Vinson & Elkins closing in Shanghai shows China is not a bottomless goldmine after all. Will it be a graveyard for Western ambitions?
Five years ago, a Chinese firm that had 650 lawyers and an annual turnover of RMB1bn ($142m) decided to think big. It set out to make a splash, tying up with an Australian firm and a UK firm. It is now a 2,200-lawyer, billion-dollar global player under the banner of King & Wood Mallesons.
But while leading Chinese firms have been growing and spreading their wings in the international markets, once-mighty international firms have hit a brick wall in the Middle Kingdom.
US firm Vinson & Elkins’ recent closure of its Shanghai office after 10 years of operation in the country’s financial centre is the most prominent sign of change. In July the Houston-based firm confirmed plans to close its three-partner Shanghai office in a bid to consolidate its China practice and focus on state-owned energy companies. Following the Shanghai closure, it will have eight partners between its Beijing and Hong Kong offices.
Vinson & Elkins has been a leading adviser on Chinese companies’ outbound acquisitions in the energy sector. Major Chinese oil and gas clients include Sinopec and CNOOC, which have instructed it on numerous transactions. Most recently, the firm advised Sinopec on its $5bn (£3.2bn) acquisition of a stake in the Brazilian unit of Portuguese oil company Galp Energia.
To many competitors that know both the Chinese market and US firms’ business model, Vinson & Elkins’ decision did not come as a total shock.
“It’s a rather rational move,” says a former China partner of a magic circle firm. “It [Vinson & Elkins] is more like a one-trick pony and its China practice mainly focuses on outbound energy deals of Chinese state-owned companies. The vast majority of their clients are headquartered in Beijing. There’s no strong case to justify the additional expense and cost base in Shanghai.”
For international firms lucky enough to have won Chinese outbound instructions, the hard-fought wins are not as financially rewarding as they might sound.
A former Beijing-based lawyer at a US firm claims that during his time at the US firm he had regularly competed against Vinson & Elkins in China and had lost a few bids to his Texas rival, which was more willing to offer Chinese companies discounts to win mandates.
With more than 180 foreign firms having a base on the ground in China, many chasing the same type of high-end work, competition on fees is cut-throat. Indeed, all the lawyers interviewed for this article insisted that it was other firms that were always undercutting, but never their own.
And it is not only the small- to medium-sized international firms that are cutting prices to sell their services but also established global players.
A former partner at a global US firm who has extensive experience in China is familiar with the scenario. He refers to a pitch he made on behalf of his firm in Shenzhen, where a state-owned enterprise (SOE) was seeking an international counsel for its natural resources project in the US. He lost the bid to
a magic circle competitor which quoted a capped fee of less than $200,000 for the whole project. According to his estimate, for a firm to break even the minimum price should have been $500,000.
“International firms in China have been under tremendous pressure regarding their revenues and profitability since the global financial crisis,” says the partner. “Very few China offices are profitable after partner distribution.
“While more firms are able to cover the cost of their China offices and make a profit, the level of profitability is not significant compared with the global average. They are more of a defence play than a huge contributor to the bottom line.”
The pricing pressure is so severe that market gossip on the subject is rife. According to some Chinese lawyers, certain foreign firms have even started undercutting local rates. A corporate partner at Beijing-based Zhong Lun claims that in a recent bid for an inbound cross-border M&A transaction his firm was defeated by a sizeable international firm that quoted a 30 per cent lower price than his firm’s offer.
“The firm wasn’t a newcomer trying to buy into deals to build up a record. The desperate price just shows how some of the established international firms are struggling in China,” says the Zhong Lun partner.
Based on informed estimates, the average revenue per office of the 15 largest international firms in China ranges between $10m and $20m. Assuming a profit margin of 25 per cent a top-quality four-partner office would have an average profit per partner of $625,000 – some way behind the average global figures of the top 10 UK and US firms.
Apart from external factors such as the economic slowdown, regulatory restrictions and fierce competition, some consider international firms’ business model as their own worst enemy.
The most restrictive aspects of international firms’ business in China are their high fee rates and cost bases.
“Because China-related work was first handled by the Hong Kong offices of international firms, Hong Kong rates still apply to mainland offices,” says a former partner at the Beijing office of an international business firm. “It’s hard for any client to accept that its international counsel’s mainland rates are double those of the Singapore office.”
