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PROFITABILITY STRATEGIES: TO GROW OR NOT TO GROW

The Alliance Option: Merger? Strategic Alliance? Joint Venture?

What’s Right for Your Future?

By H. Edward Wesemann

Don’t succumb to merger mania without considering alternatives. Your long-term profitability may be better served with a lesser commitment. Do you want to limit risks? Maximize rewards? Investigate strategic alliances and joint ventures.

 

We could call the 1990s the Golden Age of Mergers. In many industries, most noticeably the financial and service sectors, businesses merged in record numbers. Banks, insurance companies, brokerage houses, accounting firms, consultants, hospitals and even medical practices merged, and then remerged.

For law firms, merger considerations became an essential part of strategic planning. Internationally, through a rapidly executed series of mergers, firms such as Clifford Chance and White & Case quadrupled in size and found themselves in dozens of countries, seemingly overnight. In the United States, regional firms such as Holland & Knight, Foley & Lardner and Greenberg Traurig became national institutions.

Even with their frequency during the past few years, law firm mergers are not yet close to peaking. Indeed, although conflicts of interest are cited as having a dampening effect on mergers, corporate general counsels are becoming increasingly liberal in their waivers of technical conflicts. And law firm leaders seem more willing to sacrifice some clients to achieve the strategic benefits of an important merger.

Along the way, law firms have given nodding consideration to other forms of consolidation. Collectives such as Lex Mundi and U.S. Law Firm Group have became popular alternative means of achieving firm growth. There have also been examples of successful joint ventures among firms in opening new offices. In general, however, law firms have overwhelmingly preferred to merge instead of embracing options allowing a lesser commitment.

Yet why, one must wonder, given the legal profession’s traditionally risk-averse nature, the high degree of risk inherent in mergers and the surprisingly little due diligence that typically accompanies the process? Before law firms default to the next round of merger mania, it is highly worthwhile to take a look at other forms of alliances when weighing profitability strategies.

Why Merge? The Strategic Objectives

To rationally consider the options to mergers, you first need to understand what strategies and objectives drive mergers. Basically, the critical questions are: Why are we merging, and how will we know if the merger is a success for us? There are four, and only four, legitimate merger strategies.

Building capacity. Whether it is to establish preeminence in a strong practice area or to shore up a weak area, a well-conceived merger can improve capability more quickly—with less capital at risk—than lateral hiring or internal development.

Establishing a geographic footprint. Legal services are purchased on a highly geographic basis. Therefore, to enhance existing client relationships or create new opportunities, many firms must enter new locations.

Creating critical mass. It is understood that sheer size does not equal capability or success. Yet relative size does matter in the marketplace, and it is often the measure by which clients and law school recruits make decisions.

Acquiring leadership. Some firms lack partners with the training, disposition or interest to fill leadership roles. Increasingly, firms are pursuing mergers with other firms that have clear leadership vision and implementation capability.

Amazingly, many law firm mergers do not appear to advance any of these strategies. One could, of course, argue that anytime a firm adds more lawyers, it increases its capability and its critical mass, and that a merger anywhere other than a firm’s current locations expands its footprint. But does the result—in even the most optimistic assessment of the outcome—justify the cost and the risk?

Minefields: Merger Downsides

On its face, a merger is very unambiguous: It involves a change of legal entity brought about through negotiations that are documented by a formal agreement. Unfortunately, it is precisely this formality that gets in the way of some alliances that make the most strategic sense and offer the greatest potential. Here are three issues that must be resolved before any merger can move forward.

1. Cultural compatibility. The biggest concern in any merger is whether the two firms’ cultures are compatible. This goes beyond whether the partners like each other and could work together in a merged firm. Culture determines what the organization values and permits and how decisions are made.

2. Profitability differences. Profit comparability is the litmus test for most mergers, albeit profitability is as much a function of a firm’s leverage and partnership admission policies as it is of the firm’s core economics. Experience indicates that it is almost impossible to put together a merger between two firms whose profits differ by 20 percent or more.

3. Conflicts of interest. Conflicts blend business decisions with professional ethics and the personal interests of individual partners. When a merger is truly worth doing, rarely is a conflict of sufficient magnitude (in terms of lost profits) to outweigh the merger’s benefits. Firms, therefore, will balance ethical concerns for their clients’ best interests with concerns about what will happen to the billing partners for clients connected to a conflict.

