Deal Season 2008: Outlook for Transaction Support Services

Many global firms that provide transaction support services for law firms are exceedingly worried about the 2008 deal season. But is the anecdotal evidence of a drying pipeline true? A quick look at the data suggests that law and accounting firms are right to be worried about a decreased deal flow, with only a few highlights in sight.

On a worldwide basis, the number of M&A transactions announced in Q1 2008 compared with the average number of deals announced over the prior three years decreased by 6%; when compared with 2007, the drop is a much sharper: 17%. The good news is that this just returns activity to where it was mid-2005. More worrisome is that the large deals seem to be gone for now, with size of transactions having decreased by nearly 40% over the past three years and by more than 50% when compared with the 2007 average on a global basis. See Figure 1.

[IMGCAP(1)]

Will the Trend Continue?

The question is whether this sharp downward trend will continue for the rest of 2008. One set of measures that seems to indicate that it will is contained in the Composite Leading Indicators (CLI) published by the Organization for Economic Co-operation and Development (OECD). Published monthly, the OECD CLIs are constructed to predict cycles of economic growth and contraction, distinguishing in varying degrees between expansion, downturn, slowdown and recovery. In January of this year, these data indicated a downturn in the U.S., Germany and the UK, but, worse yet, an economic slowdown in the other major OECD economies (Canada, France, Japan, Italy). As recently as May, the data pointed towards a slowdown in all seven major economies. According to the CLI, only Russia is experiencing slow expansion.

Reviewing M&A transactions on a regional basis through Q1 2008 suggests that Europe and the United States are the big losers, with the number of transactions down 24% and 16%, respectively, over 2007; transaction size is down by more than 40%-50% or more no matter how one slices the comparison. The good news is that M&A activity in Asia is least affected, losing only 3% in number of transactions over the last three years and 'only' 13% over 2007. Deals in Asia are actually 25% more chunky when comparing Q1 2008 to the last three years, and this speaks to the tremendous maturing of the deal market there. See Figure 2 below.

[IMGCAP(2)]

Slicing similar data across industry sectors, only four of the 13 major industry sectors showed an increase in the number of transactions in Q1 2008 when compared to last year. These are telecommunications, consumer staples, real estate, and energy. This makes sense assuming one believes currently reported trends in these sectors. The biggest losers are healthcare, high technology, and industrials. The bad news is that even in the four sectors that are seeing the number of deals increase, transaction size is down ' as it is across all sectors. See Figure 3 below.

[IMGCAP(3)]

Law and Accounting Firms

Where does this leave law and accounting firms that have built a substantial part of their business around supporting transactions?

First, the leading indicators clearly indicate a drying deal pipeline. This confirms the anecdotal evidence by managing partners and finance directors that firms have been working to complete their existing pipelines but have noted a decrease going forward. Cash-basis U.S. firms have a chance to report stable revenues from transactions for the 2008 calendar year, as they invoice and collect deals they are completing. On the other side of the Atlantic, accrual basis UK firms with an April 30 financial year-end are showing high revenues and profits for 2007/08, which they invoiced as they worked off their pipeline at the beginning of the year, but transactional revenue will show significant decreases when next year's reports are due.

Second, there are some points of light in between. For instance, global law and accounting firms serving the transactions market are desperately looking for partners to join their operations in the Middle East and Asia. Some are more successful at motivating the right partners to go than others, but decreased utilization of partners, associates and staff in the rest of the world will motivate more to try out new frontiers.

Third, some departments clearly are going to have a more difficult time than others. Restructuring and tax departments in accounting firms are likely to do well. Transaction support services will suffer significantly, especially in firms where these services are offered primarily to keep auditors busy during the summer instead of as a core service. In law firms, corporate departments will look light, and efforts will be expended in retooling the able (and willing) or seeking to at last transfer them temporarily to locations that need the help. Banking departments may have a softer landing in that their partners will be busy restructuring previously leveraged debt. Litigation and restructuring practices should see happy times ahead defending claims of unsatisfied investors, lenders and terminated directors. Some Continental European law firms, still suspicious of complete specialization towards either litigation or transactions, are likely to most easily retool partners from deal-maker to forensic adviser.

