The Future Profitability of Law Firms

In the early summer of 2008, the American legal landscape was very different than it is today. The recently published AmLaw 100 list documented that 60 American law firms had reported profits per partner (“PPP”) of more than $1 million. This was the 10th consecutive year of record profits among the AmLaw 100. There were an astonishing 19 firms that reported PPP that exceeded $2 million and one whose PPP almost reached $5 million. The average PPP number reported for the top 100 law firms in the United States was $1.3 million.

About the same time that the 2007 AmLaw results were published, the first round of associate dismissals were announced. Not many, 100 or so in May and 150 in June. It could have been the normal “housekeeping” that most firms do in preparation for the soon-to-arrive fall class of attorneys. There were no announced dismissals in July, and August saw another 100 or so associates let go by their firms.

But then the economic landscape changed. The U.S. economy appeared to be in free fall. Each day seemed to bring a new revelation about bad subprime mortgages, weakly capitalized banks, and overpaid insurance executives. The nadir of the crisis was Dec. 11 when Bernard Madoff made $50 billion disappear faster than David Copperfield ever dreamed. The big law firms, while slow to react, made up for it quickly. In November and December more than 200 AmLaw 100 attorneys were let go each month. January saw 750 attorneys lose their jobs, and they were joined on the unemployment line by another 900 attorneys in February. March was not the cruelest month, but still another 700 attorneys lost their jobs before the 31st rolled around.

In all, more than 4,000 AmLaw 100 attorneys have been laid off since the fall of 2008. Not receiving as much attention is the more than 6,000 administrative positions eliminated during the same time period. While the numbers are not as precise, it is clear that partners were not spared, and many lost their jobs during this period. The 4,000 attorneys represent only those fired by the AmLaw 100. Not counted in those numbers are the thousands of other attorneys shed by the firms not included in the AmLaw numbers.

So the questions before us are: How do law firms survive this storm, and has the landscape been changed forever? Are the days of 10% annual growth and ever-expanding horizons for lawyers gone forever?

Well, my crystal ball is a bit clouded, but I am confident it is not the end of the world. What it is, is an opportunity for law firm leadership to exhibit some.

Two Distinct World Views

Sir Isaiah Berlin wrote an essay in 1953 about Tolstoy and world history. In that essay, he identified two distinct world views among people. He called those with one world view, “hedgehogs” and those with the other view, “foxes.”

Hedgehogs, he concluded, were individuals with strong convictions based upon ideological leanings. They were also extremely focused individuals who would work toward their goal with a singular sense of purpose.

Foxes, he observed, were a different type. Foxes were pragmatic, prone to self-doubt, and cautious. They were likely to try a number of different approaches simultaneously to solve a problem.

Berlin did not value the hedgehog approach above that of the fox; he merely identified the differences in how they chose to solve problems.

In today's environment the hedgehog is:

• Reducing office supply expense;
• Reducing administrative salary expense;
• Reducing administrative staff;
• Reducing office support services;
• Reducing library costs;
• Reducing the number of attorneys;
• Reducing the number of offices; and
• Reducing the number of partners.

All of these actions are designed to “cut” the law firm's way to profitability. They are, for the most part, tried and true methods that have worked in past downturns.

However, what if this downturn is different? If, in the words of Jeffery Immelt (the CEO of General Electric), “This economic crisis doesn't represent a cycle. It represents a reset. It's an emotional, social, economic reset. ' People who understand that will prosper. Those who don't will be left behind,” then the old tried and true measures may not be enough.

This may be a situation that requires us all to be foxes.

If so, what are the foxes thinking now? Well, the foxes I know are thinking:

• There must be a better way to survive the downturn, but how?
• Can I create an advantage out of the current situation that will enable me to prosper in the future?
• If I can figure this out, I will have a competitive advantage over firms in the future.
• What happened the last time we had an economic downturn? Who prospered? Who faltered? and
• I wonder what hedgehog tastes like?

Of course, the reductions of unnecessary expenses in purchasing, administrative support, and attorney staffing are all required actions for survival. Our clients are addressing expense reduction in a thoughtful and systematic way. We have helped clients find ways to reduce administrative expenses in the short, intermediate, and long term.