There are, of course, other merger issues. Mergers are forever. Untangling a merger is almost impossible, since putting in place the functional provisions that would permit a rapid rewind of the merger would all but assure its failure. Consequently, firms miss tremendous opportunities to avoid the risk of a bad outcome.

Also, mergers usually come with excess baggage. To obtain a practice capability or an office in a specific city, a firm may have to accept some unproductive partners, an undesirable practice area or an office in a locale that makes little strategic sense. Corporations that merge almost always "cull the herd." But the cultural costs in a partnership structure make that quite difficult in a law firm, if not practically impossible.

There are several options to mergers. The two most prevalent are joint ventures and strategic alliances.

The Joint Venture Option

A joint venture is an arrangement in which two businesses join together for a specific and limited purpose. Typically, the driving interest in creating the venture is to reduce risk.

For example, several years ago the San Francisco firm Brobeck, Phleger & Harrison and the Boston firm Hale & Dorr entered into a joint venture to open offices in New York City and London, England. Both firms believed that their clients had sufficient interests to justify offices in those cities, and both believed that a presence in those cities would permit them to generate new work from other clients. They also saw a strategic value to having New York and London listed on their letterheads, although both cities are notoriously expensive places in which to open an office. The joint venture allowed these firms to open offices at 50 percent of the overhead cost of going it alone. Each certainly had the capital and reputation to open its own office or pursue a merger with a firm in each city. However, through a joint venture they were able to avoid the cultural, financial and conflict issues that would have been present in a merger.

At the same time, they were able to enjoy the advantage of offering clients enhanced capabilities. For example, Hale & Dorr’s primary interest in New York was litigation, and Brobeck, Phleger’s was transactional. Thus each firm’s lawyers in the new office were able to refer work back and forth. In addition, the joint ventures were well publicized and both firms made more of a public relations "splash" than either could have achieved individually.

Risk vs. reward. Because joint ventures are designed to avoid risk, they have inherent characteristics that may or may not be beneficial to the participants. For one, joint ventures tend to be carefully and rigidly structured. They typically include an agreement that spells out every detail of the relationship, including the expectations of risk and reward. Such agreements can result in cumbersome decision-making procedures. For example, it is not uncommon for partners in a joint venture to fear that the active participants in the venture will, later in the game, change or dilute key protective provisions. To protect against changes, the agreement may provide that changes require approval of both firms’ executive committees or, in the worst case, the entire partnerships. Such protections often render a venture too inflexible to succeed in an entrepreneurial marketplace. They can also distract the firms’ highest management with minute details that are hardly the best use of their attentions.

In addition, the structure of joint ventures can make it difficult to pursue unexpected opportunities. Suppose, for example, that in the case of Brobeck, Phleger and Hale & Dorr, one firm succeeded to a greater degree than the other in the New York office. Unless it wanted to open a second office, the more successful firm could be constrained by both the joint venture agreement and the office lease. At the same time, while their agreement could cast the two firms as co-tenants with "Chinese Walls," to limit the risk of shared liability or conflicts of interest, those protections could effectively eliminate opportunities for joint marketing or cross-referrals.

In short, the very aspects of a joint venture that limit risk also tend to limit the potential for reward.

The Strategic Alliance Option

Strategic alliances are a "touchy-feely" version of joint ventures. In its purest form, the strategic alliance is like kids building a tree house. Someone brings a hammer, someone brings nails and someone brings surplus wood from the family garage. The participants have only a vague vision of what the tree house will look like. They don’t worry about keeping track of who is contributing what, or specify how much each participant gets to use the tree house. If someone new shows up, they make the tree house a little bigger or each uses it a little less. If a participant leaves to do something else, the alliance may or may not continue to exist.

However, several important things happen in the process of building the tree house:

• Alone, none of the builders has access to all the needed tools and materials, but together they are able to pool their assets. Each party’s investment in a strategic alliance typically involves assets they already possess.

• Among the children building the tree house, one may have learned carpentry skills from a family member, and another may intuitively know how much weight can be put on a tree branch. A key value of a strategic alliance is sharing of knowledge and skills, often involving proprietary knowledge or core competencies not readily available in the marketplace.

• By working toward their common objective, two children who have not gotten along have occasion to work together, even though they may return to being rivals when the tree house alliance is over. Strategic alliances tend to bring together parties that may have been competitors, co-opting them into allies.

