UGLINESS INSIDE THE AM LAW 100 — PART I

Every spring, the eyes of big firm attorneys everywhere turn to the American Lawyer rankings — the Am Law 100 — and the contest surrounding its key metric: average profits per equity partner (PPP). But if the goal is to obtain meaningful insight into a firm’s culture, financial strength or profitability for most of its partners, those focusing on PPP are looking at the wrong ball.

Start with the basics

For years, firms have been increasing their PPP by reducing the number of equity partners. American Lawyer reports that cutbacks in equity partners, when done correctly, are “a solid management technique, not financial chicanery.” But as firms are now executing the strategy, it looks more like throwing furniture into the fireplace to keep the equity house warm.

Since 1985, the average leverage ratio (of all attorneys to equity partners) for the Am Law 50 has doubled from 1.76 to more than 3.5. It’s now twice as difficult to become an equity partner as it was when today’s senior partners entered that club. Between 1999 and 2009, the ranks of Am Law 100 non-equity partners grew threefold; the number of equity partners increased by less than one-third.

Arithmetic did the rest: average partner profits for the Am Law 50 soared from $300,000 in 1985 ($650,000 in today’s dollars) to more than $1.7 million in 2012.

The beat goes on

Perhaps it’s not financial chicanery, but many firms admit that they’re still turning the screws on equity partner head count as a way to increase PPP. According to the American Lawyer’s most recent Law Firm Leaders’ Survey, 45 percent of respondent firms de-equitized partners in 2012 and 46 percent planned to do so in 2013.

But even when year-to-year equity headcount remains flat, as it did this year, that nominal result masks a destabilizing trend: the growing concentration of income and power at the top. In fact, it is undermining the very validity of the PPP metric itself.

An unpublished metric more important than PPP

The internal top-to-bottom spread within the equity ranks of most firms doesn’t appear in the Am Law survey or anywhere else, but it should, along with the distribution of partners at various data points. As meaningful metrics, they’re far more important than PPP.

Even as overall leverage ratios have increased dramatically, the internal gap within equity partnerships has skyrocketed. A few firms adhere to lock-step equity partner compensation within a narrow overall range (3-to-1 or 4-to-1). But most have adopted higher spreads. In its 2012 financial statement, K&L Gates disclosed an 8-to-1 gap — up from 6-to-1 in 2011. Dewey & LeBoeuf’s range exceeded 20-to-1.

This growing internal gap undermines the informational value of PPP. In any statistical analysis, an average is meaningful if the underlying sample is distributed normally (i.e., along a bell-shaped curve where the average is the peak). But the distribution of incomes within most big firm equity partnerships bears no resemblance to such a curve.

Cultural consequences

Rules governing statistical validity have real world implications. Growing internal income spreads render even nominally stable equity partner head counts misleading. Lower minimum profit participation levels make room for more equity partner bodies, but what results over time is Dewey & LeBoeuf’s “barbell” system. A handful of rainmakers dominates one side of the barbell; many more so-called service partners populate the other — and they rarely advance very far.

As Edwin B. Reeser and Patrick J. McKenna wrote last year, in Am Law 200 firms, “Typically, two-thirds of the equity partners earn less, and some perhaps only half, of the average PPP.” Statisticians know that for such a skewed distribution, the arithmetic average conveys little that is useful about the underlying population from which it is drawn.

Why it matters

For firms that don’t have lock-step partner compensation, the PPP metric doesn’t reveal very much. For example, consider a firm with two partners and an 8-to-1 equity partner spread. If Partner A earns $4 million and Partner B earns $500,000, average PPP is $2.25 million — a number that doesn’t describe either partner’s situation or the stability of the firm itself. But the underlying details say quite a bit about the culture of that partnership.

Firms with the courage to do so would follow the lead of K&L Gates and disclose what that firm calls its “compression ratio” and then take it a step farther: reveal their internal income distributions as well. But such revelations might lead to uncomfortable conversations about why, especially during the last decade, managing partners have engineered explosive increases in internal equity partner income gaps.

A future post will consider that topic. It’s not pretty.

8 thoughts on “UGLINESS INSIDE THE AM LAW 100 — PART I

  1. Massively disproportionate income distribution, concentrated at the top. Gee, that sounds a lot like Corporate America, where obscene greed has been institutionalized and, at least among the beneficiaries, celebrated.

  2. BigLaw has only two choices as I see it:

    1. Keep tuning the current business model: steer towards higher margin work (almost all firms chasing the same puck), reduce fixed costs (out-source, flexi-attorneys, lean, etc) and/or reduce equity points sharing the pie. Logic suggests these only buy time and slow down an inexorable decline in PPP (boiled frog style).

    2. Invent or adopt new business models. Experience suggests Christiansen’s innovator’s dilemma will prevent (almost) all firms from trying this path.

    It’s not pretty, as you say.

    • George,
      In early 2009, when firms began their draconian cost-cutting, I was reminded of the old poster of the predatory food chain, illustrated by a series of increasingly larger fish simultaneously poised to devour the smaller fish in front of it. I thought then that it was an apt metaphor for the crude price-based competition that firms embraced when faced for the first time with a shrinking demand pie and increasing supply competition. Each law firm tier was vulnerable to a price-based attack on their soft underbelly by firms below them.

      The problem was that the firms at the top had nobody above them to cannibalize, and also had the highest and most intractable human+facility costs. That caused me to predict that within five years, 25% of the AmLaw 100 would no longer exist as then constituted, i.e., they’d either have failed or merged. It’s starting to look like the only thing wrong with that prediction was the time line. It’s taking longer, but I’ll agree with your description, “inexorable.”

  3. Thanks Mike. Our modelling of and scenarios for Australian BigLaw firms indicates PPP halved within 10 years. My knowledge of US and UK firms suggests they are no different. And look to New Zealand to see the slide now clearly visible – and accepted by most of the large firms and irreversible.

  4. To the extent you can, please use your contacts to reveal the internal pay spreads of various firms. Which firms are still relatively evenly distributed (4:1 or 3:1)?

  5. “Focus on clients”. A very good idea. To what extent is that considered in the partner compensation review process of the average large national or international firm?

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s