The following is the first in a two-part series of bulletins exploring issues facing small and medium-sized firms in the context of the broader competitive market and with specific reference to Hong Kong.
In this bulletin we highlight a series of strategic and operational considerations for small and medium-sized law firm leaders and how these are changing with intensifying competition. The second of these bulletins will explore what law firm leaders need to do including moving from cash flow management to revenue generation as an outgrowth of this and a structural shift in organisational mindset.
While the principles of law firm management apply to firms of all sizes, their execution differs according to a firm’s organisational capabilities. Many of the challenges facing small and medium-sized firms are consistent with those of larger firms. How they respond to these challenges can differ vastly and the “trickle down” effect (from large to small) can alter the nature of the challenge, including in some cases magnifying their impact.
What small and medium-sized firms lack in organisational capability, they can more than make up for in agility both in their approach to their clients and markets and in the way in which they manage their businesses. However, this requires a clear understanding of a firm’s strategic positioning and the management skills to compete and maintain that position.
One characteristic of small and medium-sized firms in most markets is their focus on SME clients. In part, this has been driven by localised buying decisions often where a family business has retained counsel for a range of private and corporate matters. (SMEs are more inclined to use their law firm for a “package of business law services” provided the firm is truly good at these. This may not be the case from the client’s perspective.) These are segments of the market that “big law” has generally avoided because of an abundance of other, more profitable work and because their cost bases would not support lower margin work. Hence, big law and small and medium-sized firms effectively coexisted in parallel markets.
In this respect, Hong Kong has differed because of the relationship between personal wealth, closely held family businesses and the largest publicly listed companies. Small and medium-sized firms have traditionally been able to advise larger companies than would necessarily be the case in other markets.
In some markets in which competition is intensifying and in which access to SMEs is increasing, including through more efficient delivery mechanisms and lower costs of production, the separation is blurring and a number of large professional services firms, notably the Big 4 accountancy firms, are actively targeting the SME sector.
According to the Hong Kong Government’s latest statistics, there are approximately 317,000 SMEs in the territory, constituting 98 percent of its business units and 46 percent of private sector employment. Despite the considerable size of this segment, it is not out of proportion, say, with the UK in which over 99 percent of businesses are SMEs, accounting for 60 percent of private sector employment [and 47 percent of private sector turnover]. However, the relative importance of SMEs in Hong Kong has been much greater for the reasons stated above including in the way in which legal services are bought.
This raises a series of related issues in managing the business of small or medium-sized firms and questions for their leaders to consider.
A number of major business law firms (Global Elite and International Business Law (“IBL”) firms) that previously shunned private wealth services have altered their strategies in recent years. They are now investing in these areas and are actively targeting High-Net-Worth Individuals (“HNWIs”) through private wealth services as a means to secure corporate instructions. The increasing flow of investment from Hong Kong and other large Asian economies into major international capital markets and business centres has been a catalyst in expanding this focus for some firms.
This is important for small and medium-sized Hong Kong firms whose diversified client bases include HNWIs targeted by business law firms. Local firms will increasingly compete directly with IBL firms particularly those with sizeable Hong Kong offices for specific medium and higher value work from these HNWIs and their corporate portfolios. There is an inherent strategic advantage for firms that are able to advise on private client matters and simultaneously provide public company advice in some cases in multiple jurisdictions. These firms will be able to invest in relationships including if necessary adopting a loss leader approach to private client services with the aim of securing more, higher margin corporate mandates.
In the past, small and medium-sized firms have been able to undercut competitors in other segments because their cost bases were lower. However, this is increasingly unsustainable as we discuss below.
We are likely to see an increase in firm failures over the next decade as greater competition drives more underperforming firms to close. Invariably, lack of strategic focus coupled with poor management are the most common causes of law firm failures. This is particularly acute for small and medium-sized firms.
In our experience, small and medium-sized firms (as well as smaller offices of larger firms) often profess to specialise in a wide range of services and areas of law. In many cases, the number of services is greater than the number of lawyers employed by the firm or located in any one office. This relative lack of focus undermines the credibility of any such claims as to a firm or an individual’s actual expertise. This does not mean that all such firms should only specialise in a narrow range of services (although some may choose to do so) but rather that
(1) they should be able to compete for the work on which they are focused; and (2) it supports their preferred market position.
The Law Society of Hong Kong’s website lists 24 areas of practice. A large proportion of small and medium-sized member firms list themselves as experts in multiple areas of practice, often reinforced by marketing materials that make similar claims. As clients become more sophisticated in their buying behaviour, including as a result of greater choice of suppliers, the more likely this will be tested.
Hong Kong continues to be an attractive market as a gateway to and from China. Regardless of the need or otherwise for mainland offices, international firms still see Hong Kong as a safe haven and a bridge to the mainland. Well-managed and profitable local firms who have strong client bases and/or operations in the mainland are potential targets for acquisitive international firms.
In the space of the last eight years, the largest 15 mainland Chinese firms have more than quadrupled in size from an average of 359 fee earners in 2009 to 1,450 fee earners in 2016. (In 2016, 14 of the largest 15 Asian firms were headquartered in the mainland.) Whilst a small number have gone some way towards developing their international strategies either via merger (Dacheng, King & Wood Mallesons), strategic partnership (Yingke with Memery Crystal (UK)), association (Jingtian & Gongcheng with Mayer Brown JSM), or network (JunHe (Lex Mundi)), the pressure on others to do so will intensify as they compete for complex cross-border work.
