Merger mania is creeping back into the professional services business. And once again, as in the 1980s, “go/no go” analyses of prospective mergers disclose some very fuzzy thinking by firms that apparently did not learn from the relatively mediocre results of many mergers of the past.

Some firms considering mergers today might better pursue a strategic alliance, either as an end in itself or as an interim step toward a subsequent merger.

Very few mergers of professional services firms promise true synergy likely to increase long-term profitability of the merged entity. Synergy in the form of improved profitability only occurs when a merger results in increased leverage, utilization of people and other resources or billing rates.

These improvements happen only if the aggregate volume of work of the two combined firms actually increases as a result of the merger, resulting in increased utilization or leverage, or if the quality of work dramatically increases, raising rates and realization. Overhead almost never decreases, as economic survey data have consistently shown that there are no economies of scale in professional services practice.

On average, large firms spend more per professional on overhead than smaller firms. Also, the transactions costs incurred in a merger frequently result in decreased margins in early years.

As a result, a merger definitely should not be considered for any of the following reasons, although they turn out altogether too often to be the underlying rationale for ill-conceived mergers:

• To achieve economics of scale.
• To satisfy partners’ egos.
• Just to get bigger.
• To become full service, as an end in itself.

Legitimate reasons for merger can include both offensive and defensive strategies for long-term profitability improvement. Offensive merger strategies are calculated to exploit opportunities, while defensive merger strategies are intended to cure a weakness or avoid an external threat.

Adding new practice areas that current clients of either firm need and in which they will direct new work to the merged firm is an example of an offensive strategy, as is gaining access to new geographic markets where clients of either firm actually will use the resources of the merger partner.

Examples of defensive strategies are creating a new firm management that can implement a decision to downsize to a profitable combined size or filling age or experience gaps to assure future continuity, succession, client retention, and growth. Either type of strategy can provide a justifiable reason to merge.

Of course, even if there is sound business reasoning behind a merger, there still will be risk, arising from factors including the following:

• Client reaction.
• Possible clashes of cultures of the merger partners.
• Incompatibility of management styles.
• Economic disparities.
• Conflicts of interest.
• Personalities of the professionals
• Post-merger shake out of productive partners.
• Disparate firm, debt, retirement obligations, or capitalization.

Most new business potential in professional services firm mergers comes form existing clients of the two firms, through cross-selling of new services and professionals to both clients. But most firms are so ineffective at cross-selling even their own practices that they are unable to cross-sell successfully those of unfamiliar professionals. If post-merger cross-selling does not occur, revenues and profits are at best static, and may even decline.

It is here that the benefits of a strategic alliance become apparent. Two firms with complementary practices and client bases can and should be able to accomplish almost the same revenue and profit benefits of a merger without all of the attendant costs and risks if they can actively cross-sell each other.

Indeed, the fact they are discrete entities requires active cross-selling. If effective cross-selling can be achieved, merger at a later date is much less risky, since inter-firm cross-selling is a means by which potential synergies arising from a merger can be demonstrated.

Firms that might want to consider strategic alliances include:

• Those with mutually compatible specialties. For instance, HR consulting Firms and law firms could ally themselves to better handle industrial relations disputes
• Those with mutually complementary practices that might be cross-sold to the other, such as labor-employment firms and corporate/tax boutiques.
• Those in different jurisdictions, domestic or foreign, whose clients might need reliable representation in the other venue. Examples include Indonesian and Chinese firms or U.S. and European firms. Geographically diverse alliance partners might also share entrepreneurial risk in establishment of joint venture offices in third jurisdictions.

In business, strategic alliances are not new. U.S., Japanese, and European automakers have used them to compete more effectively in foreign markets. Airlines use them as well. Given the dismal results of so many law firm mergers in the past, a well-conceived strategic alliance between complementary firms provides the potential upside of a merger without its risks. But it does require a quid pro quo—reciprocal referrals—and a benefit to both parties, especially when professionals cannot share fees without disclosure and acceptance by the client.

Of course, strategic alliances are not risk-free. One party might attempt to steal clients form the others. One could “bail out” on the alliance and not fulfill its marketing responsibilities. Firms could try to steal professionals from the other. Firms might mutually conclude they are not compatible and walk away from the deal with all of their assets intact.

In such circumstances, the alliance should terminate, freeing both parties to operate independently or seek other alliance partners, if they so choose. Even if the strategic alliance does not work, each firm is a little further along the road to knowing itself better, usually leaving it better off than before, and neither firm is encumbered by the legal and public relations morass of trying to undo an ill-conceived merger.

On the other hand, a successful alliance could result in a merger, or the participants might continue the alliance indefinitely. If the alliance evolves into a merger, its prospects for success should be much better than they would otherwise.

In today’s volatile professional services market, a merger is risky. Strategic alliances, managed effectively, provide a way to reduce the risk in amalgamation and test the potential synergies that might emerge, with the tacit or implicit understanding that a merger might follow.

(By Chris van Overveen – Senior Consultant – Trimitra Consultants)

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