Changing Compensation Strategies Put Partners Under Pressure

Law firm leaders say that with each decision they make about compensation, they're sending a signal to the rest of the firm about what is and is not valued. While there are almost as many partner compensation systems as there are law firms, consultants say one thing many firms have in common is that they are growing increasingly scrupulous in how they make decisions about what to pay partners. There are several ways law firms are putting the pressure on partners, from looking only at one year's billings in setting compensation to more easily moving partners up and down the pay scale.

Firms are decreasing the numbers of years they consider in determining compensation, consultants say. Since the recession, firms have become less willing to give a partner leeway for a bad year. They also want to be able to reward a partner who does well in order to keep him or her from getting poached by another firm.

“Three years is history,” says Jim Cotterman, a principal at the legal consultancy Altman Weil. “We've contracted that. The emphasis that's placed on the current year has increased.”

That means the pressure is on for partners to constantly bring in business.

“The grace period for not performing is not very long anymore,” says Joe Altonji, another legal consultant. “A very well-run firm is lowering some people's compensation every year.”

Dorsey & Whitney managing partner Ken Cutler says that while his firm looks at three years of data, plus other subjective measures when determining partner compensation, “there's a bit of trend to place more emphasis on the previous year.”

Recently, partners' performances have varied dramatically from year-to-year, because clients are less loyal, Cutler says. They're willing to jump around between firms, making the stream of billable hours less consistent than it was in the past.

“You're competing for your clients' business every project, every day,” Cutler adds.

One Am Law 100 firm leader who did not want to be identified agreed, saying partners “can move up and move down [the pay scale] more quickly. We aren't a jump ball every year and we want longevity to be rewarded and loyalty to be rewarded, but I think at all firms, including ours, … there is less stickiness” among compensation tiers.

But some firms say they've resisted this trend. At Weil, Gotshal & Manges, for example, the management committee still looks at several years when determining a partner's compensation.

“We think that's the right measure of someone's performance,” Weil executive partner Barry Wolf says. “Someone could have an off year for personal reasons, or the market went down.”

Laterals continue to contribute to stratification within the partner ranks. Last year, the lateral market hit an all-time high since the recession, with more partners defecting for rival firms. That reality has had an impact on some firms' compensation systems. Firms must promise rainmakers huge sums if they want to attract them as laterals, while paying their own top producers equally well to prevent them from being poached.

Compensation Spreads

The hope is that the revenue generators who are brought in will pay for themselves and then some, but it sometimes doesn't work out that way, at least not immediately. Firms have to get those shares or points from somewhere, and typically it will come from the mid- and low-level producers, increasing the spread between the highest and lowest earners.

“As a firm leader, I have to make sure that my best producers of business stay,” says another Am Law 100 chairman, who asked not to be identified so he could speak candidly about compensation. “They may be willing to take a discount as compared to what they could get [at another firm] because they love the firm and they love the culture, but there are limits.”

Data collected by ALM Intelligence (ALI) shows that the spread between the highest- and lowest-paid partners has widened industrywide. In 2013, the first year ALI began collecting this information, the average ratio of highest- to lowest-paid partners was 10.6-1, while the median was 9.8-1, based on a survey of just over 100 firms on the Am Law 200 list. Last year, the average compensation ratio had risen to 11.7-1 and the median had risen to 10.4-1. This data comes from firms that self-reported, with many of the most profitable firms choosing not to disclose their compensation spreads. The figures reported include nonequity and equity partners.

Compensation spreads don't tell the full story, given that the ratios could differ when comparing single-tier with two-tier partnerships, and outliers could easily skew the spreads. But the rise in the average and median over time supports anecdotal evidence that the gaps are generally widening.

The firms that reported the widest spreads for 2015 were Squire Patton Boggs, with 30-1; Barnes & Thornburg at 29-1; Nelson Mullins at 27.3-1; and Reed Smith and Goodwin Procter, each with ratios of 27-1. Perkins Coie's spread was 26.7-1.

Perkins Coie managing partner John Devaney says his firm has a wide compensation ratio in part because of its merit-based pay system.

“We have long been a very merit-based compensation system where if you have a good year you get handsomely rewarded for it,” he says. “There can be meaningful variation from one year to the next.”

Devaney adds that the firm has a large bonus pool, so a typical partner's bonus is one-third of their income. The partners, many of whom work for newer companies with startup cultures, tend to like the opportunity to knock it out of the park and are comfortable with the risk, he says.

The wide compensation spread is also due to the fact that the firm has offices in cities like Boise, ID and Anchorage, AK, where lawyers charge very different rates and have very different expenses than their partners in New York and San Francisco. Finally, the firm promotes a relatively large share of associates and counsels to partner, which Devaney says adds to the discrepancy.

“Goodwin's 27-1 compensation ratio includes both equity and nonequity partners since ours is a two-tier partnership,” Goodwin CFO Jon Kanter said in a statement. “Our equity partner compensation ratio is 8:1 and it has not changed since The American Lawyer started collecting this data in 2013. For all partners, if we remove from our calculation a few partners who have retired as of the end of 2016, our compensation ratio becomes 19:1, which we believe is a more accurate, true ratio to use for Goodwin in 2016.”

