October 3, 2008 9:00 AM

Welcome to the Future: Heller Shock?

Posted by Paul Lippe

A law firm friend of mine told me many of his peers were "shocked" at the demise of Heller and its failure to find a merger partner. That put me in mind of the iconic scene in Casablanca, where Vichy police captain Louis Renault declares himself "shocked, shocked to find gambling going on [in Rick's Casino]" while pocketing his winnings.

So let me make a prediction: More Am Law 200 firms will Heller-ize over the next 18 months than will merge. Why?

1. Bigger Isn't Necessarily Better. How many large law firms really take advantage of their size? Most legal work is done by teams of ten or fewer lawyers, so how do clients benefit from scale, since 990 of the lawyers in a 1,000-lawyer firm don't touch that client? For 20 years, sophisticated clients have said, "We hire lawyers, not law firms," and they have spread their work around to many firms. Law is unique in having two structural diseconomies of scale: (i) conflict of interest rules; and (ii) lawyers' widely noted desire for autonomy (see David Maister's column "Are Law Firms Manageable"). If we consider the benefits of being "big"--shared knowledge, common methodologies, cost-saving investments, more sophisticated delivery systems--they're largely absent at most big firms (the U.K. firms are well ahead of their U.S. peers). So if a firm isn't doing an especially good job of managing scale, how does creating more scale through a merger create more value? See the excellent discussion in WiredGC about why law firm mergers create very little value.   

2. Everything Works in a Boom. I recently wrote that the "boom" large law firms found themselves in over the past decade has ended. One of the traps of a boom is that everything (e.g., mergers) works, so you don't learn much. Most of the profit gains associated with big-firm mergers are driven by, a) deequitizing some partners, which, if it is your goal, can be achieved without a merger, and b) price increases, which are probably only possible in boom conditions. It's not obvious to clients that law firm mergers create value for them. As Jeff Carr, GC of FMC Technologies wrote in a Legal OnRamp forum recently, "I've yet to see a law firm merger justified on the basis of a benefit to the client (other than the hubris-induced statement that 'this provides clients with services they need'). In fact, clients generally have already established counsel relationships--unless the merged firm offers a lower cost for service, then there's little if any reason to move that work. From the buyer side, I'm unable to think of any law firm merger that provides us, as the client, with any value." You won't find another industry where "cross-selling" per se is considered the synergy of a merger--normally, costs savings, or the ability to create new products, is cited.

3. Leverage. Excessive leverage was the number one reason behind the collapse of AIG, Lehman Brothers, Bear Stearns, etc. These firms each were betting $100 a throw at the casino, but only had $3 in their pockets. That kind of leverage is fantastic when you're winning, but you can't sustain very many losses, especially if the house decides to limit your credit for future bets. How well-capitalized are most large U.S. law firms? I suspect that, as measured by the ratio of firm earnings paid out to partners versus net capital in the firm, large U.S. law firms are at a historic low in capitalization. Simply put, most partners' economics are driven by their annual income, which is very vulnerable to a downturn, not their capital in the firm. Again, U.K. firms seem better capitalized, and under the Legal Services Act will have access to more capital. So once again, advantage U.K. (See "The English Advantage," in this month's issue of The American Lawyer.)

4. Insufficient Organizational Glue. As described in WiredGC, a decline of 10-15 percent in firm profitability relative to one's peers leads to partner defections. That is dramatically more fragile than most companies or professional service firms. If Bain has a 15 percent drop in profits relative to its peers, it doesn't lose partners to McKinsey; ditto for Sun and HP or Bank of America and Wells Fargo. Moreover, even the rawest start-up understands that the key IP and customer relationship assets belong to the company, not to the individuals, and that there must be some disincentives (like losing vesting) for leaving. But for reasons of customs and ethics, law firms have few strong agreements to discourage departures, such as retained capital or even seemingly effective antisolicitation (not of clients, but of firm colleagues) agreements. Also, to far greater degree than almost any other type of firm, the intellectual capital and client relationship capital belong to the individual partner, not the firm. It's no surprise, then, why partners leave.

