Mittelstand: can regional firms keep the big boys at bay?

The downturn is forcing larger firms to pay more attention to mid-sized companies. By Aled Griffiths

The Mittelstand market is the road to success for German corporate practices. Mid-sized companies – defined roughly as having turnovers of between e50m (£35.3m) and e500m (£352.7m) – make up a third of the gross national product, according to German state investment bank KfW. Even that figure fails to do justice to the importance of this market for the top 10 per cent of commercial law firms.
Hengeler Mueller may only dip its toe in now and then, but make no mistake: every other leading firm cultivates these mostly owner-managed or family-managed companies as much as they can. Freshfields Bruckhaus Deringer and Shearman & Sterling make the headlines with their deals for the German blue-chips, but Freshfields’ practices in Hamburg and Düsseldorf, and the corporate powerhouse office of Shearman in Mannheim, gain a sizeable part of their corporate work from these clients.
Although it has always been the case that the best-known firms have not shunned the Mittelstand, it is fair to say that the presence of a huge mid-sized, mid-cap manufacturing base, spread throughout the German provinces, has helped sustain a large number of small to mid-sized law firms.
Ask Bremen lawyers if their local clients would go to Hamburg for advice and they will choke on their herrings. Cologne partners will snort into their glasses of Kölsch at the suggestion of one of their charges jumping on a train for 20 minutes to go to Düsseldorf.
German clients have ten-ded to choose their lawyers according to commonly-held regional affiliations, rather than by examining larger firms’ claims of better service and more cosmopolitan advice.
But the first three years of this century have put this long-established parochialism to the test. It should not be surprising in retrospect that demand-driven changes are effecting far deeper structural changes than those on the supply side. Nevertheless, many mid-sized firms are being unpleasantly surprised that the result of the underlying currents in the most important sector of the German
corporate market is a consolidation that is far deeper, providing more significant developments than those caused by law firm mergers.
First, the lull in cross-border transactional work has meant that larger law firms have marketed far more aggressively to the Mittelstand. During the boom years, it was likely that such firms would have been
representing the strategic or institutional acquirer, leaving the disposal instruction to the regional house firm. Come the slowdown, larger firms have sold themselves as the lawyers you just have to have for that once-in-a-lifetime exit moment. And where private equity buyers are concerned, the tendency to set up an auction means that the larger firms with experience in auctions tend to get the instruction.
Second, once these cli-ents have gone, they are gone for good. Even if a regional firm has advised its client on the sale, it is almost impossible for it to gain a foothold in advising the acquirer post-transaction. While some mid-sized firms continue to be able to replenish their client bases from the bottom up, thus maintaining the general disposition of their practices, the relative market position deteriorates, at least as regards the advice to lucrative Mittelstand clients.
Third, as commentators are never tired of pointing out, German Mittelstand industry is overleveraged. For years, expansion was financed by a credit line from the local bank. The result is that swathes of the Mittelstand are having to improve their debt-to-equity ratio in order to gain a rating after Basel II that would allow it to finance its operations. In addition, the German banking supervisory authority (BaFin) is tightening the regulations on bank lending (the so-called MaK). Both these factors are restricting the traditional lines of credit, forcing Mittelstand to re-engineer balance sheets and call on the capital markets for future investment. Although a large number of regional mid-sized law firms ought to be able to carry out this work – especially the large number of multidisciplinary practices – these mandates are also gravitating to the larger firms.
If the clients are drifting away, then so too will the lawyers. Contrary to the expectations of the larger law firms, recruitment has not become any more difficult over the last two years, even though the firms are for the most part continuing their growth. That this is due to the disappearance or slower expansion of certain competitors in recruitment (start-ups, investment banks and management consultants) is obvious. But it is only part of the story. Larger law firms now get a much larger part of the graduate pie.
There is, however, no reason for the larger firms to be complacent or for regional firms to panic. When deal-flow returns, international firms will feel able to push through billing rates on transactions that they would not dare to do with the Mittelstand. So price is still an area in which regional firms can compete meaningfully, but only if they can also offer a degree of financial sophistication and service that will not send clients back into the arms of the larger firms.
This is precisely the hope of the larger firms: they have got their teeth into the Mittelstand during the slowdown and will try to raise rates (most particularly for transactional work) when the economy recovers. The potential within the German Mittelstand for investment abroad – especially Eastern Europe following its admission to the EU of the reform economies in 2004 – is huge. For the most part, it is only the larger firms that have been able to afford a network of offices in Budapest, Prague, Warsaw and beyond.
And there is one other caveat: Mittelstand work does not support leverage. That is the reason Clifford Chance, by its own admission, does less of it in Germany than Freshfields or Linklaters Oppenhoff & Rädler. So, to London management at the top of Anglo-German firms, I’m sorry to say it, but profitability in the core corporate sector in your biggest market in Europe is partner-driven.
Aled Griffiths is the editor of Juve Rechtsmarkt