Some firms say their partner compensation spreads shrunk in 2016 because of the associate pay raises prompted by Cravath, Swaine & Moore last June and matched by many other Am Law 100 firms. One Am Law 100 firm leader said his shop also raised the pay of new partners in order to ensure that becoming a partner is financially worth it, but the highest compensated partners did not get a commensurate raise, meaning the firm's compensation spread shrunk.

So far, some lockstep firms have kept their compensation systems intact, but they have seen some big producers walk out the door. An example of that was when M&A heavyweight Scott Barshay left Cravath for Paul Weiss, which is not lockstep, last year. And the British firms, which were traditionally lockstep, have largely had to modify their systems in order to keep high earners, according to several consultants and law firm leaders.

Incentives for Collaboration? Maybe

Most law firms will say their compensation systems incentivize collaboration, but in reality this is hard to achieve. Partners are likely to push back when origination credits are de-emphasized in favor of a system that awards points to lawyers who do work for someone else's client, but legal consultants say this is important.

“It's always a key question: Am I better as a partner at the firm helping a fellow partner on a $2 million relationship or am I better off going out and chasing small clients on my own?” says Cara Rhodes, a legal consultant with the firm Hoffman Alvary. “The better thing for the institution is to grow the largest client.”

It's easier to know who helps whom and who only works on his or her own clients at a smaller law firm, where all the partners know each other, than at a large firm with offices scattered across the globe.

“The bigger the firm, the more you have to rely on the numbers,” says Altonji. “It's difficult for a managing partner to have intimate knowledge of everyone's work.”

One way to go about this is through questionnaires, which several top Am Law 100 firms use. The firms ask not only who you helped, but also who helped you.

But firms are trying to work collaboration incentives into their systems in a more structured way. A couple of years ago, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo tweaked its compensation system so that no one partner can get 100% of a client's origination credits.

“That's to reinforce the collaborative nature of what we're doing,” says Mintz Levin managing partner Robert Bodian. “In some instances, it means you have less incentive to try to originate a client by yourself.”

The firm also began awarding origination credits by matter, rather than client, so younger partners will be compensated for opening a new matter with an existing client.

Dorsey & Whitney's compensation system distinguishes between a “billing attorney,” who originates a matter, and a “responsible attorney,” who does the work on it. A partner could be a billing attorney on some matters and a responsible attorney on others, but the firm doesn't give credit for being both on the same matter.

Partners who might otherwise have been both the billing attorney and the responsible attorney are encouraged to bring another partner on to the matter and designate him or her as the responsible attorney, Cutler says.

The size of bonus pools is growing. Many firms set aside a percentage of their profits to distribute to a select group of partners who had a particularly good year. Consultants and firm leaders say they're seeing bonus pools grow and, as with shorter-term decisions on how to distribute profits, it's in part to keep rainmakers from leaving for rivals.

A typical bonus pool is between 5% and 15% of a firm's profits, says Lisa Smith, a consultant with Fairfax Associates. Some firms can go up to 20%, however.

Rewarding partners with a bonus, rather than moving partners to a higher tier on the pay scale, is easier for long-term planning purposes, says Jacqueline Knight, a recruiter at Major, Lindsey & Africa. If the partner is not as productive the following year, it's easier to simply not give them another bonus, than it is to demote them.

“I have seen an increase at many firms in the bonus structure,” Knight says.

Firms are paying attention to the profitability of partners' practices, not just their books of business. Since the recession, consultants say, firms have been forced to operate more like businesses in which every line item on their budget matters. That means simply making money isn't enough. Practices must be efficient and realization rates matter — a scenario only intensified in a low-growth market.

“Historically, most firms were, and still are, top-line oriented,” says Altonji. “They look at your book of business [when determining compensation.] I have to tell you, not all dollars were created equal.”

Profitability, in particular, has become a focus of compensation committees. Some firm leaders say they are generally taking more data into account when measuring a partner's performance.

“We are looking at using more analytics rather than anecdotal evidence,” says McDermott Will & Emery chairman Ira Coleman. When determining compensation, the firm “look[s] at all the clients this person touched or all the lawyers and professionals this person brought in to help the clients.”

Compensation and Culture

Having an open compensation system makes the firm's decisions about who makes what much more consequential.

“Because it's transparent, in addition to just deciding what each partner's compensation is, we're sending messages to all the partners as to what is being rewarded,” Weil's Wolf says.

But a chair whose firm has a closed system makes the case that if partners don't know their colleagues' compensation, they spend less time worrying about who makes what. A closed system is beneficial to culture because resentments are less likely to build, he says.

Decisions about every aspect of partner compensation from how to award points to who gets to see the final breakdown have an impact on another, more nebulous concept that law firm leaders love to talk about: culture.

“Compensation drives culture by far more than any other attribute,” says the chairman of a top Am Law 100 firm.

Culture and that historical understanding of the definition of partnership are often what have kept law firms from radically altering compensation or partnership structures. But they have also contributed to overcapacity at many firms.

