The great Aussie merger mystery

There is more than one way to skin a cat. From Norton Rose’s Swiss Verein, Allen & Overy’s (A&O) team-poaching and Clifford Chance’s merger with boutique firms to the alliance between Linklaters and Allens and the recently announced full merger between Herbert Smith and Freehills it is intriguing how many ways international firms are using to fulfil their Australian aspirations. So just what is it about Down Under that is generating such a multitude of structures?

While each expansion strategy is largely dictated by the firm’s philosophy, the Australia phenomenon is a reflection of the issues that international firms have to deal with when they expand into a new, yet relatively mature, market.

“International firms are approaching the Australian market in different ways,” says Brad Hildebrandt, founder and managing director of Hildebrandt Consulting, who has participated in numerous law firm merger discussions, including King & Wood Mallesons’ Swiss Verein. “That’s partially driven by the complexity of doing global transactions, particularly when entering a very different market.”

Differences in regulatory requirements, tax regimes, risk profiles, average fee rates, overheads, and equity structures are among commonly identified challenges firms have to overcome when considering a full financial merger with a foreign entity, but fundamentally it is disparity in profitability between firms that has made integration a sensitive topic.

Here’s the lowdown on how they’ve tackled the issue.

Relative values

The pace of change in the Australian marketplace has been phenomenal. In the past two years four of the ‘big six’ national firms have lost their independence. Australia has become a key part of the global market, largely driven by its proximity to Asia and its richness in natural resources.

Strategically, Clifford Chance’s Australian merger options highlight more than most the challenges and risks for top international firms when looking to merge with large Australian counterparts.

In December 2008 Clifford Chance terminated its six months of merger talks with Australian firm Mallesons. In 2011 the magic circle firm launched in Australia through mergers with boutique firms in Sydney and Perth. The double tie-up, which went live in May 2011, saw the firm join forces with Chang Pistilli & Simmons in Sydney and Cochrane Lishman Carson Luscombe in Perth, creating a 14-partner presence in the country. Equity partners of the two legacy firms joined the full Clifford Chance lockstep.

Although aborting the Clifford Chance-Mallesons merger plan was said by both firms to be a result of post-Lehman Brothers market conditions, the magic circle firm ultimately chose to have a more focused, smaller and lower risk presence Down Under two years later.

“Australia is a G20 country – it is an important economy, but also a small one,” says Michael Lishman, managing partner of Clifford Chance’s Perth office and founding partner of Cochrane Lishman Carson Luscombe. “Its GDP accounts for less than 2 per cent of the world’s total. As a global firm, we need to align the firm to its clients and the global economy. That means the ideal size of the Australian practice should be in proportion to the country’s weight in the global economy.”

In other words it may be out of proportion to have a global firm with one third of its partners based in Australia.

The problem of size is magnified when the fluctuation of exchange rates is taken into account.

“On the back of a strong Australian dollar the proximity of profitability between a UK and top Australian firm has never been so close,” Lishman adds. “But if you have a A$400m (£263m) practice in Australia, when the exchange rate against the pound drops by 20 per cent there will be a huge impact on the whole firm’s economics.”

At the moment the British pound is around 65p to one Australian dollar. In 2008, it was around 45p to one and back in 2002 it was 35p to one – almost half what it is now.

“Economically, a merger with a big firm will be okay for the next a few years, helped by the exchange rate,” Lishman relates. “But in the longer term if the Australian dollar value goes back to its historic level the profitability gap will be too big.

“You have to have most parts of the business within a range of profitability. You can’t have one part diluting the profits for a long period of time. Given our size relative to the whole of Clifford Chance we can double our profit per equity partner [PEP] or halve it without having a material impact on the global profit pool.”

In this regard the full financial merger between Herbert Smith and Freehills will probably face a big test. At the moment, Freehills’ average PEP is estimated at £618,000, a manageable distance from Herbert Smith’s £840,000. However, should the Australian dollar value drop by 20p the gap will almost double to £413,000. If 190 partners are in Australia, that would mean a reduction of £36m in the combined firm’s total net profit.

