Over the past 30 years, globalization, deregulation, and technological change have reconfigured many service industries, such as banking and accounting. In contrast, the legal industry has remained relatively fragmented, in part as a result of the historical importance of local relationships and local laws. Every significant city in the United States has its own handful of large, elite firms, but only a few of them aspire to national or global status. However, a flurry of mergers of unprecedented scale and geographic reach—as well as several notable failures—suggest that the legal business is losing its immunity to the macroeconomic forces that have propelled consolidation and stratification in other industries. Of the world's largest law firms (measured by revenue), all but the most profitable are in some peril, and even the profit leaders, historically viewed as untouchable, will find it harder to maintain their flow of first-rate clients and talent.

Consider the year 2000 alone. New York's Winthrop, Stimson, Putnam & Roberts (265 lawyers) merged with San Francisco's Pillsbury, Madison & Sutro (490 lawyers). Paul, Hastings, Janofsky & Walker (610 lawyers), based in Los Angeles, merged with New York's Battle Fowler (120 lawyers). Chicago's Winston & Strawn (607 lawyers) linked up with New York's Whitman Breed Abbott & Morgan (178 lawyers). And Cleveland's Squire, Sanders & Dempsey (550 lawyers) acquired San Francisco's Graham & James (126 lawyers).

Even as the value of mergers, acquisitions, and other capital-markets transactions raises profits per partner at most of the largest US law firms to new heights, the partners are searching their souls. They are appointing nonlawyers as chief operating officers, building up their more promising practice areas while dropping others, opening and closing offices, shifting certain kinds of work to cheaper offices, and rethinking their compacts with their own partners. Finally, they are considering significant mergers and acquisitions—in most cases, for the first time.

The more farseeing firms will build national and, in some instances, global practices of distinctive depth and breadth of expertise—practices that can support high profits per partner and significant growth. These strengths will set in motion a virtuous cycle in which such firms cherry-pick top talent from other, less profitable competitors and invest in geographic expansion and technology. New talent and investments will help the leading firms put even more distance between themselves and the stragglers, which will be swept into an almost irreversible downward spiral, thus losing talent and stature at an accelerating pace until they unravel, get acquired, or reconstitute themselves as "commodity" players.

Globalization and deregulation

Capital today is moving across borders at lightning speed in order to pursue the most attractive investment opportunities. At the same time, deregulation has opened to competition significant parts of the US and European economies, including telecommunications, airlines, and electric power. As a result, companies that might have excelled locally or regionally suddenly find themselves competing against others with world-class expertise. To compete effectively, they must typically upgrade their skills, develop a distinctive basis for competition, and aggressively reduce costs.

Such globalizing companies increasingly seek out law firms that can provide consistent "multilocal" support and integrated cross-border assistance for significant global M&Amp;A and capital-markets transactions, as well as antitrust and tax matters. We have no reason to believe that the trend toward globalization will stop at these practice areas. Moreover, as US and UK law have come to govern the activities of the world's leading financial institutions and corporations, first-rate law firms in the United States and the United Kingdom have gained a distinct advantage in cross-border legal transactions. Recognizing this "Anglo-Saxon upper hand," most top German law firms have either allied or merged with leading UK law firms during the past two years.

The widening gap

Mergers and acquisitions have disrupted many long-standing relationships between companies and their outside counsel. And in the face of heightened global competition, companies increasingly base purchases of legal services on a more objective assessment of their value, defined as benefits net of price. Deregulation, globalization, and greater transparency—promoted in part by information technology—have expanded the choices available to corporate general counsels and made it easier than ever for them to compare the services and prices of law firms.

For routine legal needs, such as environmental compliance and insurance defense, the goal is now to obtain satisfactory legal services at minimum cost. In these areas, companies are turning to in-house counsel or to whatever outside counsel offers the best price for competent work. By contrast, for high-value-added legal services, such as M&Amp;A and capital-markets transactions, companies are more likely to look—and pay a premium—for the best attorney in a particular subpractice. This bifurcated approach to legal services rewards law firms that have distinctive depth and breadth of expertise in high-value practice areas and penalizes those with large numbers of lawyers in practices whose services are becoming commoditized.

Just as the gap between the value of different kinds of legal work is increasing, so too is the gap in average profits per partner between the 25 most profitable US firms in the AmLaw 100¹ and the others (Exhibit 1). Many of the firms in the top quartile of the AmLaw 100 (reckoned by profits per partner) are based in New York and have large, distinctive M&Amp;A and capital-markets practices that command premium rates.

Globalization and deregulation are not the only forces driving the stratification of the legal industry. Two others are technological innovation and a shortage of legal talent.

