Life cycle maturity and the professions

Warren Riddell Partner, Beaton Capital

May 2014

Global Issues Series

©Beaton Capital 2014

In February 2014 George Beaton delivered the Client Choice Awards keynote address to over 200 leaders of professional services firms, including consulting engineers, management consultants, tax advisers, auditors and lawyers. “Beware the Ides of March.” George proclaimed. Just as the Ides of March marked a turning point in Roman history, similar portents are present for professional services firms. What we term the Ides of Maturity mark a modern-day turning point of another momentous kind. These “Ides” herald an era of life cycle maturity and the start of decline for many firms.

The professions have many features in

common...

These features include high ethical standards, serving the needs of clients, enhancing the public good, and being based on knowledge. Another shared phenomenon is the fact the industries constituted by the firms in each profession (i.e. lawyers, accountants, consulting engineers, management consultants and others) are all now entering or are already in the mature phase of their lifecycles. The stages of an industry or product life cycle are generally well documented and understood; but in our opinion the life cycle of the professional services industry is the least well understood.

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The typical life cycle sees professional services firms incubate within a specialisation (‘concept development’), followed by ‘market development’ as the successful firms grow by market expansion through scaling up core services, which may include geographic expansion and also migration into adjacent areas of practice. Stepped growth starts to occur through M&A activity, or the integration of federations, often characterised by the corporatisation of governance structures and widening the footprint of ownership. By this stage many professional services firms have created a wide spread of practice areas, but are still characterised by a single operational and go-to-market business model. During this phase

we see some recognised brand names disappear as the industry ‘shakes-out’ weaker firms. Up until this point the industry has been generally growing faster than the economy at large, so business activity fuelled by increased economic activity has made life relatively easy for all firms.

But let’s focus on maturity in the life cycle for a moment. Being in life cycle maturity means the unit or volume growth in a given profession, at best increases no faster in the long run than that of the economy. By long run we are looking at the average beyond one economic cycle.

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Figure 1 – Life cycle of a professional services firm

We think it looks very much like figure 1 below:

Portents of life cycle maturity

So what are the signals or portents of maturity? Here are the most obvious:

Stagnant growth Some argue the current stasis being experienced by professional services firms in the developed markets simply reflects a longer than customary recessionary period. The evidence suggests otherwise. Where statistics exist, it’s clear that volume growth had slowed well before the GFC struck.

Commoditisation Commoditisation can be driven by clients and by firms themselves. Clients are watching how new

substitute providers are changing the rules of engagement and in many cases this is leading to clients treating services as commodities. Just look at the way legal process outsourcing has changed clients’ attitude to the cost of repetitive legal discovery work and the efficiency of the incumbent players. But firms also self-commoditise their services through their competitive strategies – often choosing to differentiate by price alone.

Commoditisation is a vivid demonstration that a market has both matured and moved into a new phase, with old delivery methods no being longer relevant. So service providers have to reinvent their delivery model or exit that market to remain profitable.

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Figure 2 – Clients’ perception of fees charged on a 0–10 point scale

Professions: Accounting | Consulting Engineering | Law Source: Beaton Benchmarks

Price taking

In many industries hyper-competition has become the norm. Beaton Research + Consulting’s time series data (Figure 2) shows Australian corporate clients’ perceptions of fee levels for consulting engineering, legal and accounting services have been trending down since the peak measured in November 2007. For most professional services firms the market is now a buyers’ market, a position that will not reverse in our opinion.

Competitive intensity Hyper-competition can be observed in other behaviours. Michael Porter’s Five Forces analysis provides a useful tool in understanding the market dynamics that give rise to increased competitive intensity (Figure 3).

