The legal industry has seen its most significant proposed merger for years after London-based Allen & Overy and New York firm Shearman & Sterling recently announced their intentions to combine forces, subject to partner vote. The combined firm would be known as Allen Overy Shearman Sterling, or A&O Shearman for short. With an estimated combined revenue of approximately $3.4 billion, close to 4,000 lawyers, and 49 offices, this merger is set to make waves in the legal landscape. In this article, we delve into the reasons behind the merger and its advantages, as well as the potential challenges that lie ahead for the duo.
A merger of necessity?
The declining performance of Shearman & Sterling is certainly one of the driving forces behind the merger. The firm experienced a 10% decrease in revenue in 2022 - a significant decline even in a year where a lull in M&A and capital markets work caused many firms to see revenue fall.
More fundamentally, Shearman has been struggling for a while to keep pace with rivals. Historically focused on advising large Wall Street banks (the firm’s oldest client is Citigroup, who they have worked for since 1891), Shearman did not make the same investment into its private equity practice as other firms in the wake of the 2008 financial crisis. As a result, whereas in the mid 1990-s Shearman was ranked no. 9 for gross revenue in the Am Law 100, in the 2022 Am Law 200 ranking the firm placed no. 50. And during that period, Shearman's headcount increased by just 33%, compared to the likes of Simpson Thacher (192%), Milbank (150%) and Weil (105%). Shearman, therefore, has failed to adapt to the rise of private capital and the reduction in big-banking work, and a merger has been on the cards for a while. A&O was not the first firm Shearman approached - talks with Hogan Lovells broke down in March.
The merger still depends on the votes of both sets of partners, who may well view it as essential to their future success. Allen & Overy, which tried to merge with US firm O'Melveny & Myers as recently as 2019, sees Shearman as an entry point into a lucrative US market it has struggled to penetrate, while Shearman seeks to remain relevant in the face of its declining performance and a series of partner exits. As the FT's Lex put it, the merger may be "more huddle than cuddle".
Survive, and thrive?
The A&O Shearman merger has several potential advantages. It offers global scale and a strong presence in key practice areas such as leveraged finance, debt capital markets, structured products, and project finance. In particular, the combined firm's financial services regulation offering would be market-leading, bringing together Band 1 lawyers like Shearman's Barnabas W B Reynolds and A&O's Ben Regnard-Weinrabe.
But what about private equity? As well as Shearman, A&O has fallen behind rivals in this area. Although the merger aims to address both firms' weakness and leverage the combined firm's scale and brand to attract clients, this will be difficult without a strong PE department on either side. Another challenge is the high cost of acquiring top private equity talent. One notable example is David Higgins, who moved to Kirkland & Ellis from Freshfields for a £7m/year reported salary in 2018. Given that neither A&O nor Shearman have fully capitalized on the private equity boom, it remains to be seen whether the combined team will be strong enough to compete. However, with global interest rates on the rise, the private equity landscape is expected to become less profitable, or at the very least more unstable. This could work in favour of A&O Shearman.
Other challenges lie ahead. Cultural integration, for example, will be important, given the typical 'eat-what-you-kill' approach of US firms and the tendency of UK firms to be more egalitarian. However, A&O has relaxed its traditional approach to partner pay in recent years and the duo have agreed on a 'modified lockstep model' that moves the UK firm further way from its the Magic Circle starting-point of remunerating partners on the basis of seniority not performance. The alignment of profits, with profit-per-equity partner at $3m at Shearman and $2.7m at A&O, will also make integration easier. Talent retention at more junior levels might be more challenging, especially since Shearman pays its NQs well above A&O's recently-raised £125,000 rate.
Is the magic dying?
As this Blog has documented previously, the UK's Magic Circle firms are increasingly under threat from US firms in London. Firms like Kirkland & Ellis and Latham & Watkins have established a strong presence with hundreds of lawyers in the City. Firms such as Skadden, Arps, Slate, Meagher & Flom, Weil, Gotshal & Manges, and White & Case have also made substantial strides. Lateral hires from Magic Circle firms have been a major tool in this battle. Just yesterday, for example, Freshfields' high-profile equity capital markets partner, Mark Austin, departed for Latham.
Part of the problem is that US firms, usually operating a lower-leverage model with fewer associates relative to partners, are simply more profitable. The profit per equity partner (PEP) of Magic Circle firms like Allen & Overy has increased, but at a slower pace than American firms like Latham & Watkins and Davis Polk. This discrepancy is magnified by the weakness of the British pound against the US dollar, which also hamstrings the ability of UK firms to attract and retain lawyers in the US, the most lucrative legal market in the world.
Combined with more restrictive remuneration models, lower profitability means UK firms struggle to match the pay offered by US competitors. Although firms like Freshfields Bruckhaus Deringer, Clifford Chance, and Allen & Overy have managed to attract partners from US rivals by loosening pay structures and investing in US expansion, there is still much ground to be made up. All the while, associates and partners in London are being poached by US firms, or potentially growing resentful about the money offered to star performers in US offices.
Avoiding a requiem?
The urgency behind A&O's decision to merge is supported by a recent report titled "A requiem for the Magic Circle?" by Arden Partners, a corporate advisory firm owned by Ince. The report argues the Magic Circle firms may need to reinvent themselves and reposition towards a mid-market position due to increasing competition from US firms and the growing market share of the Big Four accountancy firms. The report highlights three factors that support this prediction.
First, the report suggests that Magic Circle firms are being outcompeted for top-end work, with US firms surpassing their UK counterparts in corporate revenue. The limited number of firms capable of successfully serving transatlantic mega-corporations poses a fundamental problem.
Second, the report points out that UK firms are not keeping up with the growth of US firms. The top 50 US firms in London have nearly doubled their revenue since 2020, accounting for two-thirds of the market growth, while UK law firms have seen a 30% increase. The report suggests that US firms are likely to overtake UK firms in London, in the near future.
Third, Magic Circle firms are finding it challenging to attract and retain top junior talent due to being priced out by US firms. The report states that the Magic Circle is facing relentless wage inflation and cannot compete with the compensation packages offered by US firms, which poses a sustainability issue for their elite model.
The cumulative effect of these factors presents a significant challenge for the Magic Circle firms, as the competitive pressure is expected to increase. The report argues that US law firms have taken nearly two decades to reach critical mass and predicts that the competitive challenge will snowball from here.
Additionally, the report highlights that the Big Four accountancy firms have gained a substantial market share and client base, posing a serious challenge to mid-market and top-tier firms. The Magic Circle firms are being forced to focus more on the high end, but they are increasingly outcompeted by American firms.
The proposed merger between Allen & Overy and Shearman & Sterling represents a significant development in the legal industry. By combining their strengths and expertise, the two firms aim to create a global legal powerhouse capable of delivering comprehensive, high-quality services to clients worldwide. The merger augurs both challenges and opportunities, but as A&O Shearman embarks on this transformative journey, it will be essential to maintain clear communication, uphold shared values, and leverage the collective strengths of both firms to create a cohesive and successful global law firm.
Ultimately, it remains to be seen whether this is a potential new strategy for UK magic circle firms to not only stave off the competition from their US counterparts but be on the offensive instead and penetrate the US legal market. This may spell the beginning of a new trend of mergers, with US and UK firms teaming up to thrive.