Earlier this year I attended an event for managing partners and equivalents of more than 100 top law firms from the US, UK, Asia and South America. The largest contingent was from US firms. I have represented Zhong Lun at this event for the last two years.
The atmosphere last year (in the wake of the Dewey LeBoeuf collapse) was a bit tense. The mood this year remained quite sober. Law firm revenues were flat, again. Costs were increasing, again. The consensus was that it was a zero-sum game in the market and that in order to grow your business, you had to take work from your competitors, all of whom were positioning to take clients and work from you.
The economists presented a mixed bag: the overall economic outlook in the US was in some respects hopeful (read: shale oil and gas) but overall still not great (see QE dependency), but predictions for the UK and European economies were generally negative to dire (presumably, no explanation required).
From my perspective, two main themes emerged in this year’s meeting:
- Merge or die. One managing partner predicted that the US legal market would consolidate to a leading group of 30 firms. Twenty of the firms were already in position, and the scramble was on for the remaining 10 spots. It sounded like both a prediction and an invitation to dance. An unscientific survey of the other attendees (OK, I spoke with a half dozen other managing partners during breaks) revealed that there was strong agreement that this was the irreversible direction of the US market.
- Go east, go south. Economists presented compelling statistics to demonstrate that economic growth was centered almost exclusively in the emerging markets in the east and the south. China always looks so good in these charts, and the entire southern hemisphere shows well, too. Half of the managing partners in the room made two calls: first, to their brokers to shift their investment portfolios to emerging economies, and second, to their PAs to book flights east and south. No charts were shown on how closely the legal services markets in these jurisdictions tracked overall economic growth; the correlation was simply assumed (incorrectly, in my view).
So, what does all of this have to do with this series of blogs on the relative positioning of domestic and international law firms in China? It depends on how one reads the tea leaves, but a clearer understanding of the current market positioning helps us shape a clearer image of what the future may hold.
(Re)setting the Table
To recap our snapshot of the China legal services market based on the Chambers rankings:
- There is a break-away group of the Big 3 +1 firms plus another trailing group of another 8-10 generally very solid firms on the domestic side, but there is a significant drop-off in quality or scope of services (or both) thereafter.
- On the international side, the UK firms are dominant, claiming nine of the top 12 spots. No true US firm is in the top 12, but the US firms fill out the rest of the top 20 and most of the next 10-20 slots.
- Although there is some overlap (as the international firms continue to play down-market and the domestic firms continue to reach up-market), for the most part the international firms and the domestic firms occupy different segments of the legal services market in China.
- In addition, the Chambers rankings for the international firms lump together Hong Kong and mainland China as a single integrated market, while the domestic firms are judged only on their local practice capability in the mainland China market. Consequently, it is not possible to make an apples-to-apples comparison of the international and domestic law firms in China based on the Chambers rankings.
Impact of continued global consolidation in the international market
If these predictions are correct, the potential implications for the China legal services market could be quite substantial. But first we have to guesstimate what level of consolidation we are talking about in the US market. For example:
- Is the end game in the US a new top 30 or a new top 40 or a new top 50? For purposes of simple symmetry, let’s suggest a target of a new top 40, including the current top 20 (which we will not define) and a new group of 20.
- Is it the entire AmLaw 100 consolidating down to a new top 40, or is it some subset of the AmLaw 100? Let’s assume the latter, which suggests that outside of the current top 20, we have some 40-50 additional firms in the AmLaw 100 that are going to coalesce into the second 20. Some of this will take the form of full firm-firm mergers, while other firms will be cannibalised an office, group or team at a time and disappear or drop down the rankings.
- How many tiers of firms will there be in the new top 40? Clearly not all of the new top 40 will be in the super-elite category, and some differentiation will need to occur. I think there could be three tiers, with the second and third tiers differentiated more by practice areas, industry segment strengths and geographical coverage (both in the US and internationally).
It is important to remember that this (still speculative) consolidation scenario currently addresses only the US firms, but once the US firms are in play, the top-tier UK firms, which have not yet established a truly competitive presence in the US, will pounce as well, resulting in a very fluid situation, the end result of which is hard to predict, except to project that the UK firms will end up with a stronger foothold in the US than they currently have. But the second and third-tier US firms will also have greatly strengthened their position.