Strategic Sourcing

In the short term, we recommend Strategic Sourcing. Strategic Sourcing brings a structured, analytical approach to non-salary expense reduction. It analyzes each expense category and benchmarks expenses against industry costs. This results in a much more fruitful price negotiation process than merely calling in the vendors and demanding a 5% or 10% cost reduction. Our experience in the field is that price reductions achieved through “demand” negotiating are seldom achieved, and whatever results are achieved slip back to their old levels within a year. Strategic Sourcing locks in the savings for a period of years and includes a mechanism to monitor and maintain the results. Strategic Sourcing results can usually be achieved within a three- to six-month period and results in savings of 10% to 20% of the addressable spend.

Process Re-engineering

Intermediate savings can be achieved through Process Re-engineering. Process Re-engineering is based upon two principles. The first principle is that “we have always done it this way” is no answer and grounds for termination. Even if the process or methodology employed was the most logical and up-to-date 10 years ago, the world has changed. Imaging, software programs, and vendor capabilities have all changed since then and need to be re-evaluated. The second principle of Process Re-engineering is that even when firms purchase the most up-to-date software product, it is most often underutilized. The CEO of one of the largest suppliers of legal support software estimated that his best installations utilize no more than 20% of the software's functionality. Re-engineering engagements take from six months to a year and result in significant savings (usually 10% to 15%) and significant improvement in the quality and timeliness of the services provided to the firm's clients and attorneys.

Outsourcing

Longer-term savings can be achieved if a firm outsources some attorney and administrative activities. In the past several years, a number of firms have begun to outsource repetitive attorney tasks typically performed at the first-through-third associate year. Most often cited as potential areas to be outsourced are document review, legal research and opinion drafting, preparation of patent applications, and such. On the administrative side, a number of law firms have outsourced their IT support, accounting, HR, and payroll administration. Outsourcing engagements are the most lengthy and complex engagements, requiring one to several years to complete. The payback can exceed 40% of a firm's current costs, and again it is accompanied by concomitant improvement in service quality.

Thinking About Other Things

Foxes, however, are also thinking about other things. They are questioning the age-old wisdom of paying “lock step” compensation to their associates. A number of large law firms have announced that they are going to revise their associate compensation system. Many more firms are actively exploring introducing a “pay for performance” compensation system for their associates. While the details of the plans vary, they all envision much lower associate starting salaries with a significant “at risk” compensation component. Bonus payments will be based not on the number of hours recorded but on the quality of legal work provided.

Another canard that law firms are exploring is the wisdom of hiring large incoming classes of new associates in order to find a few “pearls” who, in eight to 10 years, may become partners. Many firms believed that there had to be a better way to find future firm leaders. Lavish summer recruiting programs, followed by huge annual freshman classes, were wasteful; on average, more than half of the new lawyers left the firm within three-to-four years anyway. In many large firms, associates don't start to earn money for their firm until the third year. Several recent client engagements have demonstrated to us that a law firm can develop a reliable diagnostic means of not only predicting the success of individual candidates, but also of lengthening the time that an attorney stays at the firm. Firms that understand how to better identify, hire, and retain associates will truly have a competitive advantage amongst the hedgehogs.

Finally, some foxes are also rethinking their business strategy and how to incentivize their partners to execute that strategy. More and more clients are demanding “value” for their fees and are exploring alternative fee structures and alternative law firms to provide their legal services. Fox-like firms are rethinking their strategy, expanding their “bench strength,” and eliminating practices in which they have few clients and weak service delivery capabilities. They are also analyzing past client matters to determine how much it really costs to profitably deliver specific services to clients. Knowledge of “true costs” will enable foxes to compete in the brave new world of alternative fee billing.

Conclusion

The next several years will see significant changes in the legal profession. It will not be the end of the world; most law firms will survive. However, the difference will be that the foxes will likely prosper, and the hedgehogs will survive. The choice, as they say, is yours.

J. Mark Santiago, a member of KermaPartners in New York City, has been a consultant to the legal profession for more than 25 years. He has led teams in outsourcing engagements, law firm mergers, strategy and merger due diligence, restructuring, financial management, partner compensation, service center feasibility studies and merger integration planning and implementation. Santiago is also the published author of one book and various periodical articles, as well as a speaker on topics relating to law firm management. He can be reached at [email protected].

