Law Firm Strategic Positioning

The article rightly recognized the changes that were occurring in the legal market and then moves to the hypothesis that there is a direct relationship between profits per partner, the number of equity partners and the apparent strategy of a firm. They overlay the total profit of firms as an isoquant. The prime base for measurement is 1999, although some firms have their 1993 profits also shown.

The article proposed four standard strategic positionings (in a classic matrix):

1. Incumbents, being firms with multipractices, operating regionally and that rely on long-standing client relationships for competitive advantage. They face an erosion of this competitive advantage, tend to have a significant proportion of commodity work and have underperforming partners. They lack the world-class skills and scale to compete with other types of firms. Most are moderately profitable, while a few are above average in profitability;
    
2. Shapers, being firms that dominate markets by driving their evolution. They have world-class skills, a broad but coherent set of practices and locations, and are able to command premiums;
    
3. Specialists, being firms focusing on a relatively small number of practice areas or client segments. They tend to have in-depth expertise and talent in their chosen area and can command premiums;
    
4. Full-Service Integrators, being firms with around 300 equity partners, that lack depth and breadth of expertise in particular practices and operate unprofitable practices. They lack professional and cultural ties between practices and offices.

From this the article draws the following conclusions about ‘winning strategies':

1. Two types of Shaper will emerge as successful: the global megafirms and the new economy firms;
    
2. Specialists, either as elite M&A practices or in areas such as intellectual property and litigation, will prosper and will require global reach in order to capture the highest value work in their specialist area. Without global reach, they will not build the depth and breadth of expertise;
    
3. Full-Service Integrators can become successful if they become either a U.S. ‘aggregator' or a multidisciplinary practice. The former will need to acquire practices and consolidate their business regionally, shed underperformers and manage well;
    
4. Multidisciplinary firms will be associated with accounting firms, but operate at a lower level than the global megafirms.

The Flaws in the Argument

The initial premise is the first flaw. While there is a direct link between a firm's strategy and profitability:

(a.) this link tends to be over time and not as a one-year snapshot;

(b.) the directness of the link is also a function of the maturity of development, and the legal profession is still in a stage of competitive immaturity; and,

(c.) at this stage of competitive development, the profitability of many firms is a reflection of a number of factors other than their strategic choice (e.g., effective management).

McKinsey fell for one-year profitability rather than a trend, particularly given that 1999 was a particularly buoyant year for transactions practices. The analogy they make with corporate market capitalization is interesting because the two numbers are derived in fundamentally different ways for different reasons.

The legal profession is still in a stage of competitive flux and many good firms are still finding their way. A number are spending considerable sums of money in building a much stronger competitive position and the returns are not yet coming through. For example, Slaughter and May 's higher profitability relative to the other Magic Circle firms can be explained to a large extent by their lack of expenditure on building a European operation. Whether that is the right strategy or not is not the question: until the other firms start to seriously recoup the investment costs and face operating costs rather than investments, no real comparison can be made.

The same is true within U.S. firms. Cravath will have low strategic investment costs and Wachtell has none. The McKinsey analysis is that neither will succeed unless they do, which indicates a serious lack of knowledge as to why those two firms have been so successful. And it is a projection with which we would not agree.

In other words, given the present state of competitiveness, firms are spending a widely variable amount on strategic investments. We suspect that the underlying profitability of the businesses is not as far apart as the overall profitability. In the corporate world, market capitalization takes account of differing investment levels and, in any case, investments are usually capitalized over time and not treated as an annual cost in full.

To use profitability as the basis means taking into the equation the fact that some firms have not yet invested heavily in building an organizational, management and technology infrastructure to support the business. Those that have done so may have suffered in profitability terms, but this should result in higher profitability (if successful) in the future. Again, until a more comparable level of expenditure is reached, it is hard to link profitability directly to strategic choice. The crucial issue is the immaturity of the legal profession as a business relative to most other industries.

The final point here is that the comparison includes four of the UK Magic Circle (not Freshfields, for some reason), and the rest are U.S. firms. There is still a significant market gap in profitability between UK and U.S. firms that has little to do with strategy and much more to do with the markets themselves. The U.S. market has a much larger volume of high value work than UK / Europe because the U.S. business environment has been much more transaction-oriented than UK / Europe and tends to have a higher demand for legal advice than UK / Europe. Another factor that affects profitability of U.S. firms is the much higher percentage of litigation compared with UK firms. While this is changing to some extent, there is still a profit gap explained by the difference in the markets, which distorts comparison between profitability and strategic choice.

