We are seeing a significant roll up among smaller and mid-sized law firms in the U.S. Evidence of the consolidation of law firms can be seen in Of Counsel magazine’s annual survey of the 700 largest U.S. law firms. In 1994 the 700th firm had 51 lawyers; in 2006 the 700th firm had 20 lawyers. The consolidation among law firms was sufficiently great over the past 10 years that the survey had to dip to firms of just 20 lawyers to come up with 700 firms. While consolidation has occurred among all sizes of firms, the greatest number of mergers seems to have been smaller firms being acquired by larger firms as a means of entering a new geographic market. Our consulting practice primarily centers on working with larger firms focused on growing in new markets. However, we hear quite frequently from mid-sized firms about how to deal with what they view as the incursion of out-of-town firms in their primary geographic markets. As one Managing Partner phrased it, “How do we keep the carpetbaggers at bay?”
Historically, the most attractive cities to out-of-town firms were the major markets: New York, Washington, Chicago and Los Angeles. The legal markets in those cities were so large and exhibited such active growth that there was little local concern about the intrusion of competitors. In fact, the local firms with whom the incoming national firms would primarily be competing were themselves largely national firms with a focus on moving into other markets. But as firms began moving into secondary markets like Denver, Charlotte and Las Vegas their presence is perceived by smaller local firms as a greater threat.
This level of increased geographic competition is fueled by a number of sources. In part, it is the result of firms seeking new markets to compensate for stagnation in the amount of available legal work to support an increasing number of available lawyers. The total receipts for private practice legal work in the U.S. is roughly $230 billion*. The total number of U.S. lawyers in private practice is a touch below one million**. Quick math tells us that the overall economy creates revenues per lawyer in the ballpark of $230,000. While we won’t know for sure until the 2007 economic census is published late next year, there is general agreement that the national revenue per lawyer is not increasing significantly. This is a function of all of the usual suspects — tort reform and a dampened corporate litigiousness, recession fears resulting in a shrinking number of corporate transactions and Sarbanes Oxley driving some legal work to London. At the same time, the denominator is growing as approximately 28,000 U.S. law school graduates enter private practice annually, outweighing the number of lawyers who retire or leave for other pursuits.
Another driving feature of competition is the maturation of the legal industry. Among the hallmarks of a growth industry are broadly spread market share among a large number of competitors and limited ability by customers to compare price. The consolidation of corporate America has created fewer clients and the consolidation of law firms has distributed the clients among fewer firms. The result is the beginnings of dominant national market share by a few firms, particularly if you segment the market by practice areas. At the same time, legal panels and RFPs have required firms to compete at a whole new level of fee sensitivity.
The most aggressive drivers of rate sensitivity and transparent pricing are the largest corporations that have traditionally been the cash cows of major law firms. At the same time, many corporations that for years loyally sent all of their legal work (including the juicy litigation and sophisticated corporate transactions) to their local primary law firms are now sending that work to regional specialty firms or firms in capital market cities. Indeed, these changes in law firm relationships with the global corporate giants has not gone unnoticed by the legal community and firms are realizing that the new client crown jewel is the sub-Fortune 1000 company – businesses with between $100 million and $500 million in sales that frequently have very small in-house legal staffs.
This brings us to a third form of competition (and the real subject of this piece) – geography. As competition becomes more intense for the reasons noted above, large national and global law firms are seeking new markets where they can successfully guard their current revenue streams and attempt to create new ones. So we have mega-firms opening offices in second tier cities where they see a lot of mid-sized clients and plenty of good lawyers to poach. The strategy is simple: (1) merge to create an office with local attorneys and existing local clients, (2) use the revenues generated by the local clients to cover operating costs and the compensation of the local partners so the office is self-supporting, and (3) invest in pursuing growth opportunities through client synergies and broadened local capabilities to generate new revenue streams that benefit the whole firm. As a regional or national firm enters a relatively small secondary city market, how can the traditionally dominant local firms hang on to their client bases and their lawyers – and effectively compete?
