Bubbles

This is about the Cadwalader layoffs.

But I won’t be piling on. I really won’t.

Instead, I’d rather examine how the firm got to this unhappy pass and what managerial lessons it might hold in store for us. To understand what brought it to cutting fully 20% of its lawyer headcount vs. late 2007, we have to begin, not at the beginning, but at what the firm has just done. Here are the highlights key decisions:

In a statement Wednesday the firm said: "From 2003-2007, when [commercial mortgage-backed securities] issuance tripled, the firm grew rapidly to meet client needs. With CMBS issuance now at a small fraction of previous levels, we are making these personnel adjustments in response to this change in demand. In September 2008, the firm will have 580 lawyers, the same number we were in January 2006."

At the end of 2007, the firm had around 720 lawyers.

Adding to Cadwalader’s woes are that Bear Stearns (RIP) and Lehman Brothers, now under siege, were key clients. One unnamed "chairman of another leading New York firm" said that he was not only "stunned" by the scale of Cadwalader’s layoffs but added that this economic downturn feels "fundamentally" different than the post-9/11 and post-dot-com falloffs.

"Those were lulls in activity," he said. "This is a fundamental change. A whole segment of capital markets has disappeared and we’re not sure when it will come back, in what form or if it will ever come back."

The real challenge to Cadwalader may yet lie ahead. Reportedly, all of the 96 lawyers let go this week (and the 35 let go earlier in the year) were associates or "of counsel." The question this immediately poses is: And not a single partner? Not one? It’s possible, of course, that some partners have been "spoken to," and since Cadwalader is not responding to requests for comment, we don’t really know.

Yet I promised this would not be about this week and more about how a firm could get into this fix. For that we have to go back to a strikingly revealing interview a year and a half ago profiling Bob Link, then Chairman. The first insight into Link (the article starts in the context of "bowling night out" at Cadwalader) is "’Don’t let him fool you,’ someone says as Link, 52, takes down another frame. ‘He’s the most competitive person you’ll ever meet.’" Profits per partner were on a tear, at more than $2.5-million in 2005 and $2.9-million 2006. Link had set out to make the firm almost obsessive about profitability. This from the February 2007 profile:

The oldest law firm in America and once one of the most genteel, Cadwalader under Link went through a wrenching and controversial 1990s turnaround during which it transformed itself into perhaps the nation’s most aggressively profit-focused law firm. Today’s Cadwalader, at which big producers are lavishly rewarded and underperformers are shown the door, presents a stark alternative to the more conservative ways of New York’s traditional top-tier firms.

"They are definitely the firm to watch," said the managing partner of one leading New York firm recently overtaken by Cadwalader in the profit charts. "Even though they recognize the business realities, most law firms still hold on to certain ways of doing things. Cadwalader is run like a corporation."

But whether a law firm should be run that way is a question Cadwalader is far from definitively answering. The departure last week of antitrust chief Steven Sunshine, lured to the firm just two years before from Shearman & Sterling and now heading to Skadden, Arps, Slate, Meagher & Flom, underscores persistent criticisms that the firm, while able to attract star laterals with high pay, is unable to build sustainable practices around them.

And Cadwalader’s approach has won it a reputation for ruthlessness that suits some but turns off others.

"It’s exactly the shark tank that everybody says it is," said former partner Robert Vitale, "If you’re a shark, it’s great."

Now, of course, Link is no longer Chairman, but the seeds of this week’s news were well and firmly planted at least a few years ago. In February 2007, he readily proclaimed the firm’s success in concentrating on structured finance:

"Are we going to have difficulty sustaining this?" he asked. "No, short of some cataclysmic event that hits everyone else too."

This puts me in mind of nothing so much as the infamous quote by Chuck Prince, late of Citibank:

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” (he said in an interview with the FT in July 2007).

Unfortunately, Chuck Prince didn’t foresee just how "complicated" things could be. Including forfeiting his job in short order. (Link, as noted, is no longer head of Cadwalader, either.)

Other elements of Cadwalader’s pursuit of profits included:

• Very high leverage. Roughly the same size as Davis Polk in total lawyer headcount, Cadwalader had only half as many partners. Link’s observation on this: "Why would I have any more partners than I need?"
• The abrupt closing of the firm’s 15-lawyer Palm Beach office led to a lawsuit by a former partner (who was awarded $2.4-million) and led to these remarks by the judge overseeing the case: "Such activity cannot be said to be honorable," Palm Beach County Circuit Judge Jack Cook wrote in his 1996 decision. "While life in the marketplace may well be made up of fear, greed and money … life in a partnership is not so composed."
• Partners with less than $5-million in business were "eased out."