• Parents or neighbors who might have been concerned about the tree house may be mollified by the participation of children they trust. In fact, that trust and positive recognition can carry over to things outside of, or in addition to, the tree house alliance. Often the parties in a strategic alliance can benefit from each other’s market presence and reputation.

Unfortunately, the most widely recognized examples of strategic alliances in the legal profession have not been particularly successful. The law firm affiliations such as Lex Mundi and U.S. Law Firm Group were designed to meet two primary objectives: referring business among law firms and permitting midsize firms to present themselves as having a broader geographic capability, to better compete with large national firms. It is important to point out that most of the members of these affiliations are satisfied that they receive sufficient value to justify their contributions. However, many admit that the actual business referrals have been less than originally expected.

Risk vs. reward. If there is a degree to which the law firm alliances have been less than fully successful, it results from their being a cross between a strategic alliance and a joint venture. As in a joint venture, the relationship between the firms is rather carefully defined and their risk is limited. While they hold annual meetings, there is relatively little sharing of knowledge or benefitting from each other’s assets, except by their respective physical locations. There is not a mandate that all business being referred to a city must go to an alliance member, because that could represent a risk to the referring firm. Therefore, in classic joint venture form, maximization of reward takes a backseat to risk avoidance.

Contrast that with the group known as "The Seven Sisters." While not truly a strategic alliance, seven large law firms—six from the United States and one from England—have created an informal organization with little structure, gathering lawyers from firms in reasonably noncompetitive marketplaces. The managing partners meet from time to time, as do senior staff members and practice group chairs. The result is informal sharing of knowledge, informal co-opting of rivals and some degree of asset pooling. And, while not an objective of the group, significant referral of work occurs among the members.

The particular value of strategic alliances may be as an alternative to (or perhaps a first step toward) mergers designed to enhance capabilities. Suppose, for example, that a product liability defense firm sees food additives as a significant potential liability for businesses throughout the food industry. The firm has the legal skills to manage a large-scale national tort defense, but it lacks technical knowledge and relationships with major food producers, wholesale distributors and retail chains. Engineering a merger or lateral acquisitions to obtain the appropriate capability would be difficult and expensive. But what if this firm strategically allied with a major FDA law firm that already had significant corporate representations of food chain companies and employed genetic engineering consultants? It could lead to incredible opportunities for both firms.

Can Alliance Options Really Work?

Despite the advantages, there are powerful reasons why strategic alliances could be difficult vehicles for law firms.

• Law firms, by their nature, desire specificity and structure in their relationships. Strategic alliances are, by their nature, ambiguous—therefore, law firms tend to distrust them.

• In a profession where the typical basis of value is time, it is difficult to gain consensus for involvement in an activity with no specific reward for the investment of lawyers’ time.

• Strategic alliances work best when participants do not have overlapping capabilities—that is, when everyone brings something different to the table. It is rare that large law firms don’t have common capabilities.

• Strategic alliances require leadership and vision, which are in short supply in too many law firms.

• Strategic alliances are typically focused on the results of competitive pressures. Many lawyers don’t view their marketplaces as sufficiently competitive to motivate strategic cooperation.

Look Closely

Still, in the final analysis, joint ventures and strategic alliances could be valuable structures for law firm growth, particularly as alternatives or preludes to a merger. Their viability depends on the parties involved, the precise circumstances and the degree to which the parties view the marketplace as highly competitive. When considering any consolidation, look closely at joint ventures and strategic alliances as a routine part of the due diligence process. You might find that one of these options is your best profitability strategy.

Ed Wesemann (wesemann@edge.ai) is a principal in Edge International, a consulting firm that works with law firms around the world. He limits his consulting practice to growth strategies, including mergers and other strategic ventures. He can be reached at (877) 922-2040.

The author wishes to acknowledge Alliance Advantage by Yves L. Doz and Gary Hamel (Harvard Business School Press, 1998) for thoughts about strategic alliances.

Also, a posthumous thank-you to the late Jack Colbert, former executive director of Hale & Dorr, for his insights into the Brobeck Hale & Dorr joint ventures.

SIDEBAR: The Alliance Option

Compare the Options

Joint Ventures Strategic Alliances

Objective: Risk limitation Reward maximization

Structure: Detailed agreement Free form

Management: Bilateral Delegated

Best Uses: New offices New capabilities

Ancillary businesses Business development

Back-office functions Knowledge acquisition