A loyal reader, partner in an AmLaw 25, writes, under the topic "Could we be developing a ‘bubble’ in law firm PPP:"
Bruce: I’d be interested in getting your thoughts on the above question.
If you define a market "bubble," as a period when the expressed
value of an asset (stocks or housing) exceeds the true market value of that
asset, there seems to be an argument that there may be a bubble in the "share
price" of
law firms (represented by the Amlaw 100 anyway). That "share price," as
that term has been used by some law firm leaders, is the profits per equity
partner.By my rough calculation, based on Amlaw 100 data, profits for AMLAW 100
firms has increased at a cumulative annual growth rate of over 11% for the
years from 1999 to 2006. Although increased legal work may partially explain
this growth, it appears more likely that law firms have increased their profits
by pulling a few key levers: Increasing hours per lawyer, increasing leverage,
and increasing rates. In fact, during that period, PEP grew almost 9% amongst
the Amlaw 100 (the difference from gross profits to be explained in a minute).
By contrast, the Dow increased only 1.2% during this period. Whereas during
the bubble-building period of 1995 to 2000, it grew at 16% annually.As has been widely discussed in the legal press, law firms’ ability to continue
pulling those levers is largely coming to an end. Most lawyers are working
as hard as feasible. Clients are increasingly pushing back on rate increases
(I just attended a session with in-house counsel where they noted that law
firms should not expect to increase rates this year). While law firms attempt
to increase their leverage, clients are increasingly resisting having their
work done by associates. All of this means that 10% plus profit growth is not
likely to continue.This takes me back to the "share price" — PEP. Law firms continue
to feel substantial pressure to increase that share price out of fear that
if they fail to do so, they will drop in the AMLAW 100 rankings, and lose
the prestige that is associated with such rankings. (Even if law firms could
continue to attract star talent by increasing the range in compensation to
equity partners, they still perceive themselves to be limited by the average
PEP they report). Thus, to continue to increase their PEP, they are starting
to de-equitize partners, and close the door to new associates and income
partners from moving up the ranks. (The latest example being Jenner & Block). In
fact, if you look at the numbers from the AMLAW 100 from 2005 and 2006, you
see that the number of equity partners actually declined from 2005 to 2006
(by about 0.4%). In contrast, the number of equity partners actually increased
at an average annual rate of 2.7% from 1999 to 2005 (which accounts for the
difference in the increase in profits (over 11%) and the increase in PEP
(almost 9%)).As the growth in gross profits starts to decline, law firms are still able
to increase their PEP by reducing the number of equity partners, thereby
increasing the "share price" of equity partnership. But, this increase
will become increasingly unsustainable. As junior attorneys realize that
the prospect of achieving equity status is less than slim (and may be non-existent),
many of the motivational levers will no longer exist. After all, people do
not typically invest in building a business if they do not believe they will
be with that firm long term.Corporate America has recognized this issue and attempts to
reward employees with long-term incentive programs (currently options and stock
grants; in prior generations this was done through pensions). By taking away
the long-term incentive that comes with ownership, the "true" value
of a firm starts to decline, even while the "perceived" value of
a firm increases.
As we have seen from the bubbles in the stock markets and the housing markets,
when there is such a disconnect, there can be long and painful restructurings.
Unfortunately, those who suffer the most in such bubbles are those who "bought
in" at the height of the bubble — investors who bought stock in 2000,
homeowners who bought homes in 2005. Those who get out at the peak will reap
the profits.For law firms, the "new entrants" are junior partners
and senior associates who are investing substantially in the hopes of joining
the equity ranks and reaping the rewards. The older investors — those who
are running the firms and probably on law firm management committees, are
the ones who are reaping the rewards. When it becomes apparent that law firms
can no longer afford the high PEP they are reporting, it will be the younger
lawyers who will bear the burden.As with other bubbles, this is a self-reinforcing process — as the PEP
for firms increase from one year to the next, the pressure on all other firms
to increase PEP by that amount increases. Law firms that fail to keep up
their peers perceive themselves to be at risk of entering a downward spiral
— their perceived stature declines, they are no longer able to attract top
talent; absent that top talent, they are not able to keep growing revenues,
and profits decline, resulting in further declines to PEP. Thus, all market
participants have a substantial incentive to continue to increase PEP, even
if it is illusory. No firm can rationally "opt
out."The same is seen in other bubble markets. In the last
days before the sub-prime bubble burst, the competition between companies
led most banks to make business decisions (aggressively chasing deals with
lower and lower underwriting standards) that were rational only on the theory
that everyone else was doing it (otherwise known as "irrational exuberance" in
1999). When no one wants to buy the credit any more, the model fails
and all the businesses fall together. In the legal market, that process will
be slower because the transfer of ownership is slower — the "buyers" are
the associates and students coming up through the ranks. But, as the
best of those lawyers recognize the lessoned value of law firm partnership,
they will pursue alternative careers (investment banking, private equity,
government, etc.).Eventually,
the law firm talent pool declines significantly, reducing the value that
law firms provide to their clients. The crash may not be quick, and may take
years before it becomes apparent, but it may still come, and may take a very
long time (perhaps a generation) to rebuild the law firms as institutions.
