A few years back, as exceptionally studious and faithful readers might conceivably recall, I wrote two pieces on the lateral hiring frenzy, Our Arms’ Race and Our Arms’Race (2),  which took an almost across-the-board stand against lateral partner hiring.  I followed that up about a year later with Delusions of Crowds, whose title alone should provide you with a solid basis for guessing its perspective.

Today we offer a very different point of view.

Richard Rapp, a friend and former colleague at Adam Smith, Esq., was generous enough to provide the following analytic essay on the economics underlying the pace and persistence of lateral hiring.  Richard earned his BA in economics from Brooklyn College and an MA and PhD in economic history from the University of Pennsylvania. He consults and writes about law firm partner compensation at his firm, Veltro Advisors, Inc.

Take it away, Richard:

Why is lateral hiring proceeding at a frenetic pace even though legal employment is far below its 2007 peak?  According to The American Lawyer, “Among Am Law 200 firms, the lateral partner market was so overheated that 92.5 percent of respondent to [their] new partner survey released in November said that legal recruiters already had approached them.”[1]  Is lateral hiring at this pace a destabilizing force in the law industry or a sensible, productive feature of the legal labor market?  And is it transitory or will it last?  To know the answers requires stepping back to understand the economics of the market for lawyers.  We can address this in two parts: first, managerial motives for lateral hiring which are easy to understand and, second—and harder to grasp—the market forces that propel lateral mobility, the likes of which we do not find in most other markets for senior talent.

As it turns out, the best way to think about lateral hiring among law firms is as a kind of arbitrage; arbitrage that is likely to persist as long as the gains to partners from shifting are available.  When we think about arbitrage we usually think about buying and selling to capture the gains from differences across markets, for example, differences in Euro-Dollar exchange rates between London and Singapore.  But more generally, arbitrage refers to any effort to gain by exploiting differences in prices.  In this case it is differences among law firms in the price of legal talent that is the main—though not the only—motivator of lateral moves by senior lawyers.

Managerial Motives

Law firm managements engage in lateral hiring to achieve growth, diversification, and enhanced sharing of overheads.  These benefits for law firms are easy to understand.

Growth, if profitable, increases the aggregate profit of the firm, although this does not necessarily improve the incomes of incumbent partners.  To the extent that the financial viability of the firm as a whole is strengthened by profitable lateral hiring, then incumbent partners are better off as a result.  It may take a while to realize these gains as lateral hiring of successful senior legal talent typically requires overpayment.  That is to say, the hiring firm must pay its normal compensation for senior talent plus a premium to encourage the lateral to overcome inertia and assume the risks of moving to the new firm.  This implies a reduced margin of profit in the short run.  One must be careful not to overgeneralize—there are expected added payoffs that can outweigh the lateral partner’s high initial price.  These include building new (or building up weak) geographies or practices; diversifying the firm’s exposure to practice-specific business trends and reducing the per-partner burden of overhead costs.  These managerial motives all make good business sense but there is a complicating factor.  Not all lateral hiring yields long-term profitable attachment to the hiring firm.  The risk of underperformance or outright failure is the principal downside of any lateral acquisition.

Some would argue that the lateral hiring frenzy is an aberrant, mistaken and expensive quest for rapid growth. But the proposition that managing partners are delusional and self-destructive cannot really explain why lateral hiring is so prevalent in the law industry compared, for example, with other professions or high-income occupations.  If the success over time of one lateral hire exceeds in profitability the loss from several others that didn’t work out, then survey-response headcounts of lateral wins and losses are worthless.  To understand lateral hiring we need to dig deeper.