“Magic circle firms face fewer problems in London charging premium-level fees due to their strong brands, but in China international brands don’t carry the same weight as they do in their home jurisdictions or more established markets – international firms with high price tags are much harder to sell,” says an ex-magic circle lawyer in China. He adds that it is important for partners in China to develop new clients from the market as only a quarter of his work was referred from the firm’s network.
The value proposition is even less appealing when elite local firms can provide similar quality services with lawyers of similar calibre but charge significantly less. For example, a mid-level associate of five-years’ PQE in Allen & Overy’s (A&O) Beijing office has a standard hourly chargeout rate of $800 – that is around 20-25 per cent higher than the highest partner rate of top-tier Chinese firm Fangda.
It is difficult for US and UK firms to win work in China not only because of their high rates but also as a result of the capped-fee arrangement is most popular with and preferred by Chinese clients. That means firms have to discount heavily, but this can create internal contradictions between offices.
An ex-partner at one of the US’s biggest law firms shares his experience. When he acted for a major SOE in a complex outbound investment into an iron ore project in Australia he had to offer the client a considerable discount in the form of a capped fee to secure the mandate. The deal over-ran the budget and the firm’s Australian office that carried out a large part of the work was vocally resentful about the reduced price, which they believed was not profitable.
“It’s challenging to win Chinese clients because of the huge competition on price,” he says. “This, coupled with challenges from offices outside China, makes the issue insurmountable for partners in China.”
Strict internal controls and approval procedures have also led to retention issues for international firms. For many senior Western-trained Chinese lawyers the lack of support and understanding from the rest of the network and inflexibility in client relationship management was the last push necessary to take a leap of faith and join a local outfit.
“Five years ago international firms were still attractive to Chinese lawyers but it has become increasingly restrictive for us to develop business and service our clients working in a foreign representative office,” says another senior US lawyer who is now working locally. “In my previous firm, many Chinese clients’ requests for discounts and price reductions were rejected by approval committee in the head office. But the worst thing is the unfavourable attitude towards Chinese clients because of worries over creating potential conflicts of interests with existing US clients that are paying the firm much more.
“More control over clients’ work, relationships and internal resources ultimately means more control of my own financial destiny. There are better opportunities for me in a leading Chinese firm.”
Others attribute the shrinkage to cultural differences.
“A big problem for some global firms is the disconnect between their headquarters and branch offices,” says a former partner at a global US firm. “Headquarters lack the understanding of China’s legal market. They have the intention to get to know the market but don’t keep an open mind to appreciate the differences. They see China as a huge market from 1,000 miles above and only remotely know the day-to-day challenges overseas offices face. Decisions are commonly made outside China, such as hiring, strategy planning and office openings and closures.
“Their mindset is typically ‘we’re successful everywhere else so we can assume success in China as well’. And that’s where they start to fail.”
The former magic circle partner agrees that simply trying to replicate the home market business model in China just does not work.
He adds: “China is still a market that is being cultivated, where legal spend per transaction and per litigation is nowhere near what one could achieve in the mature jurisdictions. A foreign firm has to modify its strategy to thrive in the local market.”
Resize, reshape, rethink
It would be false to claim that all foreign firms in the market are retreating or shrinking. There are still new office openings by foreign firms each month. Kirkland & Ellis is the latest to expand their mainland presence, having recently secured a licence to open a second office in Beijing.
The actual number of foreign firms and their footprints in mainland China has gradually grown. According to China’s Ministry of Justice, the number of foreign firms’ representative offices by the end of 2012 stood at 228, double the 114 in 2003.
“China’s legal market has grown substantially, and so has the demand for international legal services,” says a Chinese partner in King & Wood Mallesons. “It is in a position to support the success of many international firms, but certainly not everyone. Most unsuccessful ventures are a result of a lack of strategic vision and differentiated products.”
He also points out that many small- to mid-sized firms rushed into China mainly driven by peer pressure and marketing needs, and their China offices are headed by opportunistic partner lateral hires because of the limited talent pool.
“More often than not, these local partners’ practice focuses and skill-sets don’t match the firms’ home offices,” he says. “They are run like a separate shop and have no synergy with the home market. These firms are having a tough time in China.”
Every global-minded firm knows the importance of having a China presence and, equally, no one is underestimating the challenges of succeeding there. However, when firms have invested in the market for some years but have yet to see satisfactory returns, their patience must eventually run out.