There’s much here.
I’d like to break it down into three components: The near term, the long term, and the structural issues.
Near term: Without question, we’re in for a cyclical downturn in the growth of PPP, and, for some firms, an absolute decline. Double-digit increases in almost any measure in almost any business for a period of nearly a decade are bound to come to an end. Bull markets always do, hard as it seems to believe during the jolly times.
That’s not to say firms can’t take measures to mitigate the downward pressure:
- Redeploy lawyers in troubled practice areas to healthier ones;
- Use the opportunity of "shared pain" with your key clients to get closer to them;
- Adroitly stand by while the normal waves of attrition take their toll;
- Build or at least safeguard capacity in selected practice areas that you anticipate will emerge strongly from the downturn;
- And always, always, keep a sharp eye on costs–although, truth be told,
you don’t have much material flexibility here. You’re not moving your offices
to Brooklyn and you’re not paying less than market for partners and associates.
Is this, then, a real problem near term?
I think not. Your lawyers understand what’s going on in the economy and in
their practice areas. They know when things are slow, when the new matter pipeline
seems sluggish, when clients are avoiding phone calls and emails about paying.
There’s no reason to panic and, if you’re comfortable with your long-term strategy
and see no reason to change, sit tight. Indeed, I have predicted that
as we emerge from this tunnel, new requirements in structured finance and other
practice areas that have been hard hit will entail demand for more,
not less, lawyering of the new products. In other words,
this too shall pass.
Long term: Here the outlook is decidedly more mixed.
Our faithful
correspondent has several well-taken points, which I’d like to reiterate:
- On the billable hour model, revenue = (rates) x (hours) x (realization)
- Add in a dimension for profitability, namely (^leverage)
- And you realize that each of these four measures has some intrinsic ceiling or maximum on it:
- Rates: $1,000/hour? £1,000/hour?
- Hours: 2,400? 3,000?
- Realization: >100%?
- And leverage: At some point, associates (particularly Gen X/Y) will say that the eye of the needle they’re being expected to pass through is laughably small.
And yet the PPP "arms race" has no such intrinsic ceiling. $2-million/year?
$4-million? Even these amounts are modest compared to the compensation
that investment bankers, hedge fund managers, and private equity jockeys are
earning, as they rub shoulders in the same neighborhoods and sit at the same
conference tables as AmLaw 100 partners. The desperate measures firms
will go to to compete in these leagues are evidenced by resort to the Death
Star of de-equitizing partners.
Our correspondent is also quite correct to point out that no firm can (unilaterally)
opt out of this PPP arms race—at least not unless they are prepared to
risk the equivalent of a run on the talent bank, with all its suicidal implications. So
is the only "rational" outcome going to be the wholesale disillusionment and
disenfranchisement of a generation of associates, who will opt out of the entire
Ponzi scheme and leave the AmLaw 100 in droves?
As inexorable as that outcome may sound, I have a higher degree of faith in
the flexibility of firms—all firms in the economy, that is, not just
AmLaw firms—to reform their ways when threatened with the prospect of
a catastrophic collapse in the way they’re used to doing business. Which
brings us to:
Structural Issues:
All of these factors—the inherent limits of rates, hours, realization,
and leverage; truly serious pushback from clients on fees; the difficulty of
getting Gen X and Gen Y to serve as cannon fodder for the pyramid (an attitude
which is surely more rational and enlightened than that of the Baby Boom generation,
by the way)—lead me to predict that firms will find ways to change the
90-year-old Cravath Model. They will change it because they will have
to, to survive.
What might this mean? For starters, I would be delighted to predict
yet again the ultimate demise of the billable hour, knowing that I would be
in distinguished, and consistently wrong, company—but that’s a subject
for another day. My pet theory on this, by the way, is that its demise
will come when law firms find it in their own self-interest. More specifically,
when law firms discover they might actually be able to charge fees based on
"value to client" rather than "cost of production," but I can’t say I’m holding
my breath.
How else might firms change?
The bimodal associate/partner, up-or-out career path is, of course, already
showing tremendous signs of stress and a variety of experimental tinkerings
are well under way: Non-equity partners, most famously and most numerously,
but also staff and contract attorneys, job-sharing, and the first baby steps
towards career "time-outs" to provide the opportunity for such radical pursuits
as starting a family.
