Would You Take This Law Firm Off My Hands?

This morning brought the release of Hildebrandt’s quarterly “Peer Monitor” index for 3Q2011, showing a drop of 6 points to 56 (anything below 65 is deemed a negative operating environment).    In a nutshell, the problem was that demand growth was “lethargic” while expense growth accelerated strongly, and net realized collections hit 85.4%, a very weak showing indeed.   To unpack that a bit:  Stated rates were up 3.5%, which is certainly deilghtful in a world of ~2% inflation, but “realized rates” continued their three-year downward trend and reached an all-time low.  Collections on those rates (the 85.4% figure, which is cash in the door and all that really matters) was also at an all-time low. 

It’s safe to say this is not the hallmark of an industry whose clients think they’re getting terrific value for money.

On the other hand:  The front  page of the NYT‘s business section featured Selling Pieces of Law Firms to Investors, which would give you reason to believe we’re the latest growth industry and investors are hankering to own a piece of us.  If you haven’t heard about this coming to our shores, or thought it was limited to those wacky Commonwealth countries under Her Majesty, the picturesque, remote, and fundamentally irrelevant Australia and the royal and ancient but equally quaint UK, guess what:

An ethics commission of the American Bar Association is expected to circulate by early November a draft proposal recommending that ethics rules be amended to allow other professional service providers — like accountants, economists and social workers — to partner with lawyers and own up to 25 percent of a law firm.

Let’s quickly rehearse the pros and the cons and then I’ll tell you what we are not hearing in this debate.

Con:  “Nonlawyers might not have the same code of ethics; they  might not be bound by the same sense of professional responsibility,” said Andrew Perlman, legal ethics professor at Suffolk University Law School.  (Is the general public laughing at us yet?)

Con:  Lawyer-client privilege could be compromised as shareholders pressed to learn details about clients and matters.

Con:  “Big firms may have cultural obstacles as well: lawyers are trained to avoid risk, and partners are unwilling to cede control or equity to outsiders.”  This was sniffily confirmed by Chris Perrin, general counsel of Clifford Chance:  “It’s a nonstarter for us,” adding that the debt markets were completely available to his firm but “smaller or midsized firms may not be able to so readily borrow.”

But Ralph Baxter (disclosure: a friend) evidently thinks it will happen:  Accepting capital to invest in technology, streamline processes, and so forth, will increase the market value of the firm, so why wouldn’t outside investors want in?  “They can sell their investment because it’s worth more,” he put it pithily.

Also pro:  If you think outside shareholders would bring undue pressure for profitability,

such thinking derives from the naïve assumption that the lawyers “who currently own law firms are not motivated by profit,” said Ken Fowlie, the executive director of Slater & Gordon, an Australian law firm that was the first in the world to become a publicly traded company.   If anything, going public has increased transparency, Mr. Fowlie said, and has separated the ownership from the lawyers, giving the lawyers more distance from business side pressures than in traditional partnerships.

As a securities lawyer by training, I can’t help but think that more disclosure is prima facie good.  And what’s “material” for shareholders to know certainly does not include specifics of any single matter or even generalities about the matters of any single client; that’s a transparent red herring.

No, the “con” that has sticking power, to me, are the twin stars orbiting each other of risk-aversion and control.

But here’s what we’re not hearing:  That law firms are a diseased business that outsiders would be fools to invest in.

What prompts that heresy?

Back to the fine print of the PeerMonitor report.  Consider that strong evidence of segmentation in the industry is continuing to emerge.  Demand growth for AmLaw 100 firms was +0.6%, for second hundred firms +1.9%, and for midsize firms -1.1%.  And: 

However, in discussing rates, the PMI averages do not tell the whole
story. Rate performance continues to vary widely. Many firms are
achieving better?than?average rate growth this year, while other firms
are not faring as well in the face of client pressures, and are seeing flat
or even slightly negative rate growth.

The wheat is beginning to separate from the chaff.  Indeed, a sidebar reports that managing partners report vastly different experiences of how 2011 is going, ranging from “great–the best year in the last several” to “we’re somehow not generating much traction in the marketplace.”  Do tell.  And this is occurring in that most perilous of environments for the halt, the one-eyed, and the lame:  An industry with slack demand which some time ago (2007?) entered into an extended period of a battle for market share.

The emerging winners are distinguishing themselves by behaving like businesses (I hate to say, like public companies, but feel free to read that into it at home).  They are:

• Investing partner time in firm-building activities;
• Actually having, and executing, strategic plans;
• Treating client relationship management as if it mattered;
• Coming up with novel, and sustainable, ways to generate genuine value for their clients;
• Altering compensation models to align with the long-term vision and client service delivery; and
• Being unafraid to re-examine core assumptions including conventional career paths, billing practices, and business development customs, practices, and techniques.

I have taken the liberty of graffiti’ing the PeerMonitor index with my own editorial comment in the form of two diverging red arrows.

Get your firm on the correct arrow.

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Jerry Kowalski writes:

Another typically brilliant piece.

I also  don’t see that the ABS/Tesco model works or even makes any sense for large commercial law firms in the United States.  But, non lawyer investment in the delivery of some legal services has the potential for bringing on the next revolution in the profession, with ripple effects in every direction. For more, see this earlier comment of mine.   

Jerry

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Another commenter, from a consulting engineering firm, writes (15 November 2011):

“I’d make the observation that another profession –
consulting engineers – have been publicly traded for a number of years. And
there are still other consulting engineering firms who have remained privately
held – some with wide employee share ownership and others tightly held as
partnerships (although usually smaller firms).

 

I can discern no relationship between ownership
structure and management competence, profitability or growth.

 

I suspect that the firms that have competent
management will flourish whatever structure they choose, so long as that choice
is competently made and is supportive of their strategy.”

So there you have yet another perspective; maybe it doesn’t really matter!  Wouldn’t that save us all a lot of ink, and breath?