The second major flaw is that the segmentation used to describe the strategies of law firms is inaccurate and misleading. The only category that makes sense in the market is that of Specialist (focused on a few particular practice areas and market segments). This is a valid strategic category for law firms, given the large number of practice areas and client segments available.

The definition of Incumbents is, however, really one of a full-service generalist and, in many / most cases, describes firms that have done planning to various degrees or levels but lack a strategy: it is more about not changing from the traditional way of doing business than a strategic choice at this moment. This is much more of an issue than semantics. There are many firms in both the U.S. and the UK that are full-service generalists because that is what almost everyone was before competition. It is misleading, therefore, to describe this as a strategic choice because a choice means choosing one over another: full-service generalists have made few (if any) choices. In fact, a number of the firms included here have made a strategic choice and are changing, but not the way the McKinsey analysis suggests. Hence to use this as a strategic category confuses any understanding of the market and hides an important development as non-strategically driven firms address this. The comparisons also do a disservice to many very successful firms.

Their definition of Shapers and Full-Service Integrators is confused and confusing. Shapers are those that have driven the evolution of the markets they dominate. (All of the UK Magic Circle could be here as well as the top 15 firms in New York and a couple outside of New York.) McKinsey's wonderment that not more Shapers exist in the legal market should have raised a question in their mind as to whether it was an accurate category. They have not defined Shaper clearly in terms of practice area or client focus other than using Skadden as the example which, they say, has been built on ‘lucrative, rapidly growing core practice areas' with ‘pockets of expertise across the board.' In other words, they are firms that are more full-service than specialists but with a strong core supported by other areas of expertise. In our terms it is a full-service focused firm.

Their definition of Full-Service Integrators appears totally confused. They come across as somewhat badly managed, large and full-service firms, lacking focus. This makes them large full-service generalists with the only distinction being that they have expanded geographically. Strategically, they are little different from Incumbents. Again, this does a serious disservice to many successful firms.

The problem with these definitions is that they do not fit the market. There are full-service generalists (a lot actually), some of which are in one location and others in a number of locations (nationally or internationally). Some of these are well-managed (or getting better) and some are not. The ‘market' definition used by McKinsey does not separate Incumbents (full-service generalists) from Full-Service Integrators (full-service generalists in multi-locations) in any meaningful way. Furthermore, to define Shapers as determining their market's evolution is another confusion; the real definition is that they are full-service focused firms, having a strong core supported by key specialist areas of practice.

The principal criticism we make of the McKinsey definitions is that they do not depend on strategic concepts such as the practice area: client type/segment focus. Their Specialist definition is based on this, as is their Shaper definition (by inference). Full-Service Integrators appear to be full-service generalists with multiple locations, which makes them a subset of Incumbents. It seems that McKinsey has had to find four segments because without it they could not use their matrix, but it is strategically invalid and does not fit the existing market.

Finally, the article suggests that a few “new economy” firms and a few Wall Street firms will dominate their markets. We do not think you can compare “new economy” firms to the top New York City firms.

The final major flaw is where they have placed firms in the various segments. Even if one accepts their definitions, the segmentation is wrong and it is wholly misleading if one follows their approach.

Skadden is little different from all of the Magic Circle: they are all full-service but focused on transactions (M&A, Capital Markets and Finance), supported by ‘pockets of expertise.' They have all driven the European transactions market. Freshfields, not included by McKinsey, is certainly at least in the same category as Skadden, in that they have been a principal driver across Europe.

Clifford Chance coming under the definition of an Incumbent. While there are differences between these firms, they are not differences in the way McKinsey describes them. This can apply to many U.S. firms as well.

Equally, Cravath and Slaughters are not specialists in the true sense of the word nor by McKinsey's definition: if they are, then so is Skadden and the other Magic Circle firms. A quick look at Cravath's and Slaughter's websites show that they have the same practice area offerings as the others: they are smaller in size, so they have a tighter focus on a core client type (e.g., Fortune/FTSE 500 clients) and they might do a higher proportion of transactions work than the others, but they are, by any definition, a full-service (in general terms) focused firm, along with Sullivan & Cromwell, Shearman & Sterling and the Magic Circle.