Only firms that are distinctive and offer great expertise will escape downward pressure on prices

The advent of electronic legal databases such as Lexis-Nexis and Westlaw has accelerated the commoditization of low-value-added legal work. Clients no longer need big, expensive firms to conduct ambitious research projects speedily and comprehensively. Powerful Internet-based research facilities make it unnecessary for clients to engage prestigious Washington, DC, firms to help them find out what is happening in federal regulatory agencies and on Capitol Hill. E-mail and virtual workrooms have reduced the cost and time needed to transmit information and to conduct business. Furthermore, the Internet is likely to intensify competition among law firms by making prices more transparent. Only firms that are distinctive and offer a high degree of expertise will escape the ensuing downward pressure on fees.

As for the shortage of talent, law firms and other professional-service organizations have always competed keenly for the best people, but the competition has never been as ferocious as it is now. The declining population of 25- to 45-year-olds and the increasing demand for workers with expertise have drawn most industries into a war for talent, and the competition for legal talent is particularly acute.

Today, large numbers of law school graduates are going into business and finance. As a result, top law firms in leading markets have been forced to raise the compensation of first-year associates to more than $160,000—representing, for many firms, a 25 percent increase over the past two years. Meanwhile, more senior lawyers are going in-house to assume increasingly influential positions and to escape the pressures of client development and the tyranny of the billable hour.

Competition among law firms is also intensifying. As clients reward firms that have distinctive depth and breadth of expertise in their most valuable practices, the firms must be more and more willing to pay a premium to attract and retain partners in those specialties. With top-quartile firms significantly outpacing the rest in profits per partner, even high-quality firms outside the elite circle have trouble holding on to their talented homegrown partners and attracting lateral hires. As the talent base of the less profitable firms erodes, so will their depth and breadth of expertise and their profits per partner.

Scale, geographic breadth, and culture also give firms an advantage in the war for talent. A large firm can more easily afford to invest in outstanding laterals than can a smaller firm with comparable profits per partner. Geographic expansion permits a firm to increase its depth and breadth in a particular practice without diluting its quality by reaching further down into the local talent pool. Finally, all other factors being equal, firms with particularly distinctive and cohesive cultures attract and retain a greater share of top legal talent.

New competitors

As traditional law firms have been subjected to these challenges, they have also been buffeted by three new classes of competitor: new-economy law firms, accounting firms, and e-commerce players.

New-economy law firms

Some firms have targeted emerging high-tech businesses and reinvented the economics of the legal profession by taking equity in many of the clients they serve. Such law firms include Wilson Sonsini Goodrich & Rosati, Venture Law Group, and Gunderson Dettmer Stough Villeneuve Franklin & Hachigian as well as older, more established names, such as Boston's Hale and Dorr and San Francisco's Cooley Godward. Not surprisingly, these firms, largely based in California, have led the increase in associates' salaries in an effort to compete with the compensation offered by Silicon Valley start-ups and venture capital funds.

Accounting firms

In the meantime, the Big Five accounting firms have announced that they wish to become leading global players in the legal profession. In many ways, they already are: three of them rank among the top ten global employers of lawyers, and many of the largest law firms in France, Spain, and other European countries are owned by or affiliated with accounting firms.

In the United States, significant obstacles to the formal integration of accounting firms and law firms remain. The ethics rules governing the conduct of US lawyers prohibit them from sharing fees with accountants (except, for example, under certain limited circumstances in the District of Columbia), and the American Bar Association has opposed the advent of multidisciplinary practices combining lawyers and accountants. In addition, the US Securities and Exchange Commission hasn't taken a clear position about whether and how accounting firms could enter the practice of law in the United States without compromising the independence of auditors. Accounting firms continue to hire leading US tax lawyers, however, and have begun to form alliances with US law firms. Most notably, Ernst & Young recently financed a new Washington, DC, law firm specializing in tax law, and at least one other accounting firm is reported to be seeking a US law firm as a partner.

E-commerce players

Moreover, a new class of e-commerce firm is emerging to challenge traditional law firms. Lexis-Nexis and Westlaw have long provided electronic access to statutes, case law, administrative law, and secondary legal sources. The new firms, however, can provide synthesized, semicustomized legal content. They include Blue Flag, recently spun off by the UK law firm Linklaters & Alliance to provide commoditized professional services; eLaw.com, which offers a library of memos and briefs composed by lawyers at "name'' law firms; and LexisOne, which is owned by Lexis-Nexis and touts free case law, free forms, and access to more than 20,000 World Wide Web sites on law. Linklaters recently estimated that the Web could improve the quality and efficiency of half of its legal services.²

The profitability imperative

Public companies are subject to a market capitalization imperative: large market caps permit them to invest in growth, to acquire other companies, and to minimize their own vulnerability to takeover.3 To help such companies understand their current and desired market cap position, McKinsey's globalization practice has developed a strategic-control map, which plots the size of a company, as measured by its book equity, against its performance for shareholders, as measured by its market-to-book ratio. When a company moves across the horizontal axis, the company gets bigger; when it climbs the vertical axis, it improves its performance for shareholders. Multiplied, these two metrics produce the company's market capitalization. Because law firms are not publicly held, profitability rather than market capitalization determines their capacity to invest in new opportunities.