Many market observers expect a number of other firms to close one of their China offices following Vinson & Elkins’ move. But given the difficulty in obtaining regulatory approval to launch an office coupled with peer pressure, most will hold on with a leaner presence and wait for the tide to rise again.
Jones Day is one of the firms that has recently rejigged its Greater China teams to improve business efficiency. The reconfiguration in May saw almost half of its eight Beijing partners, along with several associates, relocate to Shanghai and Hong Kong. Jones Day’s Beijing office was opened in 2003 and was a 20-lawyer outpost prior to the moves. At its height, at the end of 2007, the firm had nearly 50 fee-earners in Beijing.
O’Melveny & Myers is another US firm that has been widely tipped to be the next one to scale back in China. Sources close to the firm suggest it plans to downsize in China, a decision said to have been taken by the firm’s new management led by chairman Bradley Butwin, elected in 2011.
“The firm’s previous management was keen on China and has invested heavily in the country, but the new management is understood to take a different view,” says a source close to O’Melveny & Myers. “There was also significant disgruntlement among US partners over all the investment in China. Its China practice is making money, but the figures are nowhere near the level of its home market, so the firm has decided to concentrate on the most profitable part of its practice.”
O’Melveny & Myers, however, forcefully rejects any local speculation that it might downsize and a spokesperson says: ”China remains a key focus area for our firm”.
In June the firm’s long-serving Asia practice chair Howard Chao, previously based in Hong Kong, stepped down from the post and the partnership to become an of counsel. He was not replaced; instead, the firm shifted governance responsibilities to its Asia committee. The leadership restructuring perhaps is a sign of things to come as well as a changing focus in Asia.
Rerun of events
US firms have a reputation of being sensitive to overheads and unproductive investment. Office closures and downsizing exercises are not new in China. In the early 2000s a number of US firms withdrew from Hong Kong or mainland China – legacy Dewey Ballantine, Paul Weiss and Gibson Dunn to name but a few. Several UK firms also departed China and later re-entered, such as legacy Denton Wilde Sapte and CMS Cameron McKenna.
Although magic circle firms generally take a longer term view on investment and are more established in China, they are under unprecedented pressure.
“Most China offices are dilutive to their firms’ global partnership’s profit distribution,” says a former magic circle China partner. “In the good years partners didn’t really care about reducing their profit shares to subsidise China, but no one can afford to leave one part of the business bleeding, particularly when the home market is tough.”
Although Freshfields’ commitment to China is unchanged and it remains a top international player there, it is believed that the only time its China offices were accretive to the global offering was in the boom time of 2006/07. The number of partners based in the mainland has decreased from eight in 2009 to five in 2013. The reduction in foreign firms’ China headcount is not obvious, as there is no public information available and ‘stealth layoffs’ are common practice.
A&O’s Greater China team has also shrunk noticeably over the past few years. In 2008 the firm had 34 partners in Beijing, Shanghai and Hong Kong. Now, the number has reduced to 26, with seven residing on the mainland.
“Five years ago, when Latham & Watkins took away a team of seven partners in Hong Kong, it really had a big impact on the China practice,” says a former magic circle partner based in China. “The firm still hasn’t quite got it back. The exit of the six senior partners in Hong Kong last year further affected certain practice areas. Overall, the China team is leaner now than five years ago.”
China’s legal landscape is vastly different from what it was 10 years ago and is still evolving. Both international firms and local firms are constantly responding and adjusting. The issues firms are facing are many and characteristic of an important developing market. Whatever steps firms take to address these issues it will be a fine balancing act.
For now, those that have reshaped their China strategy and chosen to have a leaner team but a sharper focus and a specialist offering are more likely to thrive than the ones that are yet to figure out what their raison d’être is in China.
‘Western lawyers are becoming exponentially more greedy’
Generally, the top-earning partners in elite Chinese firms can earn more than $2m (£1.26m), while most equity partners can make between $300,000 and $450,000.
Due to the tax differential a partner in a Chinese firm can take home considerably more money on the same amount of revenue generated.
It is increasingly difficult for a foreign firm to lure a rainmaker away from a Chinese rival, and the average package for the move requires a minimum $500,000 pay guarantee for two years.
Foreign firms are also facing tremendous pressure when it comes to keeping hold of their junior- to mid-level lawyers.
“Retaining talent is a painful task in international firms’ China offices,” says a former Shanghai managing partner of a US firm. “Many younger Chinese lawyers are willing to work for an international firm initially for good training, a higher salary and to build solid skills. However, they will move to a local firm after a few years, where they have a better chance of being promoted to senior associate or partner.
