap in net income. ‘There’s no magic formula,’ says managing partner Bill Drummond. ‘It’s a little bit about holding your nerve in what in some respects is the most challenging market any of us has seen – not wasting cash.’

Simple but effective. As many firms have wasted far too much cash chasing the expansionists’ carrot, with mixed success, it may be time to consider a rethink. LB

mark.mcateer@legalease.co.uk

Legal Business would like to thank Coutts for its sponsorship of the LB100.