Most (but not all) of the US new top 40 will naturally aspire to expand their global footprints to the east, the south and all other points on the map to try to compete with the established global leaders. Some anticipate that there will be a small group of five to 10 elite global firms that will hoover up the super-premium international deals, which would potentially leave us with another 20-25 international firms in the trailing aspirational class picking up significant high-end/mid-cap cross-border deals. Under this scenario, the current land rush among the international law firms in Asia, Africa, MENA and Latin America will accelerate. China will be high on this list for continued international expansion.
How might global consolidation play in China?
Under this assumed scenario, the pecking order of the international firms in Hong Kong and China will not change overnight because of the existing strong positioning of the UK firms in Hong Kong, which provides an important foundation (even irrespective of the Chambers’ framework under which the Hong Kong and mainland China markets are lumped together).
So the top end of the current top 20 international firms in China may not shift much, but over time the new top 20-40 international firms in China will be crowded much more closely together in terms of size, scope of practice, and quality. In the early stages, some of these China offices of the newly consolidated US firms will combine two money-losing offices in China and thus will continue to lose (more) money. But as these US firms consolidate further, their combined money-losing China offices will achieve more breadth and depth, and then the China offices of the US firms which are left behind will be progressively squeezed out of the China market, and become the walking dead. So we very likely end up with 30 pretty solid China offices of top US law firms, which can operate on a sustainable, if not fully profitable, basis, and which when added to the UK top 10 firms in China, creates a fairly formidable top 40 foreign firms (with high marks for unintended alliteration to boot).
So what would that mean for the Chinese domestic firms? My first response after doing the overall analysis of the domestic and foreign law firm rankings in China in the prior blogs in this series is fairly self-evident: by comparison with such a group of 40 top foreign firms in China, the China domestic law firm bench is still pretty thin.
This in turn suggests an equally unremarkable possible regulatory response: if the Ministry of Justice (MOJ) in China really understands that it very well may be 40 against 15 in terms of strong foreign firms versus competitive Chinese domestic firms, then there is a real possibility that China will not liberalise its market as quickly as many hope and as early as I originally expected (I have long predicted that the China market will open up more within this decade). The MOJ has historically taken the position that it cannot (or will not) further liberalise the market until the local firms are sufficiently mature. The analysis of the Chambers rankings undertaken in this series of blogs suggests that while there are several very strong domestic Chinese firms with very significant competitive advantages, even vis-à-vis the foreign firms, maybe there are not yet enough strong domestic firms to open the door further to the foreign firms.
As outlined in my prior blogs earlier this year (preceding this series), as a practical matter the scope of permitted legal advisory services open to foreign firms in China is already quite broad, at least in the areas of principal interest to foreign firms, which (naturally) are among the most lucrative, so maintaining the regulatory status quo is not necessarily a serious problem for the international firms. But, similarly, growth of the China offices of the international firms does not change the overall dynamics in the market, many of which trends tend to favor the domestic firms, at least in respect of several important segments of the market, including both in respect of inbound as well as outbound legal matters.
Foreign clients are more and more independent in respect of their selection of outside counsel, even in markets outside their home jurisdictions, so the growth of the China offices of the new top 40 foreign firms will not necessarily mean that their clients in their home markets will always follow them to their overseas offices. Some will and some won’t. And as these clients establish a larger presence in China, complete with local in-house counsel, the original ties of the client to the foreign firm in the home jurisdiction will naturally become further extenuated.
For Chinese enterprises going abroad, there will also be a natural segmentation of the market between foreign firms utilising their own international networks and domestic Chinese firms working with top independent law firms around the world. This market segmentation will be based on the nature of the deal and plain old client preference. These trends will continue.
From a profitability perspective, a new round of expansion by foreign firms in China would drive up compensation for talent in a still limited pool, drive down pricing as deal competition increases, further squeezing profits, thus ultimately proving not to be sustainable. The inherent challenges will be exacerbated by the fact that the growth of the China economy is slowing, and the rate of growth of the legal services market in China, particularly on the outbound side, has never been commensurate with the overall economic growth rate. It has all the makings of too many firms chasing too few deals for fees which are too low (at least for the typical cost base of international law firms).