“The three big factors to consider when contemplating a merger are name, money and power,” says Lishman. “There was no question we would adopt Clifford Chance’s name and we fit into its structure easily without upsetting its existing management power and firm culture. The way Clifford Chance entered Australia is easier and lower risk way than a merger with a large firm.”

It may be a low-risk entry strategy, but it is not without its shortcomings. Clifford Chance’s absence from the Australian government’s Legal Services Multi-Use List, the government-wide legal panel, is one example. The Australian arms or alliance firms of all other UK firms that have entered the market in the past three years are featured in the list.

Scratch card

Similar to Clifford Chance, Allen & Overy’s (A&O) strategy in Australia is also to stay focused on top-end transaction work in its core areas. However, it opted to set up an office from scratch with a group of carefully selected partners from top-tier Australian firms instead of doing a merger.

“Look at the size of the Australian economy – a 200-partner Australian firm is too big to swallow for a global firm,” says Grant Fuzi, managing partner of A&O in Australia, who led the exodus of 14 Clayton Utz partners to the UK firm in 2010. “There are ways around it but it’s very hard.

“Our strategy is to have a clearly defined offering. We’re here to focus on the firm’s core practice areas. The way we entered the market and the team we’ve assembled here is reflective of that strategy. It’s a competitive market, but we’re an integral part of a global firm with a single profit pool and partnership. That’s attractive to clients and talent.”

Clyde & Co is the latest UK firm to enter the market. It has also chosen to establish a new practice with cherry-picked partners to focus on specific practice areas. In July it hired a number of partners from Linklaters’ Australian ally Allens, who will launch the firm’s offices in Sydney and Perth on 1 October.

Starting with a clean slate and a carefully assembled team in Australia surely has its merits, but it also comes with drawbacks and risks.

“If you look at the initial cost, entering Australia through a merger or a Swiss Verein with an already profitable firm involves quite modest costs,” says George Beaton, executive chairman of Australian consulting firm Beaton Research & Consulting. “But setting up an office from scratch is more capital-intensive. It’s common to spend A$10m to set up a greenfield operation, and it usually takes three years to make it profitable,”

Verein tasty

In addition to costs, another area where issues are easily underestimated is in managing a newly established firm.

“Managing the integration of merged firms is not something to underestimate,” says one managing partner at an international firm in Australia. “But making a newly formed firm work carries a different set of risks. The risks associated with putting together a group of partners from different firms are generally about whether they have the required management skills to run a business and keep it together, and how well and quickly people can adapt to a new working environment and an organisational hierarchy that is very different from the firm they came from.”

When Norton Rose added Australia’s Deacons to its Swiss Verein there was no lack of skepticism over its nature and the degree of integration. K&L Gates’ chairman Peter Kalis famously claimed the Norton Rose deal was closer to an “arrangement” than a merger in the true sense, when the firm merged with Canadian firm Ogilvy Renault and South Africa’s Deneys Reitz in 2010.

“The Verein structure offers great flexibility in structuring a global deal and is a convenient choice, but the question remains why a partner in one law firm office should refer work to a partner in another office who doesn’t share either profitability or liability,” says one partner at an international firm. “There’s little incentive for cross-referrals and client-sharing, and there’s also the danger that people can’t work together as a seamless unit across jurisdictions to service clients’ best interests.”

However, there are also counter-arguments, mostly from firms that have adopted the Swiss Verein structure. One common argument states that financial integration is not the only way to motivate and encourage ‘good behaviours’ such as collaboration, cross-selling and client-sharing within a firm.

“By having common systems, policies, management and strategy, we can ensure a ‘one-firm approach’ and ‘one-firm culture’ among the members in the group,” says Wayne Spanner, managing partner of Norton Rose Australia.

According to Spanner the group is governed by a global executive committee, while each practice area is led by a global group practice head who works closely with sector leaders in different regions. He refers to the Norton Rose group as “an integrated business aligned along practice groups and industry groups”. The group also has a dedicated global mobility function to encourage the movement of partners and staff within the global network.

