The new normal and its implications

‘The New Normal’ and its ImplicationsFebruary 2013

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Contents – ‘The New Normal’ and its Implications

• The global landscape• The Australian market• How are the Partners feeling about these changes?• The ‘New Normal’ - What does this mean?• How do firms respond?• The Role of Leadership

“There are going to be winners & losers”

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Contents

• These thoughts are based on:• Hundreds of discussions with partners in firms across the market over the past few years• Dozens of discussions with General Counsel• Over a dozen detailed discussions with foreign law firms wishing to enter the Australian

market over the past few years• Regular detailed analyses of the Australian market• Regular discussions with many senior leaders in many of the law firms in the country• Regular discussions with leading consultants to the global law firms in Australia, US and UK• Studying the histories of accounting, consulting and engineering firms over the past 30 years

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The Global Landscape

• The globalisation of law firms is mirroring the continued globalisation of business• There are 15 law firms globally that now have more lawyers outside their home market than in it• There are another dozen firms that will be in that state within 2-3 years • This means that there will be nearly 30 truly global law firms in a few years• The history of most PS businesses is that a process of consolidation occurs after the first flurry of

amalgamations• I predict that this will happen in the global legal markets as well

• 5 to 10 years from now there will be 8 to 10 very significant global law firms with over $2bn revenue streams – and some of them significantly more than that• Probably 3 to 4 of them will be amalgams of the ‘elite’ UK and US firms• 3 to 4 of them will be global business law firms: like DLA and HL

• 5 years from now it is possible that there will be structural separation of the audit practices from the accounting firms• They will all then build significant global law firms since all their conflict issues will have been

removed

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The Evolving Segmentation of the Global Firms

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• Some of these firms focus on the high end work which produce materially different levels of profitability from those firms that seek to service clients in a ‘full service’ way

• Some of the ‘Multi-Local Globalists’ have plans to strengthen their top end work and so challenge the ‘magic circle’ firms and elite US firms that currently own the top end of the global market

• As the years roll on, it is likely that an increasing share of the top end M&A and financing transactions globally, and in Australia, will be controlled by these existing and emerging global brands – this has already occurred in Europe

• This is what has already happened with all other categories of PS firms:• Consulting: McKinsey, Bain & BCG• IBs: UBS, GS, JPM• Accounting: PwC, KPMG, E&Y and Deloitte

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• We are seeing the continued development of the ‘focused international’ firms like Herbert Smith, Shearman, Latham and Weil with expansion plans publicly committed

• The ‘Emerging Focused International’ firms are continuing to spread their wings – Squire Sanders, Jones Day, Reed Smith, and Ashurst

• The ‘Multi-Local Globalists’ are also continuing to grow and develop their global networks – note recent developments with Norton Rose in Canada• K&L Gates has now joined the ranks of these firms with the merger announced in early

December 2012 with Middletons• There is intense rivalry developing between the ‘mid’ and ‘top’ tiers defined by scale and scope• The ‘magic circle’ firms have had to date a very dominant position amongst the global firms from

a brand perspective. However, the brand recognition of the ‘mid tier’ international firms is rapidly becoming stronger and challenging this dominance – we have some data on this point to discuss in a minute

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• We can predict that• The ‘magic circle’ firms will look to continue to strengthen their position as genuine global

premier high-value firms, but this will depend on a premium US presence which has not yet been established

• Some US firms will enter that space over the next five years – Weil, Latham and Shearman are contenders

• As the years roll on, it is likely that an increasing share of the top end M&A and financing transactions will be controlled by these existing and emerging global brands – as is the case in Europe today

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Global Branding is Becoming Significant and Changes in Top 20 Reflect a Changing World Order

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Conclusions From the Brand Index Survey

• The winds of change are intensifying across the global legal market• This is reflected in Acritas’ 2012 Brand Index which reveals a very different picture to the Index of

2010• For the first time, the ‘prestigious’ law firms are facing new and very different competition• Closing in fast is a set of ambitious firms with truly global footprints and a client focused

approach at the heart of their operations:• Hogan Lovells and DLA Piper both have much stronger US platforms than any of the ‘magic

circle’ firms for example• A combination of factors have come together to provide the ideal environment for these

‘challenger brands’ to flourish. These include:• The economic slowdown, which has led to lower demand for legal services in the mature

markets and a much more price-sensitive market • A growing level of dissatisfaction with the traditional hourly rate model among clients• Clients demand for more cost-effective solutions, including technology, LPOs, offshoring,

project management and alternative fee arrangements • Increasing international reach and the consequent rise in international legal requirements

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Conclusions From the Brand Index Survey

• Law firms which have invested heavily in growth through mergers and international expansion, employees, technical advancements, better client management and client feedback programs are starting to reap the rewards

• According to Sharplegal* research, this group of law firm brands is rapidly becoming the most recognized and favoured, on a global level.