Fourth, pressure from the lacking of large deals will cause changes in client-targeting behavior. For instance, the Big Four in the past have focused on only the largest of companies in an effort to shed less profitable work. They now may try to get old, 'smaller' clients (yet still substantial international companies) back, now that they see their capacities free up ' a pattern that is familiar from prior economic slowdowns. Likewise, international law firms are likely to loosen their rates a little to compete for smaller deals as the number of large deals decreases. This will accelerate merger & acquisition activity and put additional pressure on mid-market and regional firms.

Fifth, this may be the cycle in which clients finally force their law and accounting firms to price projects on a basis other than only by the hour. Both mid-market and large companies are yearning for their service providers to deliver work on a basis that allows them to manage their own budgets better. Rethinking pricing methodologies and pricing management practices will yield more gain to profitability in the medium- and long-term than turning on other screws of profitability, even in a downturn.

Last, most law and accounting firms will have to take a hard look at their costs. In this downturn, this should, for once, not mean cutting out the flowers on the receptionist's desk or looking for redundant administrative functions. Gains can be made in cutting overhead, but decreasing unnecessary expenses will no longer yield significant cost savings. Instead, firms will fundamentally review their service delivery models. For instance, scores of providers, both on-shore and abroad, are able to provide certain aspects of due diligence and discovery at a much lower cost than any associate lawyer or staff accountant occupying expensive city center space in a financial center could. Service delivery outsourcing is the next battlefield for cost competition, in particular in the transactional area, but also in dispute resolution.

Conclusion

In the end, managing partners and finance directors of law and accounting firms that are heavily invested in supporting large transactions are right to be worried about a drying deal pipeline. Firms that have made the right investments during the last few good years will be able to work through required changes more comfortably than others who now have to make investments at a time when these surely will be unpopular with partners 'at home.' Forward-looking firms also are in a good position to hire those corporate and banking partners and teams from other firms who may all of a sudden be less busy, whose nests are empty and who are looking for a final career challenge ' in the Middle East, Asia or elsewhere.

Many global firms that provide transaction support services for law firms are exceedingly worried about the 2008 deal season. But is the anecdotal evidence of a drying pipeline true? A quick look at the data suggests that law and accounting firms are right to be worried about a decreased deal flow, with only a few highlights in sight.

On a worldwide basis, the number of M&A transactions announced in Q1 2008 compared with the average number of deals announced over the prior three years decreased by 6%; when compared with 2007, the drop is a much sharper: 17%. The good news is that this just returns activity to where it was mid-2005. More worrisome is that the large deals seem to be gone for now, with size of transactions having decreased by nearly 40% over the past three years and by more than 50% when compared with the 2007 average on a global basis. See Figure 1.

[IMGCAP(1)]

Will the Trend Continue?

The question is whether this sharp downward trend will continue for the rest of 2008. One set of measures that seems to indicate that it will is contained in the Composite Leading Indicators (CLI) published by the Organization for Economic Co-operation and Development (OECD). Published monthly, the OECD CLIs are constructed to predict cycles of economic growth and contraction, distinguishing in varying degrees between expansion, downturn, slowdown and recovery. In January of this year, these data indicated a downturn in the U.S., Germany and the UK, but, worse yet, an economic slowdown in the other major OECD economies (Canada, France, Japan, Italy). As recently as May, the data pointed towards a slowdown in all seven major economies. According to the CLI, only Russia is experiencing slow expansion.

Reviewing M&A transactions on a regional basis through Q1 2008 suggests that Europe and the United States are the big losers, with the number of transactions down 24% and 16%, respectively, over 2007; transaction size is down by more than 40%-50% or more no matter how one slices the comparison. The good news is that M&A activity in Asia is least affected, losing only 3% in number of transactions over the last three years and 'only' 13% over 2007. Deals in Asia are actually 25% more chunky when comparing Q1 2008 to the last three years, and this speaks to the tremendous maturing of the deal market there. See Figure 2 below.