Putting Jones Day , Holland & Knight, Clifford Chance, and Latham & Watkins in the same category is ludicrous. These are vastly different firms with markedly different strategies. While a few may have some things in common, most do not.

We could go on and discuss every firm, most of which do not appear to fit the definition that McKinsey places on them. Suffice to say that their segmentation and classification is wrong—and they demonstrate a serious lack of understanding about the market and of specific firms

What are Strategically Valid Positions?

Any valid strategic position starts with a focus on practice areas, client segments or both. The geographical market covered by a firm is then an ‘overlay' on this. Cravath, Wachtell, Skadden and the UK Magic Circle are among the most focused firms in the world: their core business is transactions (high value, primarily) for Fortune / FTSE 500 clients with depth across all of the practice areas important to this position. The distinction between Cravath and Slaughter on one hand and the other Magic Circle firms and U.S. firms is geographical coverage. A full-service focused (high value) position is a valid one and will constitute the primary position of ‘leading global firms.' The extent of the global coverage necessary to compete is the only issue here.

At the other extreme, a valid long-term position is as a true specialist firm which we see as a specialist in a few, related practice areas. Such firms might sell these practice areas across a very wide market (e.g., IP / IT specialists that sell their expertise to a wide range of market segments); or they might become true niche players and focus their core practice areas on a small number of industry segments that see these legal services as fundamental (e.g., IP / IT services to the technology and pharmaceutical industries).

A second distinction for specialist/niche firms is that they could develop geographically or stay within one geographical market. This decision is tied up with growth. The narrower the practice area focus and the more a firm moves to a niche position, the more restrictive will be its growth over the longer term. Wachtell can probably survive for a long time as a U.S. firm, given its quality image and the size of the deals market in New York City. If, however, it was required to build greater critical mass, then it might not be able to do so within a restricted geographic area and could be forced to expand internationally if it is to stay in its specialism . Hence being a narrow specialist or niche firm is a valid position, and this might require geographical expansion in order to maintain growth, if the firm is to remain in a narrow or niche position.

One thing that is essential in a specialist or niche firm is a careful selection of the value range over which it intends to compete. In the longer term it will be difficult to compete by working across the spectrum from commodity work to the high value work requiring high levels of leading edge expertise. Attempting to do so will leave a confused imaged in the market and be difficult to sustain on cost grounds. If the commodity end is seen as a more natural market, then the focus should be here rather than anywhere else. If the firm wishes to be seen as a market leader, then it will need to focus on the high value end and achieve depth in leading edge practices. At the high value end, it will be competing with the best in the market, including global firms that see this as a support to their core, and the specialist will need to match the biggest firms in terms of expertise and depth.

In between these extremes are the majority of firms that wish to remain basically full-service but move away from a generalist position. These firms need to face one fact, and that is that it is highly unlikely that they will be able to sustain a full-service position. The reason is that they will find it increasingly difficult to compete across a broad range because the global firms will outperform them on scale and expertise and the Specialists will outperform on expertise. Hence a full-service position means that there will be practice areas that do not achieve a feasible level of profitability, thereby dragging down the overall profitability of the whole firm, making it difficult to attract and retain even good quality people, let alone some of the best people. Hence, over time, the service range will shrink somewhat back towards a coherent package of services. This is likely to be smaller than the major global firms but still large enough to satisfy a broad range of the needs of their clients. The strategic issue is that it should be done before being forced to do so by lower profitability.

The second issue for a full-service generalist to address is its client base. There will be a need to identify clusters of client types that are prepared to buy a ‘package' of services, probably more at the mid-value level, from one firm, provided the firm can compete on value for money and on its expertise in managing client relationships. The target clients will be of two types:

1. Fortune/FTSE 500 type of clients that use the Global Firms for cross-border activities but like the idea of having a ‘second-string' firm for many of their mid-value needs, including mid-sized and more routine transactions;
    
2. The mid-market corporations that have much less need for a Global Firm and do not see any real value in paying a premium for their ‘brand.' These clients will use several law firms but one is likely to be their primary supplier.

Firms in this position will, mainly, be operating at the mid-value level in most of their services with commodity offerings where technology reduces the price. Their geographical market will be linked to size. One could operate within a regional market serving local businesses; another could operate more as a U.S. national or European firm being a competitor for mid-value work against the global firms. It would also compete against the specialist/niche firms in specific practice areas and would need to accept that it is unlikely to win the very high value work; its primary market will be in mid-value, more routine, work.