The Swiss Verein has worked well from the Australian partnership’s perspective, says Spanner, as Australian revenue has grown by 10 per cent each year since the tie-up in 2009.

Norton Rose’s argument is seconded by several management consultants.

“A Swiss Verein can work perfectly well, but it needs more management effort and a fair bonus system to reward partners who are moving work to the network,” says Hildebrandt. “I’ve seen global firms with a fully integrated partnership structure have a much lower level of collaboration between offices than Vereins,”

“There are various tools and mechanisms available to motivate one-firm behaviour,” adds Beaton. “The importance of a single profit pool in making a global merger work is overstated. In a sense, having a single profit pool doesn’t mean full profit-sharing, while members can still share profits within a Verein even there are separate financial centres,”

Evolution vs revolution

The Herbert Smith and Freehills deal has attracted great interest in the industry, as the two are set for full financial integration from day one of the merger. When the announcement was made it sent shock waves through the global legal community. Word was that the deal looked like too ambitious a leap, given the two firms’ very different partner remuneration systems. For example, Freehills is known for its merit-based renumeration system, while Herbert Smith operates a traditional lockstep system. In addition, Freehills has considerably more equity partners than Herbert Smith, where more than half of the partners are non-equity.

But it turns out that ‘full financial integration from day one’ means only that the two will share a single profit pool – it doesn’t mean a single system of distributing the profits.

There is no clarity yet on the details of how the combined firm will allocate profits, with Herbert Smith managing partner David Willis keeping things pretty much under wraps. Nevertheless, he is willing to provide a rough picture of what the new system will look like.

“The key thing is that we’ll have a single profit pool from day one and we’ll have a single management in place,” he says. “The rest of [the merger arrangements] still need to be finalised. One profit pool can best incentivise partners to work together towards a common goal – that’s why we decided to make the jump straight away.

“We’re in the process of creating a new international LLP that all partners of the merged firm will be in. There’ll be a new partner agreement to the new vehicle, which will present a new set of arrangements. The terms are still being discussed with both firms’ partners. We’ll have to converge the two renumeration systems and the result will be a modified lockstep. It will take some time to complete the process.”

A source close to the deal reveals that before the new system is in place the two sides will split profits on a pre-determined ratio and then distribute these to partners according to their current remuneration systems.

It may be a disappointment for some market participants to find out that Herbert Smith’s supposedly revolutionary move with Freehills is in essence not an entirely different beast from Ashurst’s Blake Dawson deal, which has been labelled as an evolutionary process towards a true merger.

Conservative parties

Linklaters’ alliance with Allens has been widely categorised as the least integrated tie-up and, in some sense, least effective in terms of creating value for the firms and their clients. The relationship has been described in some quarters as ‘hand-holding, but no marriage’.

Even so, Allens’ managing partner Michael Rose insists it is the best solution for his firm and its magic circle ally.

“Clients want us to have execution points in more places,” says Rose. “To continue to work with our clients we have to gain greater global capability. The alliance will focus on developing energy and resources projects across Asia and servicing existing clients in Asia through joint ventures. We only want to bring our businesses together in places we’ve identified as growth engines for the future. We don’t want to change other parts of our business.

“In relation to the Australian market we already have a strong position. We want to offer a broader global network, but it’s not necessary for us to cease to exist. Both firms value their independence and we decided that this was the best structure for what we’re trying to do.”

He also emphasises that “the alliance is not a trial run for something else”.

In the coming years the Australian market will evolve and more international firms will arrive. The next development to watch will be how K&L Gates structures its merger with Melbourne-based mid-tier firm Middletons, an outfit with a total revenue in 2011-12 of A$112m – roughly 11 per cent of K&L Gates’ global revenue. Perhaps the firm that does not believe in Swiss Vereins will introduce an innovative way of tackling the Australian merger mystery.

In the meantime, despite the variety of methods of entering to Australia the consistent message is that clients do not really care about their legal advisers’ underlying business structure so long as they meet their expectations. In that respect Australia is no different from anywhere else.