Mergers in the UK professional services market have maintained a steady pace in the last couple of years with some notable combinations in the accountancy and legal sectors. Inevitably, firms who were in the midst of merger talks in the last few months are likely to have put any plans on ice as they grapple with the immediate challenges of the COVID-19 pandemic and the consequent economic recession.
Whilst there may be a hiatus in mergers for a period, as we saw in the months and years following the 2008 Great Recession, the current crisis is likely to be a catalyst for further consolidation in the professional services sector; some of this will be driven by distressed firms seeking a safe harbour and economies of scale.
Mergers between professional services firms can often be complex and protracted, however, with advance thought and planning, mergers can be negotiated and implemented relatively efficiently. Alongside the usual financial and operational measures implemented for an economic downturn, it may also be prudent for certain firms to consider a merger as part of their contingency planning.
In this two-part series, we consider, firstly, the strategic and partnership issues that professional services firms should bear in mind and prepare for in anticipation of a merger. In Part 2, we will look at the employment law and people issues.
1. Plan, plan, plan
Advance planning and reflection is critical to ensuring your firm identifies the right merger partner as well as ensuring negotiations are successful. The key issues to consider are set out below.
• What is your firm’s strategic rationale for a merger? This can include a range of reasons such as increasing scale, expanding geographic footprint/practice areas, diversification, succession planning or, in some cases, to avert the failure and insolvency of the firm. Your business case should be clearly articulated and stress tested so that it forms a strong foundation for your merger plans.
• Once the rationale is identified, it should be possible to undertake market research and shortlist potential merger partners; have this shortlist ready even if the time is not yet right for an approach.
• Ensure senior management have the necessary delegated authority under the firm’s partnership or LLP agreement to negotiate terms with a potential merger partner.
• Put in place the appropriate constitutional provisions to facilitate a merger (discussed further below).
2. Anticipate the stumbling blocks
Many merger discussions fail because firms are not able to overcome knotty issues such as the following:
• Significant divergence in partner remuneration structures is probably the hurdle that prospective merger partners most commonly fall over. A firm with an “eat what you kill” system is unlikely to be an appropriate suitor for a firm which operates a pure lockstep remuneration system. Firms should think about what they value and would like to retain about their own remuneration system. This should inform their shortlist of potential merger partners. There will inevitably be some give and take when agreeing a remuneration structure for the merged firm; therefore, firms should also keep an open mind on what could be flexed or improved upon about their own system.
• Conflicts involving significant clients may also become major obstacles. Firms should identify in advance their critical clients and have a process in place for undertaking conflict checks. Firms should also consider their professional obligations before sharing client names or information to a potential merger partner and have appropriate safeguards in place.
• The governance structure for the merged firm can also be a sensitive issue – decisions regarding voting rights and appointments to management roles are often determined by the balance of power between the two parties. Firms should consider in advance what level of power they are willing to cede and whether certain decisions, at least during an integration period, should be subject to class consent (e.g. requiring the approval of a % of both legacy partner groups).
3. Avoid leaks and ensure partner “buy in”
If negotiations between parties progress to agreeing heads of terms for the merger, the details and proposed terms of the deal will ultimately need to be put to the partners for approval. It is important to achieve partner buy in throughout the process whilst also keeping the existence of the deal and its terms confidential. In reality, merger talks are often prematurely leaked to the press. This can have a destabilising effect on the firm, the potential merger and client relationships.
To discourage leaks and to ensure firms have recourse, should any partner be responsible for disclosing confidential information, firms should ensure that they have robust confidentiality obligations and partner duties in their partnership or LLP agreement. If not, firms may need to persuade their partners to sign a non-disclosure agreement.
Before the deal is signed, both firms will need their partners to formally approve the deal. The key to achieving partner buy in is to inform and consult partners at appropriate junctures when negotiating the merger. This will require skilful and sensitive leadership by the senior management team. Firms should factor in partner consultation and approval in their deal timetable from the outset.