But the question of deepest interest is whether Cadwalader had embarked on a new business model that we all should attend to, and which was unfortunately waylaid by the vagaries of the financial services industry’s cyclicality, or whether the model was fundamentally flawed. Eighteen months ago the former partner, Vitale, posed the question thus:

But the difference between Cadwalader and other firms he has been with is still striking to Vitale. Though he said there was no question that Cadwalader had achieved tremendous financial success, he said the firm still seemed to be trying out a "new model."

"It’ll be interesting to see whether they’ve really built something that lasts," he said, "or if it’s Finley Kumble in richer clothing."

Getting closer to the point, Link staunchly defended the firm’s concentrating its practice on asset-backed and structured finance, and Vitale underscored the difficulty the firm had in accommodating to the investments required to build practices that would diversify its exposure to the markets.

First, Link:

The engine of the firm is its asset-backed structured finance practice. Link made his name in the area and still serves as the firm’s practice leader. It is a specialized area …

It is not generally regarded as a premium practice area like M&A or high-yield bond offerings, and some have questioned how Cadwalader could have achieved such impressive results from that foundation. For the most part, the other major firms in the area are not Sullivan & Cromwell or Simpson Thacher but non-New York firms like Sidley Austin or Orrick, Herrington & Sutcliffe.

The head of another New York law firm described securitization as a high-volume "commodity" practice, an area top firms avoided because of their inability to command premium rates in it.

"Somehow they’ve managed to make a success of it," he said of Cadwalader.

[…]

According to Link, the firm only wants to be in those areas where it can achieve a similar level of profitability, primarily those revolving around financial institutions. This discipline also explains why the firm has avoided most overseas expansion apart from London and a small office in China. In the United States, Cadwalader also only has offices in Washington, D.C., and banking center Charlotte, N.C., aside from New York.

"All other offices are dilutive," said Link.

And, Vitale:

Cadwalader’s tight focus can clash with its attempts to expand into new practice areas. Vitale said it was frustrating trying to push the firm in a direction that required investment but guaranteed no immediate return. The firm did not yield.

"The firm decided that what it needed to do to expand its project finance practice, it wasn’t willing to do," said Vitale.

In his case, he said, what the firm needed to do was swallow the pill and open some overseas offices, particularly in Latin America. The firm’s unwillingness to do so meant its project finance group had a hard time competing for business with more global firms. Cadwalader could be a lonely place for those outside the humming core practices, he recalled.

And there you have the stark contrast: Link stands for reinvesting and doubling down in highly profitable areas–given the extant market conditions–while Vitale stands for the school of thought that investing in different practice areas could yield dividends down the road.

Today the choice facing Cadwalader is far more stark than the quasi-intellectual debate between Link and Vitale 18 months ago would have you imagine.

But consider this ineluctable responsibility of management: The task of management is to choose. The task of management is to decide. And the task of management is to do so with an eye towards likely future scenarios. Expecting a bubble to continue growing linearly to the sky is a mug’s game. "Everyone thought it would grow to the sky," you retort? Goldman Sachs didn’t; the vast majority of the AmLaw 200 didn’t, and (we learn through recently released emails), even S&P, one of the great enablers of the bubble through their promiscuous granting of investment-grade ratings to toxic CDO’s, knew it was a mug’s game: "We can’t rate this thing, it’s a joke." "Don’t you know we rate everything? We’d rate this thing if it were put together by cows."

Is it possible Cadwalader’s management was thoroughly in the dark about the nature of the structured finance bubble? Were they in touch with their clients? Did they read the WSJ? Did they think strategically beyond what it would take to create a strong and sustainable law firm for the future, other than showing up for work every morning and answering the phone?

In a way, you can compare the Link/Vitale schools of thought to the grasshopper/ant fable that you recall: The ant spent the six months of summer storing up provisions for the winter while the grasshopper lived off the seemingly endless fat of the land. And we know what happens when autumn arrives.

This brings us to Cadwalader today. While it’s scurrying to develop new practices, such as private equity, one has to wonder if its cultural DNA is capable of the long-term investments needed.

In the last year, the firm has established a private equity practice led by former Latham & Watkins star R. Ronald Hopkinson, as well as an intellectual property litigation practice comprising several former Morgan & Finnegan partners. The firm also substantially boosted its bankruptcy practice with the recruitment of four partners from Weil, Gotshal & Manges.

But it is unusual for new practices and partners to immediately boost a firm’s bottom line, and some question whether Cadwalader acted wisely in investing heavily in private equity, another practice severely impacted by the tightened credit environment.

"You can’t just buy some PE guys and present yourself as an alternative to Simpson Thacher to [Kohlberg Kravis Roberts & Co.]," said the [unnamed] firm chairman.

The question, of course, is whether the firm’s reputation in the recruiting market will suffer long-term damage from laying off 20% of its lawyers (albeit, as noted, no partners). But the other question is whether those partners reflecting the figurative grasshopper mentality are willing to stick around through what could be, relatively speaking, winter.