Hence, such a firm will compete to some extent on price: not on price as an absolute, but in terms of mid-value for money. Given its value is at the medium level, it will need a cost structure and economic model that allows it to undercut the global firms and specialists at the mid-value level while still generating a competitive level of profitability.

These firms will also require a competitive level of critical mass in their main practice areas. In many areas this need not be at the same level as either the specialist/niche firms nor the global firms but will still need to be of a size that gives clients a degree of comfort that the firm can handle a significant volume at the level determined by its market.

Hence a critical issue for such a firm is defining the geographical market over which it is seeking to compete. The wider the market, the bigger the firm will need to be because the critical mass criterion will rise as the market broadens. It is highly unlikely that, across a broad market, they will be seen as a leading edge, high value competitor in any major practice area, but they will hold their clients through being of very good quality overall, value for money (at a mid-level definition of value) and for their commitment to client relationship management.

There will be a number of variations in firms in this position, but they will compete on the characteristics noted in the previous paragraph and have a coherent core package of practice areas that meets the mid-value needs of their selected client type clusters within a defined geographical area. It is worth noting that the core practice area package will need to be similar (not necessarily identical, but close) for all client clusters, otherwise it will still be ‘full-service' in terms of practice areas and become uncompetitive.

Competing in a Multi-Office Position

Most positions allow firms to choose their geographical breadth, although the global firm, by definition, will have to be multi-office. Once a firm decides that it wishes to compete on a geographical scale that requires more than one office, then other competitive forces come into play.

In situations where the main reason for operating with multiple offices is ‘following clients,' there are some strict rules of competition to be observed. The critical issue is that if a home office client is to use the firm in another location, there has to be some added value in doing so over using a local firm. This has to be through the client management processes, a consistent work process style or the export of some particular expertise from the home office. This is particularly so where a client is already using local firms in a particular location: enticing them away to a newly opened office will require a demonstration that they will receive exactly the service they value in the home office. The same point holds where a home office client is new to a location: they might begin by using the office of their home lawyer but, if there is no consistency or no export of what they value, they are likely to move to local suppliers.

The second issue is where a firm wishes to export its skill in specific practice areas. For example, there are many examples of U.S. firms that wish to export particular practice area strengths into Europe. The critical issue here is the strength of their home position. A real leader in one market can leverage that reputation into another market and build a business without any existing client base; the proviso is that the market in which it has its reputation is seen at a level equal to or above the new market location. For example, because a firm in Birmingham (UK) has built a strong reputation in, say IP / IT, will have little relevance if it decides to open an office on the U.S. West Coast. The reverse is also true: a firm with a strong banking practice in, say, Chicago, has little leverage in exporting that to London or Frankfurt; a New York leading position would be a different issue. Learning this lesson will avoid many serious mistakes in the future.

These points hold true whether we are looking at national expansion or international expansion. In the U.S., there is a need to ‘hold a mirror' up to many of the expansionary firms and ask why they are in so many locations. There appears to be no strategic validity in terms of practice area leverage nor in cross-office client fertilization.

The fundamental issue for multi-office firms to consider is the extent to which there is a mutual dependency between offices. There is a high degree of fragility in firms that have more than one office but where there is little interaction between offices and where there is a significant difference in the client type/practice area mix in the offices. There is little to no strategic validity in developing across a broader geographical area by opening new offices (by organic growth or merger) unless:

1. there are existing clients of the firm in that location that would consider using the firm; and/or
    
2. there is a possibility to leverage the reputation of the firm in the home location (a reputation in specialist practice areas, market segments or both) into developing another location thereby providing a growth opportunity and strengthening the firm's position in the home location.

In either case, the firm will need to ensure that there is a consistency between the offices so that clients who use more than one office see a comparable competitiveness in each location. Firms that feel that they need to offer a wider geographical cover in order to retain clients at home, even though the geographical expansion is not directed primarily at winning the work of existing clients in other locations (but more of a reputation enhancement), should think again and examine whether they should be shifting their core client base to a different type of client where a reputation for multiple offices is of little consequence.

Options Facing Global Firms

There are two issues still under debate within the strategy for a global firm. The first is whether a competitive global position can be achieved through an alliance of a number of firms, and the second is whether a global firm needs to have a full-service capability in all (or most) offices or whether it is sufficient to only have the core practice area capability with a limited amount of back-up from other practice areas.

