The Magic Circle: where to next?

Here’s an irony.

The moniker ‘Magic Circle’, for many years quietly loved by the 5-member law firms, is increasingly seen by at least some of them as a liability. Chatting recently with one of Freshfields’ new US partners, he patiently corrected me when I used the term of Freshfields. ‘We prefer Global Elite’, he explained with a wry smile, ‘Magic Circle is a bit too UK centric’.

What’s going on?

Well, let’s start with a few background points:

• in the late 1990s Allen & Overy, Clifford Chance, Freshfields and Linklaters (the ‘Big 4’) each embarked on a strategy of merging and opening offices with the goal of becoming quality global ‘one stop shops’. It had happened in investment banking and surely clients would want legal services, another cog in the advisory machine, to follow suit. The other Magic Circle firm, Slaughter and May, pursued an alternative strategy of working closely with independent firms in other jurisdictions to service clients on cross-border matters;
• the Big 4 have since built extensive international office networks and today, quite fairly, emphasise their global credentials. For example, Allen & Overy are in 43 cities and Clifford Chance are in 30 locations;
• but they have struggled to make an impact in the US, the home of the US dollar and the biggest market for legal services. Clifford Chance’s merger with Rogers & Wells in 2000 was not viewed as a success and Allen & Overy had to abandon attempts to merge with O’Melveny & Myers in late 2019 (reputedly because of the declining value of sterling). And the Big 4’s efforts to build their own US practices through recruitment have had mixed results—although we will come back to Freshfields’ big bet;
• meanwhile leading US firms have ridden the private equity wave and established impressive practices in London. Kirkland and Latham each have over 300 lawyers in the City and others such as Skadden, Weil and White & Case have grown relentlessly. All these firms have, of course, built their teams at the expense of the Magic Circle—attracting partners and associates with eye-watering remuneration and the promise of an exciting go-go future;
• the profitability of the Big 4 has moreover, in recent years, paled in comparison with that of the leading US firms. Whilst Allen & Overy, for example, has gone from profit per equity partner of £1.2m in 2015/6 to £1.95m in 2021/2 (more than respectable) Latham has gone from PEP of $3.75m to PEP of $5.7m over an equivalent period and Davis Polk has gone from $3.75m to $7m. Even discounting for exceptional busyness in 2021, these are pretty extraordinary figures; and
• as highlighted in the Financial Times the weakness of sterling is also a problem for the Magic Circle: ‘Recruiters said that currency moves were likely to make London-based firms more vulnerable to exits by partners moving to US firms in the City’.

So, whilst I’m not a fan of the term inflexion point, I think that the Magic Circle—particularly the Big 4—may be at one. How can they avoid being a training service for the leading US firms, gradually surrendering ‘brand charisma’ in the process?

Are we facing a re-run, in Big Law land, of the late 1990s and early 2000s when Bank of America, Citi, Goldman Sachs, JP Morgan and Morgan Stanley reshaped investment banking in London?

What are the options for a Big 4 fight back?

1. A US Merger

I mention this only really to dismiss it. The mismatch in profitability and the challenge of the Sterling/Dollar exchange rate (which is unlikely to improve meaningfully over the medium term) surely make a merger with a quality US firm too hard. The Big 4 will have already, in any event, looked under every stone. And the long-running A&O/O’Melveny saga tells its own story.

In addition, the alternative to full merger of a Swiss verein holding company structure, essentially separate firms operating under one branding and services umbrella, is unattractive. No real ‘one team collaboration’ benefits and conflict complexities, as Dentons and Norton Rose Fulbright have found over past years.

2. Building a serious US presence

The Big 4 are, with varying degrees of effort, seeking to up their respective games in the US. A recent article in the FT discusses their ‘renewed assault on the world’s most lucrative legal market‘.

Three takeaways from that article are:

• the investment being made is very significant. A&O has recruited 40 US partners over the last two and a half years and Freshfields seems to be going all in with some impressive marquee hires such as Ethan Klingsberg from Cleary and Damien Zoubek from Cravath. Those new hires are expensive, with Klingsberg for example reportedly on US$10 million per annum;
• headway is also being made. A&O and Clifford Chance generated 13% of their global revenue in the US last year (up from 9% the previous year for A&O) and Freshfields, who worked on AstraZeneca’s US$39 billion acquisition of Actelion, was one of the top 10 legal advisers on US M&A last year. But there remains a way to go. Tony Williams of Jomati observes that ‘You can’t claim to be a global law firm without at least 20 percent of your revenue coming from the States’; and
• the investment in US talent has meant some hefty re-engineering of Big 4 partner remuneration structures which have been traditionally ‘lock step’ based. Even though some partners outside the US will presumably benefit from a more ‘performance based’ system the fact that the Big 4 are much less profitable than the leading Wall Street firms must imply some cross-subsidy to US partners.