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Figure 3 – Professional services firms’ market dynamics

New entrants are taking market share from incumbents. The last few years have witnessed many international law firms and some international consulting engineering firms entering Australia, keeping previously referred work for themselves and competing for the larger local clients and projects. Consulting engineers have globalised and are highly acquisitive, increasing localised competition and scrambling for talent when the investment cycle was strong. The accounting firms, primarily the Big4, are taking the ‘fight’ to the other professions as they push the boundaries of their brand permission back into aspects of law and consulting engineering.

Clients in some cases are bringing work in-house, noticeably in law and in certain engineering and construction sectors. This is driven by the clients’ perception of cost and efficiency - they can do better than the traditional service providers in the less specialised services.

Substitute providers are now real in all industries. In law new delivery models include sophisticated contract lawyers through providers such as Axiom and AdventBalance, which are targeting major corporations for major projects – i.e. they are not on the periphery. New model law firms like Riverview Law provide fixed price services and sophisticated management reporting for high volume legal services. All the professions compete with off-shoring providers from lower cost but equal quality providers in India, Philippines, South Africa, New Zealand and other countries.

The fundamental point with substitutes is that they use business models that can deliver many of the same services as traditional firms with the same quality – but at or below the break-even point of the incumbents.

Talent loyalty now comes at a price. The ‘hire and fire’ and ‘up or out’ modus operandi of the professions over the last 20 years and changing Gen Z and Millenials’ attitudes are resulting in a decline in talent loyalty and continue to drive up costs. Many of the leading international professional services firms have annual staff churn rates in excess of 20%. Differentiation between the leading employer brands is minimal, and even the slightest whiff of bad news can lead to a flight of the top talent.

All this adds up to intense competitive rivalry amongst incumbents, a sure sign of industry maturity. Maturity means, for a firm to grow faster than its competitors it must take share from them. And more often than not this means choosing to compete on the basis of price more than it would historically have done. In turn, this means firms become less differentiated in the eyes of clients. And increasingly clients view firms’ services as commodities. Infamously, this trend has been called the commodity magnet; it is a very slippery slope down which most firms are inexorably drawn.

The consequences for firms caught in this downward slide are stark. For the majority of firms as price falls and volume growth slows, costs continue to rise. This is especially true of the cost of retaining professional staff – that is for those firms that continue to treat their staff as a fixed cost. The resulting margin squeeze means reduced profits, whether measured as earnings per share or profit per partner. Beaton Capital’s modelling suggests, that for some professions profits measured this way will halve in less than a decade.

Confusion and denial amongst work-a-day owners of professional services firms are major consequences of these developments. While some firms’ leaders are grasping these unpleasant facts of life, the average owner and employee are not.

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Strategies to avoid decline

But decline need not be inevitable (Figure 4). There are many examples of firms from the different industries adopting renewal strategies to remain market relevant and competitive. Size can help with this, look at the re-invention of IBM, and the relentless morphing of the Big4 global audit firms, and even McKinsey now has a ‘lean-digital’ offering. Internationally and in Australia there are many examples of relatively smaller incumbents that are re-inventing themselves, but there are a greater number that are in denial.

The changes in strategy and behaviour required to cope with the new order of client power and competitors’ conduct are formidably large. To quote Peter Drucker, “In times of turbulence the biggest danger is to act with yesterday’s logic.” First, new mind-sets must replace the old. Understanding and playing successfully according to the new rules are formidable challenges. Sadly, many professional services firms will not learn to change sufficiently fast, but a few will. A mature, that is a secularly stagnant market, separates the ‘quick and the dead’ – or put in a less biblical way – the winners from the losers. The result will be some winners and many more losers.

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Figure 4 – Decline or Not

The firms that ‘win’ are those that recognise the need for transformational change, as opposed to mere incremental change or clipping away at the edges, and have the vision, the will (that is guts or risk-taking appetite), the capabilities and resilience to make the changes over many years (there’s no quick fix). Look at a firm like King & Wood Mallesons if you want an example of a professional services firm reputed to be undertaking fundamental transformational change.

