Just as I was thinking it was about time to publish a column on the topic
of "leverage" at law firms (roughly speaking, the associate to partner ratio,
although there’s more than one way to calculate something that people will
call "leverage"), here comes a slew of pieces on the topic, including:
- Prof.
Larry Ribstein on "the over-leveraging and over-regulation of the
legal profession:"In the longer run, we now see very clearly that running law firms as thinly
capitalized worker cooperatives is not an equilibrium solution in this
market.The answer, as I’ve said many times before, is dropping regulatory
restrictions on law firm structure and letting them be run like real businesses.
This particularly includes permitting non-lawyer capitalization and perhaps
even public ownership, as well as enabling firms to hold onto their intellectual
property through non-competition agreements. - A piece in,
of all places, The Atlantic‘s blog called "There’s leverage everywhere!"
with this pregnant introduction to our system:But let’s work the argument a little further. It surely is
true that unlike their current incarnations, the old Wall Street partnerships
did not destroy the world with excessive leverage. But in the pre-credit-boom
era, no one else was incurring much leverage either. It might be worth
considering whether there are entities that are structurally similar to
the old Wall Street firms (i.e., partnerships in which a substantial portion
of the partners’ net worth was tied up in their employer, and could not
easily be removed from same) and see whether they have taken on significant
leverage in the modern age of easy credit.As it turns out, there are such entities. We call them "big
law firms." And their example is instructive.and
- More than one of these new pieces has referenced something that ours truly wrote
about "Leverage: Friend or Foe? (Or Noncombatant?)"
back in December 2005, where I said:Common sense would tell you that in a labor-intensive service industry, where
[…] Then there’s the evil twin of high leverage: Low utilization.
revenue is driven primarily by sheer tonnage of hours worked, the higher the
ratio of associates (and non-equity partners) to (full equity) partners, the
higher the revenues and thus the profits per partner. Right? It turns out
this is one of those cases where it’s not as simple as it seems.
It doesn’t help that your leverage ratio is through the roof if nobody’s busy;
indeed, welcome to the worst of both worlds.
What has changed?
For starters, the whole world is now aware of the perils of leverage. Let
me throw a few charts into the discussion for starters. By and large,
I would like to believe, they speak for themselves.
Finally, here’s one that leaves you wondering whether to laugh
or cry—and it’s seriously out of date at this point.
It’s a chart showing the large global banks’ market capitalization
as of the 2nd quarter of 2007 (large blue-grey circles) and then as of October
20, 2008 (small green circles).
In order, left to right and top row to bottom, they are: Morgan
Stanley, RBS, Deutsche Bank, Credit Agricole, Societe Generale, Barclays, Unicredit,
UBS, Credit Suisse, Goldman Sachs, BNP Paribas, Santander, Citigroup, JP Morgan,
and HSBC:
Update (8 March 2009): A very helpful reader, who chooses
anonymity, pointed out within hours of my publishing this that the chart above
is seriously misleading. Why? Because the circles, being two-dimensional,
invite us to visually compare their areas rather than their diameters—and
the latter is what the chart-drawer actually chose to represent.
Take Citigroup: Its market cap went from $255B to $82B in the period
in question. Now that you look at it closely, you can see that’s how
the chart was drawn. But were the circles drawn to scale appropriately
in terms of their area, it’s clear that it would take only 3.11 of
the small green circles to fill the large blue circle (since 255/82 = 3.11). Your
eyes tell you in a flash that the green circle as drawn is far too small, in fact. (Full
explanation here.)
While I apologize for this mental and visual hiccup, all I can offer in defense
is that I’m not the only one:
Pretty scary, eh? It’s a chart showing the deterioration of major bank market
caps since 2007. Prepared by someone at JP Morgan based on data from Bloomberg,
this chart flashed across Wall Street and the financial world a few days ago,
filling thousands of e-mail in boxes. Putting a face on the current banking
crisis it really brought home to many people on Wall Street the critical position
the financial industry finds itself in.Too bad the chart is wrong.
[…] So it’s a typo: no big deal, right? Yeah, but what a typo! It got
past Bloomberg and JP Morgan and pretty much all of Wall Street before someone
said, “Hey, this makes no sense!”
Here’s a proper chart. While the players are somewhat different, that’s
more than made up for by the fact that it’s far more current: Comparing
the market cap as of March 30, 2007, with the market cap as of February 20,
2009—barely two weeks ago:
Still not great performance, to be sure, but if there are degrees of horrendous-ness,
this is at least less so. Plus truthfully representative.
Thank you, Dear Reader. Thus concludes the update.
While there are many reasons for these breathtaking declines,
surely a proximate cause was the sky-high assets to equity ratios of many of
these institutions. 20 to 1, 35 to 1, and even 50 to 1 were not unheard
of in the palmy days. Suffice to say that business model is, as I heard
someone remark recently here in New York, "so last August."
So other parts of
the economy (shockingly large parts!) may have gone crazy. What
does this have to do with us, necessarily?