Whilst the steps being taken by the Big 4 (with the apparent exception of Linklaters) are certainly attention-grabbing, there are two important question marks around the strategy:

• will the Big 4 brands ever really cut through when it comes to major US domestic deals or disputes? Firms such as Cravath, Davis Polk, Kirkland, Sullivan and Wachtell have exceptional cachet and brand resonance in the US, as well as practice breadth and market experience. So, if Johnson & Johnson are contemplating a bet the farm US$20bn acquisition of a Dallas headquartered business would they feel comfortable going with an A&O or a Freshfields? It may be that big individual names like Klingsberg and Zoubek do the trick—and time will tell—but it’s a pretty big ask for a CEO who would have to account to the Board if it didn’t go well; and
• assuming that the US build takes time and significant ongoing investment, at what stage do the non-US partners lose patience with monetary and emotional deference to the US, particularly with an unhelpful Sterling/Dollar exchange rate?

3. More specialised practice focus in the US. 

A&O, Clifford Chance and Linklaters have notably strong financing practices. So, they have a natural play which says that, with a global perspective, they can add particular value to US based clients in the area of complex asset based and derivative-led financing where, for example, an understanding of multijurisdictional regulatory challenges is important.

Ramping up this message feels, intuitively, like a promising approach.

The question, however, is whether this will be sufficient to move the dial in terms of driving momentum to counter the push of the leading US firms. Complex financing does not normally generate the premium fees that M&A can and it doesn’t have quite the same showroom appeal to recruits as M&A and big litigation—there are few Perry Mason moments in a tussle over the negatives pledge.

But maybe that is to undersell the opportunity.

4. Spin-off/Demerger

A radical notion, and yet...

The recently announced proposed split of EY into separate audit and advisory businesses does trigger the question as to whether there is any viable, or sensible, demerger transaction for the Big 4 to think about?

Big law firms are clearly different from big accounting firms in that there are not the conflict challenges between audit and advisory that open up the opportunities that EY see.

But the Big 4 do face certain dis-synergies, not suing banks for example, and (inevitably) differential profitability profiles as between practice areas and jurisdictions.

Whilst a rather engaging idea, it does seem implausible to spin off, for example, the disputes practice into a NewCo in an effort to create a high-end disputes practice (in the mode of Quinn Emanuel). Disputes is a core practice area, and you could hardly leave the mother ship without one.

However, are there less-profitable practice areas or jurisdictional offices which could be spun off to the relevant partners or third parties on the basis that there is ongoing co-operation arrangement with the relevant Big 4 firm? The idea would be to increase the focus and profitability of the Big 4 firm whilst not meaningfully damaging the full-service, global proposition.

There is some precedent for this. Linklaters spun their Bratislava, Bucharest, Budapest and Prague offices into Kinstellar (an anagram of Linklaters) in 2008 and it has since opened a series of further offices in Eastern Europe and Central Asia. This is a more relevant model, I think, than the recent Western law firm exit from Russia.

So, could the Big 4 do some reshaping along these lines? One wonders, for example, about the medium to long-term prospects for the China practice (leaving aside the political implications of de-emphasising China).

5. Listing

Not for the faint hearted, for sure, but listing should at least be in the frame.

Consulting and advisory businesses do list (Accenture, EY’s proposed advisory business). There are, moreover, six UK listed law firms. Mishcon de Reya announced their intention to list in 2019 and would have become the largest listed firm. The project is currently on hold given volatile market conditions.

The arguments for listing, aside from giving liquidity to existing partners, is that the firm gets additional profile, an acquisition currency and a greater range of reward possibilities. A Big 4 listing would definitely make a splash.

But:

• a listing is a hugely complicated process (just take a look at the DWF prospectus),
• the firm’s brand value becomes hostage to its share price, and
• particularly for firms operating in high profile and complex areas, like the Big 4, it is safer for ownership and management to be unified (helping to ensure that managers don’t take unsustainable risks)—one take-away from The Big Short in which Michael Lewis surmises that things started to go wrong for Salomon Brothers when they ceased to be a partnership.

So, this doesn’t feel like a desirable option for the Big 4.

6. Additional Service Lines

There is clearly scope for the Big 4 to add non-legal services to their offering.

A&O, for example, have been active here for a number of years and have Consulting, Market Innovation and a Legal Function Transformation businesses. Support around Environmental compliance and disclosure is also an area attracting increasing law firm attention.

These kinds of services complement the core lawyering service, but it is hard to think that the margins, or the scope for real volumes of revenue, will be game changing.

So where does all that leave us with the fight back challenge?

Kylie Minogue’s recent hit ‘Magic’ keeps running through my mind, in particular the line ‘Do you believe in magic?’. And the answer is that for the Global Elite—aka Magic Circle—we surely must. They are terrific businesses.

It does seem clear however that those firms, and the Big 4 in particular given their Global aspirations, need to find another yard of pace in the competition with the top US firms led, in terms of competitive edge and fight, by Kirkland and Latham.

It may be that there is no realistic alternative to going large in building US capacity but that is not without risk, and the Sterling/Dollar exchange rate will be a drag anchor. So, whilst it is clearly a firm-specific question, are there spinoff, practice focus or other approaches that can be deployed additionally or alternatively to help add pace and maintain that magic?

Christopher Saul is Managing Director at Christopher Saul Associates and a former Senior Partner at Slaughter and May.