My friend Prof. William Henderson of Indiana University Law School/Bloomington has diligently worked on an analysis of the profits-per-partner of single-tier vs. two-tier law firms, which was just published in the North Carolina Law Review (Indiana Legal Studies Research Paper No. 29, North Carolina Law Review, Vol. 84, May 2006), and a summary of which is now up on law.com.
I’m personally very familiar with the piece, not only having read it in its entirety (and parts of it more than once)—you can download the entire thing from SSRN at Bill’s page—but having co-presented an earlier draft of it with Bill to the Washington, DC office of Jones Day last year.
So the purpose of this piece is two-fold: First, of course, to shamelessly promote Bill as one of the emerging leaders of "empirical legal studies" (data-based, quantitatively focused research on the entire legal industry food chain from law schools and law firms to bar associations, state regulation of the profession, etc.), and second to clarify and correct law.com’s summary of what the paper does and doesn’t show.
The key finding is that, even after correcting for the proportion of firms’ lawyers in New York City and other "global" markets (which are universally recognized, I can say without fear of serious contradiction, to generate higher profits-per-partner than all other markets), single-tier firms generate significantly higher PPP than two-tier firms. Here’s to my mind the key table:
And this is how Bill summarizes the results himself in the paper’s abstract, which I’ve taken the liberty of reproducing in full:
"During the last decade, many of the nation’s largest law firms have converted from single-tier to two-tier (or multi-tier) partnerships. A two-tier firm contains separate tracks for equity and nonequity partner. The equity tier typically controls the firm and enjoys a larger per capita share of the firm’s profits. At present, two-tier partnerships make up 80 percent of Am Law 200. The conventional explanation for the growth of the two-tier system (or, conversely, the abandonment of the single-tier) is that it produces higher profits per equity partner (PPP), thus solidifying the prestige of the firm and improving its ability to attract the best legal talent. Drawing upon a comprehensive dataset of Am Law 200 firms, this study documents that average PPP is significantly higher in single-tier firms, even after controlling for geographic market segment and firm leverage. The higher profitability of single-tier firms appears to be a function of higher levels of reputational capital, which enable single-tier firms to (a) attract and retain a more lucrative client base, and (b) run a more rigorous promotion-to-partnership tournament.
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Based upon a ten-year longitudinal sample, this study also found negligible statistical evidence that the two-tier structure, after controlling for relative starting position and geographic market, is associated with larger gains in PPP. In light of its uncertain financial benefits, the author theorizes that the two-tier structure is primarily a bonding mechanism used by less prestigious firms to institutionalize a marginal product method of partnership compensation and consolidate managerial control for the benefit of the firm’s most powerful partners. Failure to switch to the two-tier structure leaves the firm vulnerable to defections and possible collapse. As a result, the primary economic benefit of the two-tier format may be firm stability rather than higher average PPP. Finally, this study provides some evidence that the appeal of permanent nonequity partnership status, which typically entails fewer professional demands, may set in a motion an adverse selection problem at the associate recruitment level, thus undermining some of the perceived benefits of a two-tier (or multi-tier) format."
There are several things the paper does not demonstrate, nor attempt to demonstrate, perhaps the primary one of which is that being single-tier in and of itself causes higher PPP. Rather, the causality seems to run this way:
- Single-tier firms are more prestigious, or put in economese, have "higher reputational capital," than two-tier firms.
- This prestige both means that they can retain and attract high-end corporate transactional and other "money center" work.
- Which are intrinsically more lucrative and less fee-sensitive.
- Yielding higher PPP.
One of the most interesting "unintended consequences" of the switch to two-tier that Bill’s paper elucidates is the effect on the composition of the base of lawyers two-tier firms are able to recruit from, and the composition of lawyers who stay at the firms to make their careers: They are, to put it bluntly, less ambitious than those gravitating towards single-tier firms.
As unintended as this may have been for firms making the switchover to the two-tier structure, in the past decade or two, it’s blindingly foreseeable. A non-equity partner enjoys, the vast majority of people would probably agree, an enviable life: Relatively high pay and relatively high prestige for essentially the indefinite future barring malfeasance or a sudden fit of slackerhood. From the individual’s perspective, "what’s not to like?" But from the two-tier firm’s perspective, they have accomplished two things:
- Created, for all practical purposes, a permanent class of "super-salaried" associates who, by hypothesis (otherwise they’d be equity partners) are not gifted at business and client development; and
- Created an "adverse selection problem" by removing the draconian up-or-out incentive to perform at an exceptionally high level.
Finally, Bill’s paper does not remotely show that switching to two-tier was "a mistake" for firms in general or any particular firm. There are clearly cultural advantages to firms that do not unilaterally dismiss people who may be performing at a very high level but still aren’t Olympic medalists. Nor can we perform the counter-factual experiment of looking at how those firms would have done had they remained single-tier. For a variety of reasons upon which Bill elaborates, they might have done far worse than they’re doing today—even imploded.
I commend the whole thing to you.