• The key results of this survey are as follows:• The relative strength of the ‘magic circle’ firms has been diminished considerably

• Freshfields down from 90.5 points to 57.5• CC down from 79 points to 57• Linklaters down from 67 points to 57• A&O down from 63 points to 41 • These 20+ drop in points represent a massive reduction in relative brand strength

• DLA Piper up from 39 points to 50 – and in 5th spot ahead of A&O, Skadden, Latham & Watkins and HSF

• Norton Rose up from 23 points to 31 • Slaughter & May have dropped out of the top 20 – from 12th spot

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What Does all this Mean for Australian Firms?

• Can they sustain their levels of profitability given these changes?• More competition for

• Clients and work• Talent

• Need to consider alternative ways to:• Tap into global IP• Tap into global opportunities that connect with Australia

• 35% to 40% of M&A work that comes into Australia emanates from some other part of the world

• Provide career paths for your people

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The Australian Market

• The Australian market for legal services as measured by billable hours has been in marginal decline for many years – it is a mature market• Clients have in-sourced more work for cost reasons• LPOs are having some impact• Clients are pushing back on leverage – particularly at the junior end – they want value

• Revenue growth has come from fee rate increases over the past ten years – and this has come to a shuddering halt since the GFC

• In this market, most firms have to learn to deal with negative or no growth• The heady days of double digit growth have gone – maybe for ever

• Unless you do something dramatically different – e.g. Quinn Emannuel

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• Changes to Australian market structure• New entrants in past three years: A&O, CC, SS, C&Co, K&L Gates• Existing global firms: BMcK, S&C, SA, JD, W&C• Mergers & alliances: AAR/L, D/NR, F/HS, MSJ/K&W, PF/DLA, BD/Ashurst• There are now 16 firms with global connections here today• We are aware of five other firms actively considering entering this market over the next year

or so• We could have 20 global firms operating in our market in a few years• Which mirrors trends in other markets – for example US firms in the UK, international firms in

China and Hong Kong• Some of the top firms have been reshaping their business for many years to focus more on the

high value end of the market• This reshaping process will continue for the next 3-5 years• Many of the mid market firms are searching for some difference – hence Middletons merging

with K&L gates

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• This has resulted - and will continue to result - in a redistribution of talent from the top firms to second and third tier firms

• The total market for legal services for the top Australian and international firms is around $3.6 bn

• Around 35 to 40% of this work is M&A work, broadly defined • Five years ago, 70 to 80% of this work was handled by the top four firms in this space• Over this period, this ratio has dropped to 50 to 60% as a result of:

• Increased competition from the global players• Increased competition from major local firms

• In addition, the total available M&A market is less than half of what it was some years ago• These last few points largely explain why most of the top firms are not able to extract the same

level of profitability of prior years from the market

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The Australian Market – Merger market Data

Year 2007 2009 2010 2011 2012

Deal number 346 303 387 504 305

Deal Value $Mn 348,145 164,109 305,683 226,077 60,608

Top 4 firms Market share – Deal No

80% 59% 52% 43% 43%

Top 4 firms Market share – Deal Value

68% 78% 62% 53% 57%

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How are the Partners Feelings about these Changes?

• “My banking practice requires me to be part of a global brand that has strong connections in London and New York. My current firm does not deliver on that – so I have to find a new home.”

• “My employment practice doesn’t fit with the business model of many global firms. I am going to have to shift my practice to a domestic firm that has a long term commitment to my practice.”

• “I am a M&A partner in a domestic firm. Am I going to have access to reasonable matters in the future if most of the top M&A transactions will be handled by the global firms – as has happened in most other major global markets.”

• “I want to work until I am 65, but my current firm wants to boot me out before I am 55. This is part of their downsizing process, and I fear for my future.”

• “I doubt that all of these foreign firms will succeed. Some will find that they won’t be able to deliver on the global hurdle rates, and as a result there will be bodies everywhere. I feel very nervous about that.”

• “The firm I have been with for over 20 years died a few months ago. Something else is being created in front of my eyes, and I am not sure that creation is for me.”

• I have never seen the level of angst and concern for the future amongst law firm partners – that we are seeing right now - in my nearly 20 years of working in this market.

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‘The New Normal’ – What Does this Mean?

• Law firms have for most of their history been order taking businesses responding to external events, and their organisations, structures and systems have been designed inside out• This model is not sustainable

• Law firms have been in the ‘time and materials’ business – firms were paid on inputs times an hourly rate – not on value created for the client• This privileged position is slowly – and in some places quickly - coming to an end

• Over the past 10 years revenue growth came from putting prices up in the computer – this was easy – but has now come under serious attack for 5 years

• Recent years PEP for 12 major local and global firms operating in this market show:• 2 = $600k• 4 = $900k to $1000k = around 80th most profitable global firm• 4 = $1000k to $1100k• 1 = $1100k to $1200k• 1 over $1300k = around 50th most profitable global firm• Over the past 12-18 months many firms profitability have been declining – some firms have

experienced very significant reductions

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• In the recent past some firms dreamed about growing profitability into top 20 global territory – which means a PEP of around $2 million

• Most of those firms now dream about hanging on to past achievements• The financial engineering of law firms needs to be re-thought given these huge changes in the

market forces• The key financial profit drivers are all under attack or not well managed by most firms:

• Leverage – under attack• Clients don’t want to pay for lots of ‘wet behind the ears’ juniors• They want everyone on a case team to add value

