Rumours of merger mania have been greatly exaggerated

The market is in turmoil and there is no sign of things changing anytime soon, the managing partner at a respected medium-size firm told me recently. "Merger has never been on our agenda before but now we would be mad not to look seriously at all options out there." It says it all.

With the economic pincers tightening and fundamental changes to the operation of the profession now enacted, each day seems to bring fresh reports of malaise.

A key driver for change lies in a business model which is inherently weak; with undercapitalised balance sheets, profits paid out fully every year, high fixed costs ratios and inflexible working practices. In the protectionist past none of this mattered much but now, such ill-suited business structures are leading to outright failures, fire-sale acquisitions and forced mergers.

From a strategic viewpoint, every firm's aim should be to create sustainable competitive advantage. In addition to a clear vision and strategy, this requires financial stability, succession planning, better infrastructure, improved management capabilities and keener client focus. But a merger only makes sense if the result provides a better opportunity to compete together than alone.

The dramatic increase in law firm mergers is but the tip of an iceberg; for every merger reported a significant multiplier should be applied to adequately reflect the live discussions between firms which are also in play, from informal coffee gatherings to advanced due diligence. Only '¨a fraction will complete but the rising trend is clear.

As the industry matures its shape will change and a previously fragmented sector will consolidate. A substantial component of overall consolidation will be the acquisition of failed or failing firms rather than the more traditional union, through merger, of two broadly-'¨willing parties.

My view is that the number of registered firms will not reduce to such a huge extent as some have predicted, but there will be substantial structural change and increased stratification in the market. The gap between firms in different weight classes will become much more pronounced, and moving between weight classes will become commensurately more challenging.

A structure analogous to the accounting profession will emerge with larger organisations grouped in a relatively small number of distinct tiers followed by an increasingly long tail of very small firms. These micro-businesses will scrape a living (struggling to meet regulatory obligations, investment needs and professional indemnity insurance costs) while confronting the full competitive force of larger firms and more discerning clients.

Growth through M&A has been a long-standing strategy for a small number of firms, but many of the current players are considering merger for the first time. Their discussions are driven not solely by desire for scale but by perceived need and fear; the need to create (or find) a safe harbour for their firm and the fear of decline or failure in a hostile market which increasingly has no place for the general purpose small operator.

This is not to say that every firm should blindly pursue a relentless growth path, but rather that each needs to achieve a scale, footprint, service breadth and operational efficiency which is right for its market and its aspirations. For many this will entail a level of enlargement which cannot be achieved organically.

Fears for the future are counter-balanced by a fear of the unknown and a deep-seated desire to retain independence. This creates emotional inertia even when there is intellectual consent. Factor in the challenge of finding a suitable merger partner, together with the diminishing pool of candidate firms in some areas, and it is clear that the process will be slow and the attrition rate high. Mergers will be a rising trend but we're unlikely to see an explosion over the next two years. SJ