At least as fundamentally, I believe the core processes by which law firms
manage cases and deals must and will change. Mention "project management"
to an average lawyer and you draw a blank, yet cases and deals are, at core,
projects which must be managed. There is typically a critical path of
activities, there are assets and resources to be deployed against the tasks
to be done (each, yes, with a price), and there are more and less profitable
and efficient ways to structure the project. Even if lawyers never learn
these skills, why couldn’t firms engage practice group managers to perform
this function?
- Project management, .
- Combined with our ever more powerful knowledge management
systems, - And with all expected to briefly go back at the conclusion of a
matter for an exercise in "lessons learned,"
Will enable firms to substantially
enhance their economic performance even while weaning themselves away from
the familiar ways of doing business.
Ultimately, our correspondent describes a future of unsustainable trends where,
on the current model, the AmLaw firms hit a figurative brick wall. I
believe we’ll take decisive evasive action sooner. The demand for high-end
legal services by the Fortune 500 and the FTSE 100 is not diminishing with
globalization; it is increasing. The
ongoing re-engineering of structured finance will not yield deals with fewer
covenants, warranties, representations, and contingencies; it will yield deals
with more of all of those, and probably some new features yet to be invented. Increasing
cross-border and transnational economic activity requires lawyering of everything
from immigration visas to multi-billion dollar project finance.
Mom and pop law firms cannot serve these needs; only the AmLaw 100, the UK
50, and their like, can. The scope of the future demand is, to my mind,
utterly beyond question. Law firms with the scale and capability
to match will step up to the plate. If our correspondent’s envisioned
future plays out, there may be different players on that future roster of sophisticated
firms, but players there will be. After all, as Herbert Stein, chairman
of the Council of Economic Advisers under Nixon and Ford, said of unsustainable
trends: "They tend to stop."
Update, 6 May 2008.
A 3L at an Ivy League law school writes (emphasis supplied):
"Hi Bruce,
"As a graduating 3L, I thought I’d offer a couple observations
on your piece about PPP."My main observation is that the trend towards diminished interest in becoming
partner is growing more pronounced. In my class, I’m not
sure I know a single person who would say that their goal was to become a
partner. I
know people who want to leave Big Law for all sorts of in house, investment
banking, government, public interest, and other field. I know people
who want to work for a few years, and then leave practice to raise a family. I
am not sure I know anyone who wants to be a partner. This seems odd,
because the rewards for rising to that level have never been higher. I
suspect that this view is partly a result of the diminishing chances at making
partner. Many students view it as so unlikely
that it’s not a
goal worth aiming for."I also am not sure that this is likely to change anytime
soon. The
bread and butter of Big Law looks, at least from my vantage point, to be work
that requires considerable leverage. In a big case, or a big deal, there
is a lot of junior and mid level associate work then there is partner level
work. For
an extreme example, consider the recent Bear Sterns deal with JP Morgan. The
merger agreement itself is not very long, and surely the main points were the
subject of careful attention from the most senior lawyers representing the
parties. Meanwhile, there was an enormous amount of diligence to do,
and the number of hours involved in reviewing all that almost certainly dwarfed
the time spent on negotiation and drafting of the merger agreement."To successfully navigate this environment, which can perhaps be characterized
as a high-turnover equilibrium, firms need to nurture the development of
new partners. They further need to do so without giving the impression that
everyone, or even very many, of their new associates will make partner. This
has no doubt been a problem for many years at large law firms. My impression
is that it will be a bigger problem in the future, because turnover has become
so rapid. Managing the careers of young lawyers so that at least some
of them grow to be partner material appears to be less of a priority than it
used to be, and that is likely to hit the bottom line of firms that don’t
worry about it."I fully expect some of my classmates to ultimately become partners. The
challenge is that partnership has become so unlikely that it’s just
not the career path that anyone expects for themselves. I suspect that
the result will be good prospects abandoning the pursuit of partnership prematurely,
and some who do make it stumbling into it. (This is closely related
to the equity/non-equity partnership issue you just wrote about). Overall,
I think that current law students look at their careers in a way that tends
to narrow the pipeline of future partners – and does so beyond the
narrowing that is inherent in the “tournament” approach that
dominates. I assume that this is not to the long term benefit of law
firms."Best Regards, […]"
Can any partner in an AmLaw 100 firm read that and assume business as
usual will suffice for the foreseeable future?
"Business as usual" meaning:
The same half-hearted attempts at professional
development and associate training and mentoring, the same bizarre and archaic
bimodal career path, the blinkered pretense of being able to ignore
the fact that the partnership tournament years coincide with prime child-raising
years, and the assumption that since we lived through Parris Island it won’t
kill Gen X or Gen Y, and they’d just better get used to it.
If you believe changes are not afoot, I want to be able to live in the same
reality distortion field you inhabit.
The future will look different than the past, and one thing we know to a
certitude about the future: It will arrive. The only question is who will
be prepared for it.