In the early summer of 2008, the American legal landscape was very different than it is today. The recently published AmLaw 100 list documented that 60 American law firms had reported profits per partner (“PPP”) of more than $1 million. This was the 10th consecutive year of record profits among the AmLaw 100. There were an astonishing 19 firms that reported PPP that exceeded $2 million and one whose PPP almost reached $5 million. The average PPP number reported for the top 100 law firms in the United States was $1.3 million.

About the same time that the 2007 AmLaw results were published, the first round of associate dismissals were announced. Not many, 100 or so in May and 150 in June. It could have been the normal “housekeeping” that most firms do in preparation for the soon-to-arrive fall class of attorneys. There were no announced dismissals in July, and August saw another 100 or so associates let go by their firms.

But then the economic landscape changed. The U.S. economy appeared to be in free fall. Each day seemed to bring a new revelation about bad subprime mortgages, weakly capitalized banks, and overpaid insurance executives. The nadir of the crisis was Dec. 11 when Bernard Madoff made $50 billion disappear faster than David Copperfield ever dreamed. The big law firms, while slow to react, made up for it quickly. In November and December more than 200 AmLaw 100 attorneys were let go each month. January saw 750 attorneys lose their jobs, and they were joined on the unemployment line by another 900 attorneys in February. March was not the cruelest month, but still another 700 attorneys lost their jobs before the 31st rolled around.

In all, more than 4,000 AmLaw 100 attorneys have been laid off since the fall of 2008. Not receiving as much attention is the more than 6,000 administrative positions eliminated during the same time period. While the numbers are not as precise, it is clear that partners were not spared, and many lost their jobs during this period. The 4,000 attorneys represent only those fired by the AmLaw 100. Not counted in those numbers are the thousands of other attorneys shed by the firms not included in the AmLaw numbers.

So the questions before us are: How do law firms survive this storm, and has the landscape been changed forever? Are the days of 10% annual growth and ever-expanding horizons for lawyers gone forever?

Well, my crystal ball is a bit clouded, but I am confident it is not the end of the world. What it is, is an opportunity for law firm leadership to exhibit some.

Two Distinct World Views

Sir Isaiah Berlin wrote an essay in 1953 about Tolstoy and world history. In that essay, he identified two distinct world views among people. He called those with one world view, “hedgehogs” and those with the other view, “foxes.”

Hedgehogs, he concluded, were individuals with strong convictions based upon ideological leanings. They were also extremely focused individuals who would work toward their goal with a singular sense of purpose.

Foxes, he observed, were a different type. Foxes were pragmatic, prone to self-doubt, and cautious. They were likely to try a number of different approaches simultaneously to solve a problem.

Berlin did not value the hedgehog approach above that of the fox; he merely identified the differences in how they chose to solve problems.

In today's environment the hedgehog is:

• Reducing office supply expense;
• Reducing administrative salary expense;
• Reducing administrative staff;
• Reducing office support services;
• Reducing library costs;
• Reducing the number of attorneys;
• Reducing the number of offices; and
• Reducing the number of partners.

All of these actions are designed to “cut” the law firm's way to profitability. They are, for the most part, tried and true methods that have worked in past downturns.

However, what if this downturn is different? If, in the words of Jeffery Immelt (the CEO of General Electric), “This economic crisis doesn't represent a cycle. It represents a reset. It's an emotional, social, economic reset. ' People who understand that will prosper. Those who don't will be left behind,” then the old tried and true measures may not be enough.

This may be a situation that requires us all to be foxes.

If so, what are the foxes thinking now? Well, the foxes I know are thinking:

• There must be a better way to survive the downturn, but how?
• Can I create an advantage out of the current situation that will enable me to prosper in the future?
• If I can figure this out, I will have a competitive advantage over firms in the future.
• What happened the last time we had an economic downturn? Who prospered? Who faltered? and
• I wonder what hedgehog tastes like?

Of course, the reductions of unnecessary expenses in purchasing, administrative support, and attorney staffing are all required actions for survival. Our clients are addressing expense reduction in a thoughtful and systematic way. We have helped clients find ways to reduce administrative expenses in the short, intermediate, and long term.