[IMGCAP(2)]

Slicing similar data across industry sectors, only four of the 13 major industry sectors showed an increase in the number of transactions in Q1 2008 when compared to last year. These are telecommunications, consumer staples, real estate, and energy. This makes sense assuming one believes currently reported trends in these sectors. The biggest losers are healthcare, high technology, and industrials. The bad news is that even in the four sectors that are seeing the number of deals increase, transaction size is down ' as it is across all sectors. See Figure 3 below.

[IMGCAP(3)]

Law and Accounting Firms

Where does this leave law and accounting firms that have built a substantial part of their business around supporting transactions?

First, the leading indicators clearly indicate a drying deal pipeline. This confirms the anecdotal evidence by managing partners and finance directors that firms have been working to complete their existing pipelines but have noted a decrease going forward. Cash-basis U.S. firms have a chance to report stable revenues from transactions for the 2008 calendar year, as they invoice and collect deals they are completing. On the other side of the Atlantic, accrual basis UK firms with an April 30 financial year-end are showing high revenues and profits for 2007/08, which they invoiced as they worked off their pipeline at the beginning of the year, but transactional revenue will show significant decreases when next year's reports are due.

Second, there are some points of light in between. For instance, global law and accounting firms serving the transactions market are desperately looking for partners to join their operations in the Middle East and Asia. Some are more successful at motivating the right partners to go than others, but decreased utilization of partners, associates and staff in the rest of the world will motivate more to try out new frontiers.

Third, some departments clearly are going to have a more difficult time than others. Restructuring and tax departments in accounting firms are likely to do well. Transaction support services will suffer significantly, especially in firms where these services are offered primarily to keep auditors busy during the summer instead of as a core service. In law firms, corporate departments will look light, and efforts will be expended in retooling the able (and willing) or seeking to at last transfer them temporarily to locations that need the help. Banking departments may have a softer landing in that their partners will be busy restructuring previously leveraged debt. Litigation and restructuring practices should see happy times ahead defending claims of unsatisfied investors, lenders and terminated directors. Some Continental European law firms, still suspicious of complete specialization towards either litigation or transactions, are likely to most easily retool partners from deal-maker to forensic adviser.

Fourth, pressure from the lacking of large deals will cause changes in client-targeting behavior. For instance, the Big Four in the past have focused on only the largest of companies in an effort to shed less profitable work. They now may try to get old, 'smaller' clients (yet still substantial international companies) back, now that they see their capacities free up ' a pattern that is familiar from prior economic slowdowns. Likewise, international law firms are likely to loosen their rates a little to compete for smaller deals as the number of large deals decreases. This will accelerate merger & acquisition activity and put additional pressure on mid-market and regional firms.

Fifth, this may be the cycle in which clients finally force their law and accounting firms to price projects on a basis other than only by the hour. Both mid-market and large companies are yearning for their service providers to deliver work on a basis that allows them to manage their own budgets better. Rethinking pricing methodologies and pricing management practices will yield more gain to profitability in the medium- and long-term than turning on other screws of profitability, even in a downturn.

Last, most law and accounting firms will have to take a hard look at their costs. In this downturn, this should, for once, not mean cutting out the flowers on the receptionist's desk or looking for redundant administrative functions. Gains can be made in cutting overhead, but decreasing unnecessary expenses will no longer yield significant cost savings. Instead, firms will fundamentally review their service delivery models. For instance, scores of providers, both on-shore and abroad, are able to provide certain aspects of due diligence and discovery at a much lower cost than any associate lawyer or staff accountant occupying expensive city center space in a financial center could. Service delivery outsourcing is the next battlefield for cost competition, in particular in the transactional area, but also in dispute resolution.

Conclusion

In the end, managing partners and finance directors of law and accounting firms that are heavily invested in supporting large transactions are right to be worried about a drying deal pipeline. Firms that have made the right investments during the last few good years will be able to work through required changes more comfortably than others who now have to make investments at a time when these surely will be unpopular with partners 'at home.' Forward-looking firms also are in a good position to hire those corporate and banking partners and teams from other firms who may all of a sudden be less busy, whose nests are empty and who are looking for a final career challenge ' in the Middle East, Asia or elsewhere.