A weasel-free take on legal services and the credit crunch

Don’t you hate it when financial journalists try to weasel out of giving an actual view on the market when things get bumpy? Out come the hedged bets, fence-sitting and anything to avoid actually taking a view on what the likely outcome will be. Legal Week recently tried to avoid such prevarication with an analysis of the impact of the current turmoil in credit markets, largely focusing on the perspective of acquisition finance lawyers.

As the situation has moved on since then, with central banks last week repeatedly intervening to avoid money markets shutting down, we may as well take a wider look at the outlook for legal services. The piece below is an internal assessment written last week for my boss (I used to be a debt securities reporter) of what the current market shake-down means for law firms. Doubtless, much of it will come back to haunt me, but at least I didn’t weasel out:

“Current turmoil in the credit markets divides into two outlooks: short-term and medium-to-long term. The longer term view is, on most readings, actually quite positive. The global economy is still doing well, corporates have relatively low debt and healthy profits. Though the US economy is slowing, major emerging markets and Europe appear to be taking up some of the slack. Shares are also – despite claims of market excess – actually quite conservatively valued, which will provide strong support to deal markets, especially the M&A and IPO activity that is the bedrock of the legal services industry that we cover.

"More importantly, the retrenchment of credit conditions after a period of what many would regard as excessive, even reckless, lending is an entirely positive correction – a return to a more rigorous and risk-conscious environment.

"Where the outlook is less positive is in the alternative investment industry, meaning to a certain extent private equity but especially hedge funds. These sectors operate with lots of debt and are vulnerable to market volatility. In the case of private equity houses, they are still sitting on a lot of money to invest but they will have to scale back their ambitions in terms of mega-deals for a while. Hedge funds are in a worse position – I would guess that the next few years will be less kind to the hedge fund industry (you may start seeing house prices stall in Mayfair and Chelsea).

"However, I think the impact of all this on law firms, in itself, will be minimal. As said above, there are still solid conditions for deal markets and hedge funds currently constitute relatively little revenue for legal advisers. Law firms will feel the impact of buy-out houses pulling in their horns but since that should mean lawyers’ plc clients start doing more acquisitions, the impact may even be positive. There is further deal support from commodity-backed foreign acquirers like sovereign wealth funds that have buying power that dwarfs private equity.

"Likewise, a rise in restructuring work that would follow tougher credit conditions (which many law firms are expecting) would in theory open up a new line of highly lucrative work. This could involve contentious restructuring work linked to LBOs or litigation involving instruments like CDOs. Firms like Bingham McCutchen, Cadwalader and Herbert Smith will be gauging the market for opportunities.

"It also looks increasingly likely that interest rates will begin coming down fairly soon (previously it was expected that they would not peak until late 2007 or early 2008). Overall, I would guess legal services will continue to perform well, even though it will be a leaner year for the City in general.

"However, despite a relatively benign medium-term outlook, there is no disguising the fact that credit markets are currently very volatile and prone to shocks. It is entirely possible that a short-term panic could lead to full-blown credit crunch or a total seizure of the short-term debt markets. A related issue is that as global house prices are very high, there is a danger that a housing market crash could have a dramatic impact on Europe if it turns out the lenders here are heavily exposed to sub-prime issues, or worse, debt simply becomes unsupportable. Currently it looks like European banks’ exposure is considerably less heavy than in the US.

"The bottom line is that there will be a bumpy few months – if the dust has settled without a complete crunch or major banking failure by the September/October, the short-term risks outlined can be said to have dramatically fallen away, leaving you with the medium-term outlook above.”

alex.novarese@legalweek.com