So (to answer the question posed at the end of my last blog), China alone is not likely going to rescue the stagnant profits of many of the prospective new members of the new top 40 US firms, but nor will it be possible for these firms to ignore China. If this scenario actually plays out as projected, it will certainly make for a very interesting few years in the China market as the lateral partner hiring merry-go-round would be set to spin at an ever increasing pace until halted by exhaustion or achievement of a happy equilibrium through a rising tide of profitable work.
Prospects for future Sino-foreign law firm “mergers” (aka “strategic alliances”)
So is there another way forward? Everyone looks at the KWM merger as a harbinger of things to come, but perhaps they should also look at the Mayer Brown JSM merger as a successful market entry strategy. Others may also want to look at the McDermott Will & Emery (MWE) link-up with MWE China Law Offices, an “independent” domestic firm. Norton Rose has already indicated publicly that it wants to find a top Chinese firm to join its newly expanded global platform, and I am sure there are many other international firms with similar designs.
The challenge with the Mayer Brown approach is that there are very few dance partners in the Hong Kong market who are both suitable and available, and those who are available likely will not have a platform from which to push effectively into the mainland China market. The Mayer Brown JSM tie-up may end up being a sui generis kind of market entry strategy.
On the Chinese law firm side, there are many potential affiliation partners and even some potential merger partners for foreign law firms to approach, but as demonstrated by the weighted scores of the China top 20 law firms based on the Chambers rankings, there are not many good quality domestic law firms from which to select. The general lack of internal integration of most Chinese firms, including many of those in the top 20, presents a significant obstacle to a true firm-to-firm relationship. In most cases, foreign firms will find that they are in fact connected only to a group of partners in the firm who will tend to hold the relationship too close to the vest to make this interesting to top foreign firms.
Such affiliations are plentiful and relatively easy to achieve, but they have little if any impact in the broader market. The MWE approach is more unique and should be considered to be substantially more successful but only within a modest scope given the modest scale of the operations. MWE China places very respectably in the mid 20s based on weighted Chambers rankings of Chinese domestic firms, but the firm’s weighted score is still only about one-tenth of the leading weighted scores among the domestic firms. More tellingly, there is only modest separation in the weighted scores of the firms ranked 21 to 100 – a single additional band one ranking in any practice area, core or non-core, would jump a firm in the bottom part of the top 100 to the mid 20s. Still, overall this actually reflects quite positively on the strength of the core partners in MWE China, who are very well respected in the local market, but it also reflects the fact that their scope and scale are modest by any measure. As successful as this arrangement may be for MWE as an alternative to opening its own offices in China, it is widely considered to be a bit of a non-event in the broader market context.
Moreover, there are clear limitations to this type of strategic alliance. Under MOJ rules, foreign firms cannot share costs or profits with a local firm. A foreign firm can work side-by-side with a domestic firm but each firm must bill separately for its own services. This can be done on a prime-sub basis as well, with either firm fronting the client relationship (subject to tax considerations), but the principle remains. This means that the foreign firms cannot directly obtain the benefit, in whole or in part, of the individual profitability of partners and associates in the local affiliated firm on an integrated financial model basis. It is possible to have off-setting service fees paid both directions or to agree to other fixed-fee allocations that may approximate such a profit-sharing arrangement, but the more direct and transparent the arrangement, the higher the risk that this may be deemed to contravene the proscriptions against sharing of profits.
Sounds a bit like a Swiss verein structure on a smaller scale without the shared brand, doesn’t it?
All of these regulatory restrictions on affiliations apply equally to so-called mergers, which in fact cannot be true mergers with full financial integration in China for these very reasons, hence the Swiss verein structures. Many of the top global firms get a bit sniffy when talking about Swiss verein “mergers” – a shared brand with multiple independent financial systems and, in some notable cases, separate know-how and email systems do not qualify as a true merger, so these “unbiased” experts say. But that is all one can hope for with a Chinese “merger” partner.