Of course, the partners of law firms have always had a powerful personal incentive to maximize profits. But intergenerational conflicts, and in some cases "eat-what-you-kill" compensation systems, have created a bias toward immediate distribution. Today, the cost of acquiring talent, implementing state-of-the-art information technology systems, and opening foreign offices argues for reinvesting surpluses. And it is profits, rather than markets, that must finance this reinvestment.

To create a "profitability map" for law firms, we have plotted the size of a firm, as measured by the number of its equity partners, against its performance, as measured by its profits per equity partner. Multiplied, these two metrics produce the firm's earnings, indicated by an isoquant. Thus, firms located on a single isoquant have achieved comparable earnings through various combinations of scale and profits per partner. Exhibit 2 shows the positions of selected Global 50 law firms4 in 1993 and in 1999. Baker & McKenzie's scale and scope, for example, contrast with the lower-volume, higher-profitability strategy of Wachtell, Lipton, Rosen & Katz. Significantly, many firms are clustered in the lower-left-hand corner of the map, as they have neither distinctive scale nor distinctive profits per partner.

The profitability map also highlights changes over time. Both Skadden, Arps, Slate, Meagher & Flom and Latham & Watkins made impressive moves along the two axes from 1993 to 1999. Other firms, including Cravath, Swaine & Moore, moved vertically by sharpening their M&Amp;A focus during the 1990s. London's Clifford Chance, New York's Rogers & Wells, and Frankfurt's Pünder, Volhard, Weber & Axster merged to achieve preeminent scale.

A firm's position on the profitability map provides strong insights into that firm's strategic choices

A firm's position on the profitability map provides insights into that firm's strategic choices. While the precise location of the lines dividing the map into quadrants is subject to debate, firms in the upper-left-hand quadrant tend to be "specialists" by virtue of their focus on a single, profitable practice or on the most lucrative work across a limited and related set of practices. By contrast, firms in the lower-right-hand quadrant, having developed a broader set of (on average) less profitable practices, are generally "full-service integrators." Firms in the upper-right-hand quadrant tend to be industry "shapers," which have achieved both significant scale and significant profitability by combining a distinctive strategy with top-notch execution. "Incumbents," occupying the lower-left-hand quadrant, have neither the profitability of the specialists (though some incumbents are highly profitable) nor the scale of the full-service integrators.

Incumbents

As Exhibit 2 shows, there are two broad categories of incumbent: those with moderate profitability ($500,000 to $750,000 in profits per partner) and those with high profitability (typically, more than $900,000 in profits per partner). Both kinds of incumbent suffer from certain disadvantages, but moderately profitable firms are, of course, more vulnerable than their very profitable counterparts.

Many of the moderately profitable firms operate on a multipractice, regional basis and, for their competitive advantage, rely on long-standing relationships with clients and on familiarity with local ways of doing business. This advantage is eroding as industries consolidate and as increased competition prompts even small and midsize regional companies to base their purchases of legal services on more rational, economic grounds. Incumbents also tend to have many partners who work in commoditizing practices or fail to perform satisfactorily. Collectively, these firms lack both the world-class skills to compete with the specialists and the scale and geographic scope to tangle with the more successful full-service integrators.

The more profitable incumbents include both leading New York and UK firms. As compared with most others, they have enviable economics, client bases, and talent pools. Even so, the profits per partner of leading New York firms in this quadrant lag behind those of their specialist counterparts by more than 25 percent. Similarly, leading UK firms in this quadrant lack the scale and scope of Clifford Chance.

Shapers

Firms in the upper-right-hand quadrant dominate markets by driving their evolution. One striking difference between the legal industry's profitability map and the strategic-control maps of other industries is the fact that only one firm—Skadden, Arps, which earned more in 1999 than any other firm, though it isn't the largest—falls in this quadrant so far. For more than a quarter of a century, Skadden, Arps has enjoyed towering strength in its M&Amp;A practice, complemented by what partner Joe Flom calls "pockets of expertise across the board."5 The firm's strategy of building on a lucrative, rapidly growing core practice area is similar to that followed by many other industries' shapers, which have first moved up the strategic-control map and then turned right.

As the legal industry restructures, more shapers will probably emerge. These firms will have world-class skills in a broad but coherent set of practices and locales that allow them to command a premium. As a result, they will achieve rapid and highly profitable growth.

