MERGERS, METRICS, AND OTHER MUSINGS
Recently I was musing about the frenetic merger and acquisition activity that has engulfed the business landscape, including the business of practicing law. In its MergerWatch press release for year-end 2006, Hildebrandt International, Inc. said 58 mergers and acquisitions involving U.S. law firms were completed in 2006, vs. 49 in 2005 and 48 in 2004. The company said it expects “to see merger activity continue at an active pace” in 2007.
What are we to make of this law firm M&A activity? In the “non-law business” business world, mergers often fail to accomplish their intended purpose. In a 2004 article entitled “Where Mergers Go Wrong” McKinsey & Company noted, “[I]t is typically not the buyer but the seller who captures most of the shareholder value created.” The article’s authors believe this result is due to the fact that “Most companies routinely overestimate the value of synergies they can capture from acquisitions.” You remember “synergies” –the enhanced economic value expected from the merger, but often defined by “new” math as 2 + 2 = 5. Synergies occur in the areas of revenues, expenses, and capital costs.
The McKinsey article asserts the area of greatest estimation error relates to revenue synergies – nearly 70% of the mergers in its database failed to achieve the estimated revenue synergies. The article points out practical steps executives can take to improve their odds of successfully capturing synergies:
For starters, they should probably cast a gimlet eye on estimates of top-line synergies, which we found to be rife with inflated estimates. They ought to also look hard at raising estimates of one-time costs and better anticipate common setbacks or dissynergies likely to befall them. They might also vet pricing and market share assumptions, make better use of benchmarks to deliver cost savings, and get a better fix on how long it will take to capture synergies.
What things can law firm M&A candidates do to avoid the “synergy trap”? Right away one thing comes to mind – LawBall-type analysis, including a pro-forma of the post-closing firm, to facilitate the “due diligence” review. Certainly, numbers aren’t the entire story to a successful M&A transaction; the transition and integration of the people, technology, and processes (including the typical law firm hot spots – culture and management) in the post-closing firm are critical. But LawBall analysis, as with financial operating performance, can lead one to ask critical questions that facilitate a deeper understanding of the strengths and weakness of both the pre- and the post-merger businesses.
Let’s quickly look at 2 examples. The first is the merger of Kirkpatrick & Lockhart Nicholson Graham and Preston Gates & Ellis, a merger announced in late 2006 and effective on January 1, 2007. Using The American Lawyer’s 2006 (2005 operating results) AmLaw 200, here’s a look at both firms, as well as a “pro forma” for the consolidated firm with no changes in the number of lawyers, partners, gross revenue, or profit for either of the merger partners:
Note the disparity in pre-merger return on equity (ROE or profit per partner). Law.com reported that:
[K&L Chairman Peter] Kalis said the difference is not much of a concern for the firms. He said Preston Gates has a higher percentage of equity partners than his firm, and the firms believed that the synergies between them would overcome the difference in PPP. Kalis said no one is being de-equitized as a result of the merger.
Some of those synergies between the two firms, Kalis said, are Preston Gates' technology practice and Kirkpatrick & Lockhart's financial services and manufacturing practices.
It looks to me like Kalis’s expected “synergies” are revenue synergies, which based on the experience noted by McKinsey & Company will be difficult to realize. Also, note the return on assets (ROA or profit per lawyer) both pre- and pro forma post-merger, which appear low by comparison to the ROAs we’ve looked at in prior postings. That indicates an inefficient use of assets (lawyers). Finally, pro forma post-merger changes in margin, asset turnover, financial leverage, ROE, and ROA all favor Preston Gates; only does pro forma post-merger cost per lawyer favor K&L. Was this kind of analysis used? If not, would it have changed anyone’s opinion? I don’t know; but as a member of either firm I would’ve wanted to see this analysis long before I voted so I could ask financial questions and get comfortable with the answers.
The second example involves a merger that was announced but called off – the merger between Dewey Ballantine and Orrick Herrington & Sutcliffe. Although one look at the 2005 individual and pro forma consolidated numbers indicates that a merger might make sense, another view signals that there could be problems. Here’re the numbers, again from the 2006 AmLaw 200 and from the 1997 AmLaw 100:
I'm surprised at how close the margin, asset turnover, financial leverage, ROE, ROA, and cost per lawyer for the pre-merger firms are in a relative since – both between the 2 firms and to the consolidated pro forma for the post-merger firm. However, when I examine the 9-year compounded annual growth rates (CAGR) for both firms, one thing screams at me – Orrick’s growth rate in all areas vs. that of Dewey. Such a disparity tells me that I’d likely find differences in management and culture that might be too severe to overcome for the merger to succeed. When reporting the cancellation of the merger, Law.com said:
A source close to the deal said there were three major sticking points: Disagreements over management and governance at the new firm, concern over Dewey's unfunded retirement benefits, and concern over the number of defecting Dewey partners.
Oh, yeah – one other musing. This same LawBall analysis will work – and be helpful – in lateral hiring decisions, whether a firm is hiring 1 lawyer or 50 lawyers. When a law firm proposes acquiring assets (which lawyers are), it should understand the potential financial impact just like, say, an office REIT that seeks to acquire a portfolio of office buildings.