The first issue addresses the need for a one-firm level of consistency across all offices of a global firm and the difficulty of attracting clients to use one firm across borders if quality is variable. Conceptually, it would be possible to achieve it through a network of independent firms, but there are a host of issues that get in the way of doing so in practice. No firm has achieved it in any other profession. At the end of the day, achieving common work standards, common work styles, common client management processes, common billing and pricing policies etc. is extremely difficult when firms are managed independently and have their own profit pools. Hence the practical difficulties (and these are hard to address even in one firm) suggest strongly that in the longer run global firms will be able to compete only when they are one firm rather than an alliance.

The second issue is a complex one and we will give a summary view here. There are two aspects to this, coming mainly from the U.S. The UK firms are, in Europe, putting down offices in all major locations that have a ‘full-service' competitive capability in the local market as well as having a high value capability for large, cross-border transactions. While size is not an objective, the demands of critical mass across the core practice areas means that they will tend to compete as one of the larger firms in the countries where they operate.

Firms such as Cravath and Wachtell have criticized this approach and claim that, outside the U.S., they will compete more as niche practices in each location. This means that they will have a core transactions capability plus a limited range of supporting practice areas. Their argument is that their strong U.S. position and connections will allow them to compete successfully on a global scale without the need to develop large offices in locations outside the U.S.

The critical issue is whether it is sustainable in the long term against competition from the full-service approach of Freshfields, Clifford Chance etc. It is an effective way of competing at present, but the UK firms are only part of the way through their development. Projecting out, say beyond five years, and, on the premise that Freshfields and others succeed, they will have a leading capability in all major markets in Europe and in New York, they will have strengthened their relationships with New York bankers and they will have achieved a one-firm consistency throughout their service offerings. Competitiveness with these firms will be challenged on two grounds:

1. The Full-Service Global Firms will have the critical mass (i.e., depth of expertise) in all of the practice areas required by a large transaction in all major business centers; and
    
2. The firm will be recognized as a leader in all major markets, giving clients a strong sense of security.

Conclusion

What this means is that there are three primary strategic positions for law firms, each with a different client type/practice area focus, and each position has a geographic dimension in its competitiveness. In summary these are:

1. global firms that will be in major business centers in the world, focused on the high value transactions needs of Fortune / FTSE 500 client types along with a number of supporting specialist practice areas. They will have high levels of expertise in their core and compete primarily on their depth of expertise, geographic scale and organisational strength across borders;
    
2. focused mid-market firms that have a broad range of practice areas containing a coherence and that compete for the mid-value work of clusters of client types (industry, size, etc.). These firms will compete primarily on mid-value for money (as defined by their core clients) and client relationship management. They will occupy a variety of geographical positions from national down to local / regional. Where they have more than one office they will need to provide a consistent offering across all offices. There will be little need for these firms to compete on a global scale but they may well cover a region (e.g., Europe or Asia);
    
3. specialist or niche firms that have a limited practice area range but develop competitive depth in high value, leading edge expertise in their core and are able to compete with anyone at the high value end. Specialist firms will compete across a wide market in terms of client types and niche firms will compete within specific client-type segments. Over time many of these will develop geographically within their focus in order to compete on scale but others will remain competitive within a defined geographic region. (There is a role here for some firms to focus on commodity work as a specialism or niche keeping in mind that one firm's commodity work is another firm's high quality work.)

Within these three primary positions there is enormous scope for variation, primarily around the practice areas and client types selected. What is critical is that there must be a high degree of integration between the two: i.e., a firm should not have practice areas that are not capable of being sold into its core client base and vice versa. Achieving this tight focus over time will be one of the challenges that successful firms meet and the less successful ones struggle with.

McKinsey Law Firm Segmentation Appendix I

1. Incumbents

• Allen & Overy
• Linklaters
• Debevoise & Plimpton
• Winston & Strawn
• Paul, Hastings, Janofsky & Walker
• Morrison & Foerster
• Hogan & Hartson

2. Specialists

• Wachtell, Lipton, Rosen & Katz
• Cravath, Swaine & Moore
• Slaughter & May

3. Shapers

• Skadden, Arps, Slate, Meagher & Flom

4. Full-Service Integrators

• Clifford Chance
• Latham & Watkins
• Jones, Day, Reavis & Pogue
• Holland & Knight
• Baker & McKenzie