If there are analogies to be drawn across professional service
sectors, leverage is out for the investment banks and leverage is out for us
as well. For the I-banks, as noted, it was (in retrospect and even, to
some more astute observers at the time) outrageous ratios of assets to equity,
and for us it may be the high ratio of lawyer leverage.
I said at the outset that there are different definitions of
"leverage" in our world, and I want to take some time and spend a little bit
of effort breaking them out, because I believe the subtle differences matter.
Courtesy of The American Lawyer, here are the
top 25 most leveraged firms from the AmLaw 100 and the bottom 25 least leveraged
firms.
Top:
And bottom:
These figures are calculated by dividing the total number
of lawyers at the firm (full time equivalent) by the number of equity
partners. For example, using firm #100 here, Faegre & Benson has
424 total lawyers and 255 equity partners, so 424/255 = 1.89.
Again, we can debate whether this is the ideal measure of leverage or not; my own preference is to divide all lawyers who are not equity partners by equity partners, but the results would be directionally similar. (Using Faegre & Benson as an example, again, the number of “lawyers who are not equity partners” would be 424-255 = 169, and dividing that by the number of equity partners yields 169/255 = 0.66.)
Why does leverage matter? For starters, as I noted in my 2005 column I quoted at the outset, leverage is your best friend in good times and your worst enemy in bad times. While we’ve heard the drumbeat of client complaints about paying for useless junior associates for years, this is suddenly the kind of environment where it will grow sharp teeth and bite hard. Either: (a) massive litigations will not be pursued because they’re too complicated, uncertain, protracted, and expensive; and/or (b) if they must be pursued, contract attorneys, staff attorneys, and outsourcers will provide the human throw-weight needed for massive document review; and/or (c) corporations will simply insist that document review be completed for flat fees of $X/unit [$1.00/page? $0.50/page?]. In any event, no one I talk to–absolutely no one–believes that the litigation “factory” model with one partner overseeing half a dozen or more associates who are billing ’til the cows come home will be a predominant source of revenue going forward.
All well and good, but I think a more interesting calculation
compares the ratio of non-equity partners to equity partners. The
charts and calculations that follow are premised on The American Lawyer‘s
conventions, which denote someone an equity partner if they receive a K-1 and
a non-equity partner if more than half of their income is guaranteed. This
is not the place to debate that methodology; the point for present purposes
is that all firms are hewing to the same metric. While the raw data is courtesy of The American Lawyer, the calculations and the sorting are my own.
Here are the firms where the non-equity to equity partner ratio
is greater than 1.00:
And here are the firms where that ratio is less than 0.25:
Note that I’ve drawn lines segregating the 11 firms with a non-equity
to equity ratio between 0.00 and 0.25, simply because—depending on what
may be special circumstances unique to each firm—arguments could probably
be made that they don’t "really" have non-equity partners as they see it; they
just have to report this way based on The American Lawyer definitions. Also
note that I alphabetized the listing, by firm name, of all those reporting
0.00 ratios.
Why does this matter? Aren’t all the firms reporting layoffs
reporting exclusively layoffs of associates and staff, not partners.
Yes, but those reports reflect actions taken to date, and I want
to essay a little vision into what we may be seeing in the future, and to set
the stage I think the two charts above are most informative.
First, why have no firms announced partner layoffs? Isn’t
this the worst kind of cronyism, safeguarding one’s peers, taking it all out
on the "little people," and demonstrating lousy business judgment to boot,
when the cost savings realized by offing (say) 10 associates could probably
be realized by tossing a single partner overboard. (Such, to paraphrase,
is how it has recently been expressed to me, in tones ranging from outrage
to derision to glum resignation.)
The issue, as so often is the case, is more complex than that.
Simply put, it takes time to get rid of partners. They
are not employees at will, as associates and staff. They must be cajoled,
"spoken to," almost certainly offered incentives to walk gently towards the
door. Note, importantly, that this is almost universally true of non-equity
as well as equity partners. (Off the top of my head, essentially every
partnership agreement I’ve seen that addresses the issue at all treats non-equity
and equity partners alike on the topic of termination—that is to say,
it’s hard to accomplish without cause.)
And there’s more. More and more non-equity partners, that
is. This chart shows the percentage of all lawyers at AmLaw firms who
are not equity partners, from 2000 through 2006. The big red
bars are of course associates, ranging from 82% of the total in 2000 to 75%
in 2006. The light grey slices are "income" partners, growing from
9% to 13%, and the darker grey slice at the very top, growing from 9% to 12%,
are "other non-equity lawyer" (don’t ask me about the terminology; I’m just
the reporter here). The chart is courtesy of last year’s Citibank/Hildebrandt Client Advisory.
Now—bear with me—one more data point.
Here’s the "productivity," measured by annual hours billed, of
(a) equity partners; (b) income partners; (c) associates; and (d) other non-equity
lawyers, at "higher profit" and at "lower profit" firms:
What it shows with conspicuous graphic clarity is that income
partners and other non-equity lawyers are systematically the least productive
lawyers in these firms. Associates work the hardest, but equity partners
work almost as hard. (At higher profit firms, the associates record a
negligible 2.5% more hours than equity partners.)