Many of our clients are often surprised to find that a merger deal requires approval by an unattainable majority of partners (such as 90% or even unanimous approval). It is tempting to amend the partnership or LLP agreement to reduce the threshold and enable the merger to be approved but this approach may be risky and open to challenge by partners if done immediately prior to the merger being approved. It is advisable to review the voting thresholds in your partnership or LLP agreement as part of your initial merger planning and to amend the thresholds as necessary before the initiation of any merger discussions.
4. Formulate a strategy to deal with dissenting or surplus partners
It is common for one or more partners to disagree with a merger. If the merger is approved by the requisite majority of partners, dissenting partners have no choice but to accept the decision or otherwise resign. The firm may also wish to exit dissenting partners as they will inevitably lack commitment to the merged firm.
Firms may also identify partners that they think will not be a good fit for the newly merged business (e.g. partners in practice areas or offices that the merged firm wishes to discontinue or close). Mergers are also often viewed by firms as being an opportunity to jettison underperforming partners. In each case, firms should be careful that the selection criteria for such partners are not discriminatory and do not disproportionately affect partners in certain groups with protected characteristics (e.g. older partners).
Firms should have a clear strategy in mind for negotiating exit packages with dissenting or surplus partners. If mutually acceptable exit terms cannot be agreed, partners could be forced to leave with or without notice by the firm – but only if the partnership or LLP agreement contains effective compulsory retirement or expulsion provisions. Again, careful thought needs to be given to whether the firm has the necessary constitutional powers to remove such partners as part of the firm’s initial merger planning.
We also recommend including garden leave and suspension provisions in the firm’s partnership or LLP agreement to ensure that any outgoing partner does not have the opportunity to damage the firm before they leave. Such provisions can prevent the partner from attending meetings and voting on the merger deal and from communicating with (and potentially negatively influencing) others in the firm.
5. Consider how any capital profits will be shared
Although relatively rare, in some instances, the “larger” party in a merger may pay consideration to the other party as part of the merger deal. Indeed, certain listed law firms have financial “war chests” set aside for strategic acquisitions and may see the current crisis as an opportunity to acquire struggling law firms.
All partnership and LLP agreements typically set out how revenue profits will be shared between partners. However, in our experience, many agreements do not specify how capital profits will be shared, in which case, any cash proceeds from the merger will in default be shared in the same way as the revenue profits. As part of the merger planning process, firms should consider how the proceeds (if any) of a merger or sale should be allocated between partners and record this in their partnership or LLP agreement.
6. Ensure the firm’s goodwill is adequately protected
The prospect of a merger can often cause unrest amongst partners; key rainmakers and teams may vote with their feet and move to a competing firm if they are unhappy with the strategic direction of the business or the proposed merger. Such departures can seriously destabilise a firm and derail its merger ambitions. It is therefore vital to ensure that the firm has essential protections in its partnership or LLP agreement to avoid an exodus of partners and protect its goodwill.
Key provisions to include are an appropriate notice requirement, a “waiting lounge” restricting the number of partners who can resign in a certain period, garden leave, restrictive covenants and good/bad leaver provisions. Firms should also include a provision in their partnership or LLP agreement which allows them to assign the benefit of the restrictive covenants to a merger partner or acquirer to whom the business of the firm is transferred. Provided the covenants and the assignment language is carefully drafted, the merged business will be able to enforce any restrictive covenants.
The above constitutional protections should also ideally be reflected in the merged firm’s partnership or LLP agreement so that the new business has a strong foundation for success.
The partners in the newly merged firm can also be locked into the business through a restriction against resignation during a specified period (typically ranging between twelve months to two years) after completion of the merger. Good/bad leaver provisions, particularly those linked to deferred consideration, can also be a strong deterrent against partner departures in the initial years following a merger. Such provisions can help to stabilise the ship during the tricky genesis of a newly merged firm.
If you would like more information on mergers between professional services firms, please contact Partner Zulon Begum or Senior Associate Wendy Chung who both specialise in non-contentious partnership law. Please click here to listen to a podcast on mergers by Partners Zulon Begum and Beth Hale.