Similarly, mainland Chinese firms seeking to “go out” often begin with Hong Kong because of its importance as one of two major regional capital markets and a preferred route through which much of their clients’ outbound investment is channelled. Eight of the ten largest mainland firms have a Hong Kong office and many others have a presence or relationships with domestic Hong Kong firms.
This becomes an important strategic consideration for small and medium-sized firms in Hong Kong whether they are committed to independence, are open to joining or are actively seeking a mainland or international law firm.
In recent years, “mid-market” business law firms in most countries have been the biggest “losers” as competition has intensified. The middle ground has contracted as IBL firms and disruptors (largely driven by technology) have taken market share from domestic business law firms. (These are typically large firms in their own markets but small by comparison with their international counterparts and increasingly unable to compete with them for higher value cross-border work.) Over time, their share of purely or predominantly domestic work has also been eroded as clients consolidate their suppliers. In the markets where this trend is most advanced, the mid-market segment is likely to disappear within the next five to 10 years.
The latest list of Hong Kong’s 25 largest law firms included only five local firms. Outside the top 25, the average size of Hong Kong’s remaining 846 law firms (both foreign and local) was less than eight lawyers, with many significantly smaller practices.
In some markets, a new generation of boutiques are emerging as a diaspora from larger firms’ established niche practices, including in higher value practice areas. One consequence of the trickle-down effect is that small and medium-sized firms will need to compete with more specialist boutiques in key areas.
A question of scale?
In the past, law firms as long as they have remained a certain size (particularly as founder-led firms), have been able to do so in the absence of robust systems and processes. Inevitably, practices develop organically as firms grow but typically lack the discipline required of a high functioning business. Once these firms reached a certain scale, it became apparent that the existing systems and processes (or the lack thereof) were inadequate to enable these firms to transition into a new phase of growth.
Start-up firms can avoid this by ensuring that scalable systems and processes are in place from the outset. This is made easier by the fact that many more off-the-shelf products and outsourced solutions now exist that are suited to smaller platforms and that would require lower capital investment than has been the case in the past.
An appropriate business model (including systems and processes) increasingly forms part of a firm’s organisational capabilities regardless of its scale. Greater compliance obligations are likely to amplify this.
Increasing Price Pressure and Other New Sources of Competition
Technology, including the fast pace of adoption of Artificial Intelligence (“AI”) as part of wider process efficiency initiatives, is intensifying competition. For larger firms, technology is helping to drive down the cost and speed of production by automating tasks that would otherwise be performed by lawyers.
In the past, these tasks might have been “farmed out” by lead counsel or the client to small and medium-sized firms who could perform them at a lower cost. The emergence of Legal Process Outsourcing (“LPO”) provided clients with an alternative model, albeit questions remained about the quality and consistency of work product in many cases. AI now promises more, cheaper and faster solutions with the additional benefit of continuous and systematised learning.
Small and medium-sized firms for whom this has been an important and often lucrative source of income will need to consider the impact of technology on the flow of referrals and direct instructions.
Rising Cost of Doing Business
A key measure of the health of any firm and its competitive performance is its cost multiple. In other words, the ratio of the revenue generated to the direct costs of the fee earners who generated it. The direct cost of fee earners is their salary and related costs and must include a cost of equity partners.
As a small or medium-sized firm, capital commitments are likely to be relatively low. In the past, this may not have been an issue at all. Capital costs for small firms are not generally onerous and, depending on the nature of those costs, are typically self-funded by partners. However, changes in the business model may require higher capital injections than previously have been the case.
Some of the larger international firms in Hong Kong have moved or are contemplating moving their back offices and in some cases their front offices out of Central. Rental costs in particular and their impact on firm margins have long been a source of concern but before now few have been prepared to relocate or have faced significant resistance from partners to avoid doing so.
With time, the adoption of more technology-led work processes will sufficiently alter the shape of their business models in some cases that they will be able to reduce their headcount and, hence, their need for expensive office space.
Small and medium-sized firms are not immune to the same cost pressures whether or not they are based in Central. However, nor are they likely to achieve the same technology-driven economies of scale even if they are able to fund the capital investment required.
Whilst local firms in Hong Kong as in other Asian markets have mostly benefitted from relatively low employee costs compared with some markets, the cost differential will shrink as larger firms drive down the cost of production including the cost per lawyer.
The Tasks of the Owner-Manager
As a small professional services firm, we understand the competing demands in your markets.
Inevitably, small and medium-sized firms lack the infrastructure and organisational capability that larger firms have in abundance. Administrative tasks that would ordinarily be delegated to professional managers naturally fall to the partners (often the founder) to juggle with fee earning, client relationship management and business development commitments.
Role clarity is key in terms of the responsibilities of partners, senior lawyers and associates as are the disciplines and accountability that go with managing these. How much time is allocated to business generation, fee earning work, supervision, etc. and whether or not routine tasks can be performed more efficiently (including potentially through outsourcing these) will come into sharper focus.
Questions to consider:
- How clear is your strategic positioning? Who are your core clients? What are your core work types, values, volume positioning, competitive capabilities and organisational capabilities?
- What are the implications of the changing nature of your client base?
- How well is your strategic positioning understood in your core markets/by your core clients?
- What is the optimum scale for your practice? Do you have the systems and processes in place to compete in five years’ time and, if not, what will you need to do to address this?
- How adaptive is your business model to disruptive technology and/or to price pressure from traditional and non-traditional sources of competition?
- How will you fund the capital investment required to achieve your strategic goals over the next three to five years?
- How will your role change over the next five years and what additional support will you need in managing your firm?