By Hugh A. Simons and Joe Blackwood for Law.com
Profits per equity partner at the Am Law 100 grew by 22% for the 12 months ending November 2020, according to actual firm data contained in Thomson Reuters recently published State of the Legal Market report. PEP will probably be tamped down through prepayments of rent, etc., and end closer to 15-17% but, even so, this is extraordinary performance given the prevailing economic conditions. What lessons should we take from this and what does it mean for what is to come? The following offers some food for thought.
Lessons
The experience of 2020 reinforces the view that the value clients derive from legal services is, at root, assurance in the face of risk and uncertainty. Thus, while the economy stalled, uncertainty abounded and aggregate demand for outside counsel support largely held. When the final numbers come in, we’ll probably see Am Law 100 total hours down only 1-2%.
The year’s performance also confirms something we’ve long known but of which we did not have proof: There was a lot of slack in law firm administrative structures. Firms have struggled over the last decade to get staff-to-lawyer ratios down from above 1.0 to 0.8 or 0.9. In 2020 we saw that with tech-enabled self-service, there was a further 0.2 reduction readily available. While there will probably be some rebound in this ratio when people get back to the office, we’ll eventually resume the slow downward trend. As a benchmark, consultants, who are forced into self-service by constant travel, operate at staff-to-consultant ratios of about 0.2. Thus, there is still a long way to go.
Last year also demonstrated that firms recognize that they are real businesses (rather than bastions of intellectual prowess existing on some higher plane) and should be managed as such. Roughly half of law firms availed themselves of the Paycheck Protection Program, and about the same number deferred cash payments to partners. About 40 percent deferred compensation of associates and staff. With hindsight, these deferrals can be viewed as unnecessary. However, the quality of a decision can only be assessed based on the information available at the time, and back then we simply didn’t know how low things could go in a global pandemic. The industry erred, it appears, on the opposite side to disaster.
Another lesson: Contrary to the common narrative, 2020’s PEP growth was not all about overhead cost reduction. While, yes, overhead costs came down by 5-6%, we should keep in mind that overhead is not the most important part of a firm’s margin structure. It typically represents 25-30% of revenues, so for an Am Law 100 firm whose total profit pool equates to about half of revenues, a 5-6% decline in overhead translates (all else equal) to only about a 3% increase in PEP.
If it wasn’t overhead cost reduction, then what drove PEP growth? The evidence suggests the biggest driver was billing rate increases. Big Law went into the COVID crisis having just raised billing rates by 5-6%, the biggest increase in over a decade. Such an increase would translate (all else equal) into a 10-12% increase in PEP (allowing for some realization loss). Leverage also played a role. The Am Law 100 entered the crisis with the highest equity partner leverage (in both full-time equivalent and hours terms) of the past decade and 3-4% above the prior year’s level. All else being equal, this higher leverage alone would drive a 6-8% increase in PEP. The lesson here is perhaps that billing rates and leverage not only drive long-term profitability growth; they also reinforce firm finances in times of crisis.
These mechanics also suggest that we’ll see double-digit PEP growth again in 2021. Demand will pick up (especially in Q3 and Q4); lawyer head count is 2% below where it was a year ago; billing rates ticked up modestly at year end; and while leverage starts the year a hair below where it was this time last year, it will likely rise as partner ranks are reviewed. Further, we’ll see the full year effect of last year’s decline in overhead (albeit with some bounceback in the second half). Three percent increases in volume, rates and realization, and 2-3% declines in head count and overhead, would deliver over 10% PEP growth.
A final point has to do with Big Law’s structural challenge and what this year’s performance says about the industry’s response. We know that Big Law is in what MBA courses refer to as “segment retreat”—firms are competing in a slowly shrinking segment of the market for which in-house counsel, non-traditional providers and lower-priced regional firms aren’t perceived by clients as viable alternative providers.
We see proof of this in the shifting mix of U.S. lawyers’ professional homes. For the decade after the global financial crisis, in which the economy grew by 25%, the number of U.S.-based lawyers at Am Law 100 firms was flat while the number of in-house lawyers grew by 50%. Firms generally have refocused away from those clients and service offerings most prone to in-house substitution and have shed partners in the affected practices as the segment contracts. In an effort to make their offerings cost less for clients, some firms have spoken about reengineering their service delivery models through increased standardization and use of technology, streamlined work flows and having more work done by paraprofessionals, but in actuality they have achieved relatively little progress. This isn’t surprising, as it requires firms to cannibalize their own higher-margin offerings.
This reengineering is an important lever in Big Law’s response to segment retreat. It would slow the rate of retreat (and perhaps even allow some lost ground to be regained). However, we should recognize that what we saw in 2020 was not some inflection point in Big Law’s path toward a reengineered service delivery model. The main sequence by which service is delivered didn’t change; rather, the secretarial support provided to the traditional lawyers working in their typical ways was replaced by tech-enabled self-service (and firms saved on money travel to boot).
Implications
PEP growth will be tempered by measures such as tech licensing fees or prepayments of 2021 expenses, but reported PEP growth will still be eye-catchingly robust. Clients aren’t going to be happy, especially in the wake of new 2021 billing rates. Similarly, there’ll be some snarky mass media coverage. The truth provides a useful counterpoint: Uncertainty was high, the fundamental legal offering is the mitigation of such uncertainty, hence it’s not surprising that demand was robust and the services provided were seen to deliver compelling value.
While strong profitability makes life generally easier for managing partners, it’s not without its challenges. As usual, compensation is the issue and, as is so often the case with compensation, it’s not about the absolute level but about comparisons with others.
The pandemic has widened the range of economic contribution of individual partners’ practices to the firm profit pool. If compensation distributions don’t evolve to reflect this widened range then two bad things happen: partners who overcontribute to profits relative to their compensation become grumpy and more likely to be wooed away by rival firms; and partners who undercontribute are insulated from economic reality, thereby lessening the urgency with which they feel they need to evolve their practices. These pressures will be most keenly felt at firms whose compensation systems have strong vestigial lockstep elements and those whose international partners (the economics of whose practices have been especially badly affected) are part of a single firmwide compensation system.
It’s natural not to want to side with those partners who, earning what they do, still complain about any aspect of compensation. However, the overcompensation of the undercontributors gives merit to the complaints of the overcontributing partners. Sheltering from economic reality those partners with practices for which demand and price point are being eroded (as the industry continues its segment retreat) is unfair to these same partners—they need to feel the economic consequence in order to internalize the need for change.
It’s uncomfortable to acknowledge, but there’s a paradoxical altruism in the grumpiness of the highly contributing partners.