Strategic Sourcing

In the short term, we recommend Strategic Sourcing. Strategic Sourcing brings a structured, analytical approach to non-salary expense reduction. It analyzes each expense category and benchmarks expenses against industry costs. This results in a much more fruitful price negotiation process than merely calling in the vendors and demanding a 5% or 10% cost reduction. Our experience in the field is that price reductions achieved through “demand” negotiating are seldom achieved, and whatever results are achieved slip back to their old levels within a year. Strategic Sourcing locks in the savings for a period of years and includes a mechanism to monitor and maintain the results. Strategic Sourcing results can usually be achieved within a three- to six-month period and results in savings of 10% to 20% of the addressable spend.

Process Re-engineering

Intermediate savings can be achieved through Process Re-engineering. Process Re-engineering is based upon two principles. The first principle is that “we have always done it this way” is no answer and grounds for termination. Even if the process or methodology employed was the most logical and up-to-date 10 years ago, the world has changed. Imaging, software programs, and vendor capabilities have all changed since then and need to be re-evaluated. The second principle of Process Re-engineering is that even when firms purchase the most up-to-date software product, it is most often underutilized. The CEO of one of the largest suppliers of legal support software estimated that his best installations utilize no more than 20% of the software's functionality. Re-engineering engagements take from six months to a year and result in significant savings (usually 10% to 15%) and significant improvement in the quality and timeliness of the services provided to the firm's clients and attorneys.

Outsourcing

Longer-term savings can be achieved if a firm outsources some attorney and administrative activities. In the past several years, a number of firms have begun to outsource repetitive attorney tasks typically performed at the first-through-third associate year. Most often cited as potential areas to be outsourced are document review, legal research and opinion drafting, preparation of patent applications, and such. On the administrative side, a number of law firms have outsourced their IT support, accounting, HR, and payroll administration. Outsourcing engagements are the most lengthy and complex engagements, requiring one to several years to complete. The payback can exceed 40% of a firm's current costs, and again it is accompanied by concomitant improvement in service quality.

Thinking About Other Things

Foxes, however, are also thinking about other things. They are questioning the age-old wisdom of paying “lock step” compensation to their associates. A number of large law firms have announced that they are going to revise their associate compensation system. Many more firms are actively exploring introducing a “pay for performance” compensation system for their associates. While the details of the plans vary, they all envision much lower associate starting salaries with a significant “at risk” compensation component. Bonus payments will be based not on the number of hours recorded but on the quality of legal work provided.

Another canard that law firms are exploring is the wisdom of hiring large incoming classes of new associates in order to find a few “pearls” who, in eight to 10 years, may become partners. Many firms believed that there had to be a better way to find future firm leaders. Lavish summer recruiting programs, followed by huge annual freshman classes, were wasteful; on average, more than half of the new lawyers left the firm within three-to-four years anyway. In many large firms, associates don't start to earn money for their firm until the third year. Several recent client engagements have demonstrated to us that a law firm can develop a reliable diagnostic means of not only predicting the success of individual candidates, but also of lengthening the time that an attorney stays at the firm. Firms that understand how to better identify, hire, and retain associates will truly have a competitive advantage amongst the hedgehogs.

Finally, some foxes are also rethinking their business strategy and how to incentivize their partners to execute that strategy. More and more clients are demanding “value” for their fees and are exploring alternative fee structures and alternative law firms to provide their legal services. Fox-like firms are rethinking their strategy, expanding their “bench strength,” and eliminating practices in which they have few clients and weak service delivery capabilities. They are also analyzing past client matters to determine how much it really costs to profitably deliver specific services to clients. Knowledge of “true costs” will enable foxes to compete in the brave new world of alternative fee billing.

Conclusion

The next several years will see significant changes in the legal profession. It will not be the end of the world; most law firms will survive. However, the difference will be that the foxes will likely prosper, and the hedgehogs will survive. The choice, as they say, is yours.

J. Mark Santiago, a member of KermaPartners in New York City, has been a consultant to the legal profession for more than 25 years. He has led teams in outsourcing engagements, law firm mergers, strategy and merger due diligence, restructuring, financial management, partner compensation, service center feasibility studies and merger integration planning and implementation. Santiago is also the published author of one book and various periodical articles, as well as a speaker on topics relating to law firm management. He can be reached at [email protected].