5. The Dog That Didn't Bark. While some employees and commentators have described Heller's situation as "tragic," there is no such concern expressed by clients. Why? Because for the client, it's not a tragedy. Clients have grown accustomed to lawyers switching firms, or firms merging without any particular impact (good or bad) on them.

6. The Lake Wobegon Effect. In Lake Wobegon, all the children are above average. In law firms, at any moment some partners contemplate leaving because they believe that they should be paid more and would be at another firm. Since many firms have been willing to pay top dollar for laterals or mergers (an example of "winner's curse," identical to the M&A market as shown by deals like Wachovia-World Savings, which brought down Wachovia), many of those partners are correct. So from a simple Prisoner's Dilemma model, the partners who can make more money as free agents have a financial incentive to move, and those who will be harmed by the departure of the top producers also have a financial incentive to move, since they would be "unmasked" if the top performers leave before they do. Which means any firm with lots of unstable partners will seek out a merger, unless...

7. Why Buy the Cow When You Can Get the Milk for Free? Any acquiring firm in a merger quickly figures out they can cherry-pick people rather than acquire the firm as a whole, and all its liabilities. In a boom, people overlook the worries, but in the current climate, fear of the unknown will loom much larger; compare the spree of bank mergers pre-Credit Crunch to the inability to get any done without government support in the current environment. When I managed buy-side M&A for a public software company, there were two fundamental things we learned by studying our own and others' mergers. First, if someone wants to sell you their company, there is something wrong with it that they know more about than you, so you better figure out what the problem is and how you can fix it better than they can. Second, once people know the company is in play, it destabilizes existing relationships. If the process continues very long, things can implode. The best people are in the most demand so they will either leave before the implosion or their departure will catalyze it. There's also the matter of...

8. The Free Agency Infrastructure. There is a large and aggressive infrastructure of consultants and headhunters who are actively engaged in encouraging interfirm mobility. A typical firm partner may hear every week from someone encouraging them to make a move. How often do they hear from someone inside the firm encouraging them to stay? These folks are highly compensated for driving moves, at the individual partner, practice group, or firmwide level. And if a headhunter sees a troubled firm in merger talks in which they don't have a stake, do you think they can figure out to contact a few partners whom they already know to encourage a move? And did I forget…

9. Underwater Leases. While law firms are retaining less capital, the biggest item on their balance sheet is probably the office lease. The combination of a decline in commercial lease rates, slower growth in head count, the collapse of the sublease market, and a dip in law firm revenues (i.e., exactly 2009's economic scenario) can mean leases are underwater, so partners may face an increased share of liability risk if they stick around an underperforming firm. My friend Craig Johnson is starting Virtual Law Partners, where everyone works at home. That kind of cost-advantaged strategy has hardly been common for law firms, but may start to be very compelling.

10. Failure Is the Norm. To predict some level of organizational failure is hardly the height of Nostradamus-like courage; in most businesses, some rate of failure is the norm. And when change accelerates, the failure rate increases. Every time a law firm fails (see, e.g., Testa or Brobeck, or now Heller), folks want to act as if it is an anomaly--but it's not. The anomaly has been the remarkable success of law firms during the law boom. Now that the boom is over, we'll see a "normal" failure rate, accelerated by the stresses of adjusting to a post-boom world.

So what are firms to do? 

As Tom Wolfe described in The New York Times on Sunday, hedge fund-ization is almost certainly the next step for the financial services industry, as most of the bankers who previously worked for the large financial institutions will devolve into smaller hedge funds. If Heller similarly breaks up into 15 small firms, is that a tragedy?

The question for those leading large firms is how to demonstrate that their people are better off in their current large organization, rather than in a different large organization or a smaller one. See Bruce MacEwen’s excellent post AdamSmithEsq. The answer to this will include demonstrating to clients how the firm brings superior value through scale to their work.

The scary part is that managing this change will require greater investments in capital and culture than firms made during the boom, investments that will likely be destabilizing in the short term. At the same time, we can safely predict the merger of big firms will be a very rare bird.

I for one will not be shocked by the next Heller, even while I hope to be pleasantly surprised by the vast majority of firms taking the needed steps to strengthen their institutions.

Paul Lippe is a founder and chief executive officer of Legal OnRamp.

Previous Columns in This Series:
Welcome to the Future: Law After the Boom

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