Last Friday I attended a presentation at Jones-Day’s Washington,
DC office, hosted in their top-floor conference room with a picture-postcard
view of the Capitol dome. (I’m not kidding about the postcard view;
CBS News has built a broadcast booth on the Jones Day roof, where they
most recently installed Dan Rather for Bush’s second inaugural, and which
they use whenever there’s Capitol-centric news.)
The presentation was by my friend Prof.
Bill Henderson of Indiana University School of Law/Bloomington,
and focused on some fascinating, and counterintuitive, empirical findings
of his about trends in the AmLaw 200 over the past decade or so. (The
law school’s dean, Lauren
Robel, was also there.) Here are some highlights:
- In the past decade, one-third of the AmLaw 200 has converted from
single-tier, up-or-out, partnership structures to two-tier structures
with so-called "non-equity" partners. - 160 of the 200 (80%) are now two-tier firms; whereas the single-tier
model had a virtual monopoly on the leading firms say, 25 years ago,
it’s now the distinct minority structure. - The universally accepted common wisdom is that firms moved to a two-tier
structure to increase profits per partner.
So how do single-tier and two-tier stack up?
- Single-tier firms are more profitable (higher PPP,
that is); - Single-tiers have lower leverage; and
- Single-tiers are more prestigious (measuring "prestige" by Vault associate
surveys).
All these results are, on a statistical basis, "highly significant"
(meaning less than a 1% probability that they result from chance). What’s
counterintuitive about this? First
of all, if the goal of converting to two-tier status was to increase
PPP, by and large it hasn’t panned out. True, you get higher leverage,
but evidently something else is going on that means that leverage does
not translate one-for-one into higher profitability. (In
a microeconomic sense, one can say that a "unit" of leverage
is more valuable in the single-tier world than in the two-tier world;
or phrased differently, that single tier firms do intrinsically higher-value
work.)
One can also say with high statistical certainty that: (a) associates
in single-tier firms bill more hours per week; and (b) when surveyed
by The American Lawyer, report that they are significantlly
less likely to stay for the next two years. In other words, single-tier
firm associates work harder and are unhappier with their jobs. Putting
aside for a moment the human cost (this is a blog, after all, about economics),
this finding invites the question of whether two-tier firms have not
introduced an "adverse selection" process into their recruiting.
The theory is simple: Associates who prefer to work a little less
and choose a larger measure of "lifestyle" over achievement, gravitate
toward two-tier firms. Not only will the demands on them as associates
be (relatively speaking, anyway) milder than in single-tier firms, but
a material proportion of them will ascend to non-equity partner status,
earning perhaps $300,000/year or more with no meaningful client-development
or business-generating responsibilities. This is an utterly rational
choice for the individual—but it does saddle the two-tier firm
with some highly paid people who, by hypothesis, are not bringing in
business.
On the other hand, for me the primary take-away from Bill’s presentation
is that, while single-tier firms remain a homogeneous category, two-tier
firms are extremely heterogeneous, and generalizations across the universe
of AmLaw 200 two-tier firms are best taken with a large dose of skepticism. (At
the conference, I likened it to averaging Toyota and Porsche and claiming
your result equated to a real-world car company—of course it does
no such thing.) In other words, the real empirical work on two-tier
firm-land remains to be done.
Update (14 Nov 2005, 11:15 am): Ron Fleury, editor-in-chief
of The New Jersey Law Journal, kindly sought permission to
reproduce this post in today’s
issue, which I of course granted.
I wonder if Prof. Henderson is looking at the right question.
The real question is whether at any given firm, PPE would have been greater or lesser if that firm switched from a one-tier to a two-tier firm. Clearly,some firms have been more profitable than other firms and that is a historical fact and it is possible (even likely) that less profitable firms are more likely to switch to a two-tier system to increase profits (and in fact increase PPE) but still have significantly lower PPE than the single tier firms. Now, a study of the theoretical PPE that a firm would have had without a switch is probably impossible; but it may be possible to do two studies: one, for any given year, what is the rate of PPE growth of the two tier firms vs. the one tier firms, and second for any given firm that switched, what was the average rate of PPE growth before the switch and after? The first study will compare different firms at the same time period (which should take out the effect of the general economy) but comparing different firms has its own issues. The second study would be affected by general and specific economic conditions that were independent of the switch, but it might be telling especially if there was a slowing in the rate of growth before the switch.
Second, I am not sure I agree with the premise of the study which is that firms make the switch to increase PPE. A – some firms may do it not to increase PPE, but maintain PPE (or maintain a rate of PPE growth). B – some firms may do it precisely for the ability to offer longer term “tenure” positions to lawyers at the peak of their usefulness to the firm. Especially if a firm is in a period of rapid growth, it may need a group of mid-level management types who can supervise and train associates. Leverage is a two way street. Firms that are interested in quality control need to have people with experience and expertise to supervise associates. That’s why I think a two tier system extends leverage.
Interestedreader (IR) makes some interesting points, some of which are dealt with the actual paper. A couple of comments.
First, IR makes a valid point that we don’t know what the counterfactual is: What would have happened if a firm did NOT switch to two-tier? Maybe things would be even worse. Yes, I agree. In the paper I suggest that one of the true benefits to switching is that rainmakers, whose power is now consolidated in the equity tier, won’t leave the firm. So the firm is less at risk to implode. Between average PPP and implosion, most of use would pick the former. So switching to the two-tier can involve factors besides higher PPP.
But comments from managing partners and consultants in the legal press clearly suggest that there is an expectation that switching to the Two-tier will produce higher PPP, and that turns out not to be the case–probably, as Bruce suggests, because the switch can be done well or done poorly and the effects cancel each other out in the regression model.
Second, two-tier firms DO have higher rates of PPP growth, but they also have LESS absolute PPP growth. (Remember that PPP are not randomly distributed among firms of different tier structure; single-tier firms generally have MUCH higher PPP.) A two-tier jumping from $400K to $800K PPP is a 100 percent increase, while a single tier jumping from $1M to $1.6M is a 60% jump. Obviously, I’ll take the $600K increase over the $400K increase. The percentage growth is little consolation.
The regression model looking at growth control for (a) % of lawyers in NYC, (b) increase in lawyers in NYC, and (c) 1993 profitability (i.e., starting position). Holding these factors constant (i.e., an “apples to apples” comparison), switching to tier structure is NOT associated with greater PPP. But that does not condemn the two-tier structure. As noted above, many switches may be poorly implementation. Also, many firms might have imploded without the switch.
So, on balance, I agree with IR’s intuitions. But I think the paper works through the issues he raises.
Dear Damien Geradin:
I appreciate your taking the time and effort to comment, and I’ve approved
your comment in full; it appears verbatim on the blog now.
More importantly, I wanted to reply by letting you know that, while money is
*not* my only bottom-line, it is, I believe, the most interesting topic for
the vast majority of readers of “Adam Smith, Esq.,” and, furthermore, an
ineluctable reality in today’s world. No single law firm has the option of
“opting out” of the bottom-line driven system, which rules the market for
lateral partners, practice groups, client mobility, and so forth. We may
rue the reality, but it is the reality. On “Adam Smith, Esq.” I try to
reflect that.
For other views about life and values in law firms, I would commend you to
other blogs; that is one of the blogosphere’s primary virtues (an enormous
diversity of voices). My blog represents one view, and I intend to stick to
it.
Again, many many thanks for commenting; I appreciate your time and agree,
essentially, with your point about two-tier’s enabling a firm to retain
senior associates. The point I’m making is simply that that decision,
valuable as it may be in itself, entails consequences.
Cheers and best regards,
:Bruce