By ‘winning firm’ we mean those that maintain or improve their profitability in a sustainable manner. And by ‘lose’, those that decline, usually irreversibly, into lower profitability, or consolidate in search of elusive savings, or lose of key staff and key clients. From our research across all the professions we have identified that ‘winning’ firms recognise the following success factors within the market and within their own organisations:

Behaviour – ease of doing business Generally expertise is not a point of differentiation, it is a given by clients, it’s your ticket to play. It is the behaviour of your people that will set them apart from the competition, attributes such as responsiveness, consistency, ease of doing business, and, can I trust you with my money (or cost consciousness, as we call it) have become critical in being positively differentiated.

Service – quality and consistency Clients want more. Often firms respond through pricing. But often what clients are really asking for is better service. This comes back to the behaviour of your people on the one hand and the KPIs firms set their people on the other. You have to ask yourself, are your KPIs consistent with providing the best service possible, as distinct from maximising the yield from your people?

Segmenting your business model A one-model-fits-all approach to service provision can no longer apply. Whether its marketing, BD or project delivery, client relationship management, commercial structures, risk sharing – we find the larger multi-disciplinary organisations struggle to compete with specialists who seem to be better able to mirror the needs of their clients, and so be more relevant.

Stop selling – start listening There is a lot of selling out there. For many consultants they face a commercial world of tenders and bids; with clients keeping then at arms length. However, it does come back to segmentation, knowing if a deeper commercial relationship is possible. Many clients are overwhelmed with sales calls – it eats into their day and can become a burden. In other professions we have found that many clients are keen to trade off these disturbances for an embedded relationship with one provider – you just have to ask.

Be aware how your clients are changing their business model Financial pressure and competition is impacting your client’s environment, just as it is impacting yours. You see it through price pressure and tougher buying processes. That said, we also see the more sophisticated clients open to discussing new ways of working, sharing risk and how they pay for professional services. Some of this is not new, but ask yourself this ‘when was the last time you initiated discussions with a client rather than being asked?’

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Becoming best in class

In a mature market the distribution of firms across the profit spectrum skews to the left or becomes bimodal, see Figure 5. In an expanding market the green distribution typifies the broad spread of profit distribution. But as the market matures and stagnates that distribution shifts to the left, denoted in red. That is, on the right in the red hatching are the winners in much smaller numbers making superior, sustainable profits and on the left are the larger numbers of losers. In this

representation, the green zone has reduced to the red zone as the previous levels of profitability can only be sustained by a smaller number of players. These players will be the best-in-class, and their characteristics are generally seen as follows:

The best position for the future. This type of firm is usually well recognised – they are the natural leaders in their industry, they seem to deal effortlessly with those ‘over-the-horizon’ issues and are always ready to deal with change and new opportunities. They are always one step ahead.

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Figure 5 – Redistribution of profit in a mature market

The best keep it simple. Whether it is the organisation structure, policies, strategy or execution. People know their place in the organisation and what is required of them. Performance is enhanced because of this simplicity.

The best know it’s about people. Be they clients, staff or suppliers – from reception to the boardroom – people are the fundamental ingredient in an organisation. Teamwork is revered in best-in-class firms.

The best focus on performance. Execution is second nature, excellence comes naturally, great client service leads to great clients and great outcomes.

The best know who they are. They invest time understanding themselves, how they sit in their chosen market and what that market thinks of them.

Whilst the various professions have all reached life cycle maturity, it does not mean to say that all will be losers, as the above analysis shows. There will be winners, and there will be many more losers. The future winners have already recognised the need to change and are changing.

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Author Warren Riddell, Partner, Beaton Capitalwarren.riddell@beatoncapital.com

ReferencesGeorge Beaton, Why we are reaching the Ides of Maturity for professional services firms, 22 February 2014. Melbourne: Beaton Research + Consulting

www.beatoncapital.com + Melbourne+ Sydney + Brisbane+ Hong Kong