The reaction of local firms typically evolves, beginning with a general denial about the out-of-town firms’ ability to realistically compete in their city. The first acknowledgement of a changed competitive environment often comes not from competition for clients but more with the loss of partners, who have a free-standing billing base, to the out-of-town firms entering the market. The eventual reaction by the local firms can take a lot of forms, ranging from complete fatalism to full warfare mode. But among the most common reaction is the expectation that the only course open to the firm is to be acquired by one of the incoming national firms.
It should be noted that there are a couple of important misconceptions that local firms have about competitors entering their marketplace. The first is that these new firms are better managed and more strategic. There is very little evidence of any correlation between the size of a law firm and the rationality of its actions. There are extraordinarily well managed large and small law firms. Here is a typical scenario of how geographic expansion occurs in many law firms: a partner of a national firm has a case in Austin, Texas. He or she likes Austin, sees that it is a growing area and thinks it would be a good place to have an office. She prepares a business case designed to support an Austin office rather than objectively considering the facts because, of course, she is by nature an advocate. The business case is presented to the management committee and, if she is persistent and no other firm members’ interests are averse to having an Austin office, the firm initiates a search for potential merger candidates in Austin. The fact is that large firms often operate no more strategically than small ones.
A second misconception is that out-of-town firms are usually successful in capturing markets from local firms. This is sort of the Wal-Mart philosophy that, if you are a merchant and Wal-Mart comes to town, you might as well shut your doors. In fact, a large number of out-of-town firms never grow much beyond the size of the practice of the firm they initially merge with and often decline in size.
But the most important point is also the most obvious. In order to be successful in a market, an out-of-town law firm must be able to attract the best clients and/or the best lawyers in the marketplace. True, there are possibilities of synergies with other clients in other cities but, normally, if a firm merely stays the same size with the same lawyers and clients that they acquired when they came to town, they will have done nothing to improve the overall firm. Therefore, the primary strategy of any incoming firm must be to build talent and client base (and, frequently, client base comes with acquired lawyers).
By extension, therefore, the core defensive strategy of local firms must be to safeguard its assets – the firms’ key client and its partners with portable client relationships. There are three primary strategies that we have seen local firms use:
1. The Loyalty Card. Whether protecting the firm’s lawyers from bolting to new firms or hanging on to traditional clients, loyalty to the firm and to the community play an amazingly effective role. This includes making sure that the firm is a vital and visible part of the community and making sure partners appreciate the value of the firm’s culture. Using loyalty, of course, presumes that the firm has maintained an active role in the community and has a collegial and supportive culture.
2. Designed Capability. This requires understanding the unique needs and sensitivities of clients and contrasting the local firm’s ability to serve them compared to the out-of-town firm. Clients have an inherent fear of “being just a number” at a large firm and some local firms have successfully played on this. By the same token, to retain partners the firm focuses on the needs of its partners in advance of recruitment efforts by out-of-town firms, and attempts to develop the means of meeting those needs. The core of this strategy is to focus on the fact that any benefit provided by a larger out-of-town firm is off-set by other disadvantages compared to using or being with a local firm.
3. Pricing. A strategy that resonates well in retaining both clients and partners is the concern that out-of-town firms may cause an increase in rates. The message that local firms send is their intention of maintaining a local rate structure even though the presence of out-of-town firms may cause an overall increase in price by competing law firms.
Much of the foregoing is common sense. Expansion into new markets will continue to be a core strategy for expanding the practices of larger firms. But there are basic strategies that local firms can pursue to defend against out-of-town firms entering their markets. However, these strategies are at best stopgaps. The best defense is a strong offense and these defensive strategies need the support of an active strategy to grow within the marketplace. And this means developing strong new capabilities and sustainable areas of differentiation.
*U.S. Department of Commerce figures for 2002 interpolated by increases in GNP and professional service employment through 2006.
**The ABA reports the total number of licensed lawyers in the U.S. at the end of 2007 as 1,143,000; however, this includes lawyers who are licensed but not in private practice.