• Fee rates – under attack• Clients are even negotiating fees downward with the best firms on the planet

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• The key financial profit drivers are under attack or poorly managed:• Utilisation – law firms mostly don’t manage manage this driver well

• Some major firm data follows• Around 75% of firms achieve close to 5 hours a day – or 1200 hours pa = 62%• The best firm in the country does around 6 hours a day = 75%• The best law firms in the world do over 100%• The best engineering firms do over 90%• The best consulting firms do over 90%• The major drivers of utilisation are

• Large revenue streams from relationship clients• Most law firms don’t know how to do this well

• Very good management processes that connect the sales pipeline to capacity on a daily basis

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• Overhead rate• Only two major firms in Australia are at a current best practice ratio of 30% of revenue• To sustain historical profit levels, law firms are going to have to do what the rest of the

business world has been doing since the GFC• Get more productive

• It is the case - and it is an unpalatable truth - that a significant % of law firm cost is spent on functions and activities that prop up the lack of capability in many partners

• Some firms are aiming for a new benchmark of 25% overhead rate• I think that firms should test themselves to see what they need to do to achieve a 20% rate

• Accenture are currently running around 17% overhead rate

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• Competition is intensifying at all levels:• M&A and capital markets

• Smaller volumes of work being attacked by a growing pool of global firms and more aggressive domestic firms

• A growing proportion of ‘bread and butter’ work is going in-house for cost reasons• The second and third tier firms are growing their capability and as a result are competing

more effectively for that ‘middle level’ work• LPO’s are attacking the bottom end of the market

• An increasing proportion of lawyers are suffering from depression – partly driven by a lack of meaning in what they do • These forces are not helping this state of mind of a lot of people – partners and lawyers

• Most firms don’t have the people capabilities, systems and processes to prosper in the long term in this new set of market conditions

• There will definitely be winners and losers

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How do Firms Respond?

• Put the client at the centre of everything• Law firms organise themselves around geography or practice groups right now• The best firms in the world are inching their way to focus on sectors and within sectors key

clients• Sectors and clients are becoming the primary organisational focus for many of the best

firms• Engineering story

• Strategy is about two things• Where to compete• How to compete

• Firms need to be crystal clear where they are going to compete – and there are a variety of models being developed:• Focus on M&A and capital markets work in clearly defined sectors and clients• Focus on a sector – e.g. resources• Focus on a service line

• Quinn Emannuel• You need to choose a market position that is right for you

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• Put the client at the centre of everything• Learn how to manage clients better – the account management process• Learn how to manage client relationships better

• Refocus all your discretionary marketing spend on building the relationships with key buyers in your targeted clients

• Engage your people around making a difference to your clients• This will make a difference to their lives – and provide meaning to a lot of people who are

searching for that• Invest in building the capability of all your people to serve clients better• Invest in the systems, processes and technology that will help your people serve your clients

better• Need a strong partner culture to deliver on this

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• Generate differentiation – the ‘how to compete’• Focus on a few service attributes most valued by your key clients• Build a culture to deliver on those

• Get into the demand generation game• Which is what the best PS firms do – and the best law firms do as well• An example is work at the board level on major risk and compliance issues

• The rise of the litigator• Demand generation can only come from a deep understanding of industry issues and specific

client issues – and thinking about how to connect all the firm’s capabilities to deliver major benefits for clients

• Re-engineer your financial model:• Build commercial models that are attractive to your clients• Slash your overhead costs

• Tell the partners that their crutches are going to be progressively removed• Learn how to manage utilisation better

• Link stock levels, sales pipelines and capacity forecasts

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• Reward partners who manage, nurture and develop client relationships• Most law firms in Australia only regard ‘work’ as billable hours• In a world where everything is contestable, people who bring in the work need to be

rewarded effectively• The US law firms do a much better job of this

• Top US firm – highest paid partner• 68 years old • Origination - $40 mill• Clients managed - $30 mill• Responsible billings – 0• Personal billings – 0

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The Role of Leadership

• Leadership is the capability that is core to long term success in any highly competitive market• Law firm boards need to answer these questions:

• What leadership do we need to implement the strategy of the firm?• What leadership do we have right now?• How do we plug the gap – on a sustainable basis?• How do we get the leaders to behave according to our values – and so build a strong culture?

• Leadership in a law firm covers all partners and all key functional executives• It is not just the managing partners

• Getting the answers to these four questions right will allow the firm to deal with all the issues we have discussed and prosper going forward

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Contact Details

John ColvinPrincipalE: [email protected]: +61 409 183 174S: +61 2 8823 3485Level 36, Governor Phillip Tower1 Farrer Place, Sydney NSW 2000, Australia

Sandra HeinigSenior AssociateE: [email protected]: +61 416 731 897S: +61 2 8823 3485D: +61 2 8823 3487Level 36, Governor Phillip Tower1 Farrer Place, Sydney NSW 2000, Australia

Sian O’ShaughnessyResearch Analyst E: [email protected]: +61 2 8823 3485 Level 36, Governor Phillip Tower1 Farrer Place, Sydney NSW 2000, Australia

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The new normal and its implications