“Other downsides of working in international firms are the greater pressure on billable hours and the lack of exposure to quality work. Junior lawyers feel pigeonholed
in international firms and it’s not good for their marketability if they stay too long.”
Some China-based partners blame the obsession with the average profit per equity partner (PEP) rankings for some international firms’ shrinking presence in China.
“The top global firms’ PEP numbers have rocketed compared with 10 years ago,” says an ex-magic circle lawyer. “But why are partners so concerned about PEP? Many firms’ goal these days is to be in the top 10 globally as measured by PEP, because a firm with a higher PEP is perceived
to be a better firm. Western lawyers are becoming exponentially more greedy.”
What the partners say about China…
Fang Jian, China national managing partner, Linklaters
“We expect China will grow to be one of the ‘pillar’ markets for legal services in parallel with the US and UK and as a global firm, this is an opportunity we cannot afford to miss. China is indeed a tough market for any business.”
Stephen Harder, office managing partner for Beijing and Shanghai, Clifford Chance
“Competition in China is fierce, and the legal sector is no exception.”
Patrick Sherrington, Asia managing partner, Hogan Lovells
“Mature practices in China have stronger business fundamentals than those firms which are essentially start-ups. When it comes to making money in China, it can be a long march.”
Justin D’Agostino, China managing partner, Herbert Smith Freehills
“Profitability is a challenge for law firms in many countries. There is no doubt that China presents challenges. Any country growing as quickly as China will always have surprises for the unwary.”
Paul Tan, China managing partner, Baker & McKenzie
“Recognising that the China legal market is becoming more crowded…we invest our own time in understanding our client’s business and their preferred methods of working…and respond with broadened service offerings and flexible pricing arrangements.”
Chinese firms’ success has been at the expense of foreign firms
The remarkable shrinkage of international firms’ China offices has much to do with the economic climate. There is a low level of activity in the China-related capital markets and M&A transactions – sectors that international firms’ China practices are heavily focused on.
Regulatory restrictions on foreign firms’ business scoops and practice areas have also played a role in constraining their growth. For example, foreign firms are still barred from advising on local law and representing clients in Chinese courts. They can employ locally qualified lawyers but only if these lawyers suspend their Chinese practising licences, limiting their ability to provide local legal advice.
A strengthening local bar and increasing competition from Chinese firms add further challenges.
Some 20 years ago, when China first opened its doors to foreign firms, most of today’s leading Chinese firms were not established. Foreign investment-related Chinese legal services were mainly provided by the legal departments of government bodies such as the China Council for the Promotion of International Trade (CCPIT).
The Chinese partnership of today’s King & Wood Mallesons was founded in 1993 by a group of lawyers who previously worked in the CCPIT.
In the early years the first bunch of international firms with a presence in China – including Baker & McKenzie, Clifford Chance, the now defunct Coudert Brothers and Gide Loyrette Nouel – enjoyed robust business as foreign investment flooded into the country.
Prior to that, many international firms had started providing China- related services from Hong Kong in the late 1970s, when China began major economic reforms.
“In the 1980s and early 1990s international firms were playing the role of ‘virtual Chinese firms’ because China didn’t have enough credible and capable local advisers,” says a veteran international lawyer who has been working in China since the early 1990s. “Foreign firms such as Bakers filled this void. The regulators allowed it to happen because they needed foreign advisers to facilitate foreign investors concerned about the rule of law and protection of their rights.
“But the main trend in the past decade has been the migration of inbound work from international firms to Chinese firms, with their coming of age. This is a process of rationalisation with regard to who does what portion of the work. Chinese firms will continue to work alongside international firms on large cross-border transactions that require expertise from different jurisdictions.”
In a way, Chinese firms’ success has come at the expense of foreign firms.
The growing in-house departments of multinational companies’ Chinese subsidiaries add another layer of context to the international firms’ story in China. The majority of established multinational companies in China have already gone through ‘localisation’, including setting up local legal functions to service local businesses and operations. These clients’ legal needs will mostly be related to local laws and regulations.
This development has done away with a big chunk of the corporate work traditionally handled by international firms.
“The business structures on the ground have changed and legal services needs have become a lot more sophisticated – only firms in the position to offer differentiated products have a long-term future in China,” predicts the international lawyer.