From both a human and an economic perspective, this is all perfectly
logical. Non-equity lawyers don’t have to beat their brains out. So
they don’t. Their deal—again, a perfectly rational one, to them—is
that, premised on good behavior, they have a job essentially for life at, say,
$350,000 to $450,000/year, adjusted for inflation. If you think that’s
not an attractive deal, I suggest you immediately take the elevator down to
the street and ask the first ten people you encounter if they’d like such a
job.
What else do we know about non-equity lawyers?
They are the most expensive form of leverage. They
make more than associates, to state the obvious, and have also "maxed out"
on any variable benefits one needs a certain period of tenure to earn, such
as 401(k) matches, etc.
This, frankly, is the least of it. The real issue is cultural.
Go back and take a look at the firms with non-equity to equity partner ratios < 0.25. Better yet, focus on those where the non-equity tier is either nonexistent (0.00) or de minimis and probably only an artifact of The American Lawyer‘s reporting system.
What do they have in common?
Indeed: An unusually high combination of cultural cohesion and readily articulable strategy. Just a sampling proves the point:
- Cleary, Cravath, Davis Polk, Debevoise, Paul Weiss, Simpson Thacher, Skadden, Sullivan & Cromwell, Wachtell.
Like them or not, you can say of each of those firms that they stand for something, and that achieving partnership there is dependent on several dimensions beyond that of being a mighty rainmaker.
Vs. those with the non-equity to equity ratio > 1.00: Without (re-)naming names, it must be said of that group that their strategies are extremely diverse and, in some cases, as yet unproven. Additionally, many of the firms in that group have high proportions of relatively new lateral partners.
But back to culture. I submit that firms with high proportions of non-equity partners have changed their culture. They may not have intended to, they may not have foreseen it, but change it they have.
Thirty or twenty years ago and even pretty much today, at least in New York-based firms, the reality is truly up or out. This attracts a certain cohort of hard core Type A people who (as I felt at that time) have never been anywhere other than at the top of their classes and who don’t intend to be anywhere else now. As a managing partner said to me last week, "We’ve all heard the statistics that only one in 25–or whatever–starting associates at Cravath will make partner. But you know what? All the Cravath on-campus interviews are hugely oversubscribed! Everybody thinks they’re going to be the one in the 25."
He has a point.
So how does the introduction, and more importantly the perpetuation, of a material cohort of non-equity partners change the culture of a firm?
Let me editorialize about a few consequences:
- The culture shifts from "excellence or else" to "good enough."
- I don’t think that "good enough" is sustainable in this environment.
- In the palmy days of 2001–2007, having a flexibly extensible non-equity tier served as a crutch for firms that wanted to avoid making difficult decisions about people or having awkward conversations with them.
- I don’t think that those difficult decisions and awkward conversations can be postponed in this environment.
- One of the reasons we’re seeing widespread associate layoffs–apart from the pure economic imperative to cut costs in order to match revenues to capacity–has to do with morale. It’s dreadful to morale to walk the halls seeing a bunch of your colleagues with too little to do, who are then guiltily sneaking out at 5:30.
- The non-equity tier, with nothing to aspire to and perhaps (psychological speculation on my part, which I am shockingly unqualified to offer) feeling themselves ever so slightly "damaged goods" only exacerbate this.
- None of us, none of our firms, have room for morale-busting zombies in this environment.
- The ranks of the non-equities grew not by design but by happenstance and, frankly, inattentiveness. While it may be true, as Oliver Wendell Holmes famously remarked, that "the life of the law has not been logic, it has been experience," it’s time to apply some analytic logic, some serious and rigorous strategic evaluation, to the weed on steroids that has been the growth of the non-equity tier in too many firms over the past palmy period.
- And no, we cannot afford to do otherwise in this environment.
We read, finally, that firms are drastically cutting back their summer programs and dialing back first-year offers, postponing start dates, offering semi-paid sabbaticals, and so forth. All well and good and relatively innovative examples of rising to this dismal occasion.
The pipeline of new talent must be kept as full as anticipated demand warrants. Law firms live and die on their talent, and they cannot short-change their investment in it based on next quarter’s or next year’s depressing projections, although they can certainly try to size it to better approximate the new reality.
But the talent that may not be carrying its weight, that needs profound re-examination, is that of the non-equity tier.
If you were starting your law firm today, would it look as it does in terms of non-equity partners?
Better yet, or more realistically yet, perform Andy Grove’s famous thought (and reality) experiment when Intel was a low-end maker of commodity DRAM chips, having their lunch eaten in the late 1970’s by the voracious and talented Japanese, threatening Intel’s very existence.
I paraphrase: Grove said to his top management team, "If we don’t turn things around in a very serious way, the Board will fire us. So why don’t we ‘fire’ ourselves. Let’s march out of this conference room and march back in assuming we’re the new team the Board has hired. What would we do then?"
They performed the exercise, decided to abandon DRAM’s and invest in microprocessors. The rest is history, and it’s history residing under your desk or in your lap.
I’m suggesting you perform a "Grove Intervention" on your firm. And if you’ve read this far, you know where I think you might start.