One more important thing – the name of the “merged” Sino-foreign law firm. The KWM experience (being the only relevant experience in the market) is instructive. The registered name of KWM in China is 金杜 (jin du), the literal translation of which refers to three of the five elements (gold, wood and earth) and obviously bears no direct relation to the firm’s English name King & Wood or for that matter King & Wood Mallesons, neither of which is registered. The firm’s Chinese name has remained unchanged after the KWM merger; the Chinese name of Mallesons, which is well known in the market, does not appear anywhere in the registered name of KWM in China. The English name is not required to be registered so KWM can use whatever English name they please.
Perhaps the MOJ wanted to have K&W with the lead name in the merged firm to suggest the primacy of the Chinese firm in the merger process as a point of national pride. The managing partner of a leading Canadian firm told me that he sees K&W as an “SOE” and expects that the MOJ has instructed K&W to pursue its plan of global expansion as part of the overall global strategy of “China Inc.” I personally do not see it that way. From my observations, the top Chinese firms operate as purely commercial organisations and are not direct extensions of the Chinese government in any shape or form. But they are also quite savvy and follow the market trends, and in some cases, as with K&W, break the mould in a fairly dramatic way. And no doubt national pride does come into play with the level of governmental support K&W has received in terms of its international strategy.
But there is another critical element at play here, and that is that the international activities of the Chinese law firms effectively are not regulated by the MOJ, while the activities of foreign firms in China are. That probably suggests that if there are to be future Sino-foreign law firm mergers, the name of the “merged” firm may have to have the Chinese law firm name in the lead to satisfy MOJ requirements that domestic law firms be independent of foreign control in China, which probably also dictates that the same naming conventions be followed globally for sake of consistency and purposes of common brand building.
So if you are a top-10 global firm whose partners are eager to change your firm’s name to “Zhong Lun [your firm’s name here]”, give me a call. I expect if we could achieve some real second-mover advantage, we would be open to talk! Of course, as mentioned in prior blogs over the last two years, I don’t see ZL or any of the other top-tier Chinese law firms following K&W’s lead in any time soon, but this also points out that no top international firm is likely to be willing to link up in a similar fashion with any second- or –third-tier Chinese firm (the only ones likely to be willing to “merge”) if it means that it will have to rebrand globally with the Chinese firm’s name.
Other implications of potential further global consolidation for the top Chinese firms
At a recent conference I chatted with the leading legal industry consultant who brokered the KWM merger and shared with him my view that we were unlikely to see other Sino-foreign law firm mergers. He replied that we would need to keep our eyes open and be prepared to react as market conditions continue to change.
We may both be right. For the moment, I think all of the top Chinese firms think their interests are better served by remaining independent and having lots of friends. But if we eventually end up with 40 strong international firms with a global footprint and a stronger presence in China, that will result in a different set of dynamics in the China legal services market, and the top Chinese firms will need to respond accordingly since with more mouths to feed in China these firms will be the source of fewer referrals to the Chinese firms (although as noted above, foreign clients will still come directly to the Chinese firms in many cases and there will still be many opportunities to work side by side with the new top 40 global firms as we now do with the top international firms in China on the bigger deals).
But the top Chinese law firms will not be alone in this regard. All of the top independent law firms around the world will be in the same boat, and there will still be compelling reasons to remain independent (after all, it is not possible for any global firm to have a top-tier presence in each key jurisdiction around the world), but there will likely also be compelling reasons for these top independent law firms to forge a closer alignment among themselves in order to fend off increasing competition from the new global top 40 firms. It will be interesting to see how these trends play out.
I hope the observations in this series add some points for consideration for all current and prospective players in the China legal services market. Some points are undoubtedly controversial and others are probably flat out wrong (certainly, I readily concede that the new Asia Pacific 150 report issued by The Lawyer is much more extensive and useful as a strategic guide in Asia in almost all key respects), but if nothing else, it should spark additional conversation. Only time will tell, and we will all be scrambling to keep up with and (where possible) race ahead to take advantage of the ever-changing market conditions.
For part one of this series, click here
Part two, click here
Part three, click here