Specialists

Law firms focusing on a relatively small number of practice areas or client segments that offer high returns are specialists. The spectacular growth in profitability achieved by M&Amp;A specialist Wachtell, Lipton, Rosen & Katz, for example, has coincided with the steep rise in the number and value of M&Amp;A transactions. Wachtell's world-class talent and the intellectual capital and distinctive brand that the firm has developed in the M&Amp;A arena attract a global clientele willing to pay a premium.

Specialists have historically focused on building their depth and breadth of expertise in a single office. But we believe that they will face growing pressure for geographic expansion to maintain world-class capabilities in their specialties and to meet the increasingly global needs of their clients.

Full-service integrators

Most of today's full-service integrators have roughly 300 equity partners and profits per partner of from $400,000 to $700,000. The intensifying competition for lucrative client work and first-rate talent will press these firms to develop greater depth and breadth of expertise in individual practices and to boost their profits per partner. To do so, the firms will have to shed their unprofitable practices and concentrate on the more profitable segments of every practice they retain. Full-service integrators will also have to strengthen the professional and cultural ties across their practices and offices to capture economies of scope and scale more effectively and to avoid losing talent to smaller, more cohesive firms.

A few full-service integrators have already distanced themselves from the others. Clifford Chance and Baker & McKenzie, with 645 and 558 equity partners, respectively, have distinguished themselves through the breadth of their practice portfolios and their geographic footprint, while Latham & Watkins has combined significant scale with profits per partner of more than $1 million. And, the role of the full-service integrator is likely to be a natural one for accounting firms, given their scale and global reach.

Winning strategies

Although the precise evolution of the legal industry is impossible to predict, we believe that some winning strategies can already be identified.

Two classes of shaper are likely to emerge as winners: the global megafirms and the new-economy firms. The first class of shaper will have upward of 2,000 attorneys and (like Skadden, Arps) a broad but coherent set of practices and locales permitting it to command a significant premium by helping large clients with their most lucrative legal issues, such as cross-practice and cross-border support in the M&Amp;A and capital-markets arenas. To play this role, the megafirms will invest considerable sums in their IT and knowledge-management infrastructure. In most cases, they will also have to increase their resources by making significant acquisitions or mergers in a number of countries relatively soon. The winners will therefore have to be skilled at negotiating and structuring deals and at integrating and governing a large, diverse, and highly dispersed group of attorneys.

And new-economy firms such as Wilson Sonsini and Cooley Godward, though they haven't achieved the profitability or scale of Skadden, Arps, have already reshaped the legal landscape and are likely to go on increasing their earnings significantly. With offices in Silicon Valley, these firms saw the opportunity in their backyard and developed distinctive expertise to serve the high-tech industry and emerging growth companies. They also operate under a new economic model—equity in lieu of some fees—that permits them to attract high-tech clients around the world and to follow start-up activity to new locales, including Austin, Texas; Denver, Colorado; McLean, Virginia; and Seattle, Washington.

Elite Wall Street firms, such as Wachtell, Cravath, and relatively small firms that focus on practices such as intellectual property and litigation, will continue to benefit from winning specialist strategies. These firms will build ever-greater depth and breadth of expertise and global reach to capture the highest-value work in their narrow set of practices. They will have to grow organically and, in some cases, seek mergers with or acquisitions of firms that have compatible practice portfolios and cultures.

Among the full-service integrators, there will likely be two classes of winner: US "aggregators" and multidisciplinary firms. A half dozen US aggregators will consolidate moderately profitable local and regional firms to achieve greater depth and breadth of expertise in high-value practices, as well as greater geographic presence, while also taking aggressive steps to improve profitability. The resulting firms will have upward of 1,500 attorneys, focusing primarily on the US market. These US aggregators will need to arm themselves with the managerial skill of the global megafirms, though in most cases they will lack the latter's international presence, profitability, depth of expertise, and ability to dominate the most lucrative practice areas. To be successful in the long run, the US aggregators will have to shed their underperforming partners and practices quickly while they refocus and retool other practices and roll up formerly independent firms into new, larger entities.

Multidisciplinary firms will offer their clients coordinated global access to standard accounting and legal services. But with the notable exception of tax work, these firms will tend to focus on less profitable practice and client segments than will the global megafirms.

In addition to choosing and executing a winning strategy, all law firms should make a handful of "no-regrets" moves to improve their competitiveness and thus their ability to recruit and retain talented attorneys and to attract desirable merger partners. Chief among these moves are improving profits per partner, increasing the depth and breadth of expertise in strong practices, and developing a more corporate governance structure that facilitates faster and better decision making and execution. While such actions, which include shedding underperforming practices and partners, will be hard for most firms, this course is surely more desirable than the alternative: leaving their fate in the hands of others.