If an Am Law 200 firm started anew today, would it be structured like the rest? The shifting partner compensation models are testing the bounds of a law firm's culture in the face of the business realities of running a partnership akin to a Fortune 1000 enterprise.

*****
Nell Gluckman writes for The Am Law Daily, an ALM sibling of this newsletter. She can be contacted at [email protected] or on Twitter @NellGluckman.

Law firm partners have never been able to make as much money as they can now. The highest profits-per-partner on the Am Law 100 rankings in 2015 came in at $6.6 million (at Wachtell, Lipton, Rosen & Katz), while the rainmakers and leaders at a select few firms can make at least twice that. But being paid more at the top can mean less for those below, stretching the definition of “partner.”

The legal profession has never been more cutthroat. As the race for revenue intensifies, firms are putting more pressure on their partners to perform in a number of criteria. If they don't, it will be reflected in their compensation, title and possibly their place in the firm. For a profession that once provided a secure path to upward mobility, some partners are sliding back down in compensation, to the benefit of those still on the climb.

Sending a Message

Law firm leaders say that with each decision they make about compensation, they're sending a signal to the rest of the firm about what is and is not valued. While there are almost as many partner compensation systems as there are law firms, consultants say one thing many firms have in common is that they are growing increasingly scrupulous in how they make decisions about what to pay partners. There are several ways law firms are putting the pressure on partners, from looking only at one year's billings in setting compensation to more easily moving partners up and down the pay scale.

Firms are decreasing the numbers of years they consider in determining compensation, consultants say. Since the recession, firms have become less willing to give a partner leeway for a bad year. They also want to be able to reward a partner who does well in order to keep him or her from getting poached by another firm.

“Three years is history,” says Jim Cotterman, a principal at the legal consultancy Altman Weil. “We've contracted that. The emphasis that's placed on the current year has increased.”

That means the pressure is on for partners to constantly bring in business.

“The grace period for not performing is not very long anymore,” says Joe Altonji, another legal consultant. “A very well-run firm is lowering some people's compensation every year.”

Dorsey & Whitney managing partner Ken Cutler says that while his firm looks at three years of data, plus other subjective measures when determining partner compensation, “there's a bit of trend to place more emphasis on the previous year.”

Recently, partners' performances have varied dramatically from year-to-year, because clients are less loyal, Cutler says. They're willing to jump around between firms, making the stream of billable hours less consistent than it was in the past.

“You're competing for your clients' business every project, every day,” Cutler adds.

One Am Law 100 firm leader who did not want to be identified agreed, saying partners “can move up and move down [the pay scale] more quickly. We aren't a jump ball every year and we want longevity to be rewarded and loyalty to be rewarded, but I think at all firms, including ours, … there is less stickiness” among compensation tiers.

But some firms say they've resisted this trend. At Weil, Gotshal & Manges, for example, the management committee still looks at several years when determining a partner's compensation.

“We think that's the right measure of someone's performance,” Weil executive partner Barry Wolf says. “Someone could have an off year for personal reasons, or the market went down.”

Laterals continue to contribute to stratification within the partner ranks. Last year, the lateral market hit an all-time high since the recession, with more partners defecting for rival firms. That reality has had an impact on some firms' compensation systems. Firms must promise rainmakers huge sums if they want to attract them as laterals, while paying their own top producers equally well to prevent them from being poached.

Compensation Spreads

The hope is that the revenue generators who are brought in will pay for themselves and then some, but it sometimes doesn't work out that way, at least not immediately. Firms have to get those shares or points from somewhere, and typically it will come from the mid- and low-level producers, increasing the spread between the highest and lowest earners.

“As a firm leader, I have to make sure that my best producers of business stay,” says another Am Law 100 chairman, who asked not to be identified so he could speak candidly about compensation. “They may be willing to take a discount as compared to what they could get [at another firm] because they love the firm and they love the culture, but there are limits.”

Data collected by ALM Intelligence (ALI) shows that the spread between the highest- and lowest-paid partners has widened industrywide. In 2013, the first year ALI began collecting this information, the average ratio of highest- to lowest-paid partners was 10.6-1, while the median was 9.8-1, based on a survey of just over 100 firms on the Am Law 200 list. Last year, the average compensation ratio had risen to 11.7-1 and the median had risen to 10.4-1. This data comes from firms that self-reported, with many of the most profitable firms choosing not to disclose their compensation spreads. The figures reported include nonequity and equity partners.

Compensation spreads don't tell the full story, given that the ratios could differ when comparing single-tier with two-tier partnerships, and outliers could easily skew the spreads. But the rise in the average and median over time supports anecdotal evidence that the gaps are generally widening.

The firms that reported the widest spreads for 2015 were Squire Patton Boggs, with 30-1; Barnes & Thornburg at 29-1; Nelson Mullins at 27.3-1; and Reed Smith and Goodwin Procter, each with ratios of 27-1. Perkins Coie's spread was 26.7-1.

Perkins Coie managing partner John Devaney says his firm has a wide compensation ratio in part because of its merit-based pay system.

“We have long been a very merit-based compensation system where if you have a good year you get handsomely rewarded for it,” he says. “There can be meaningful variation from one year to the next.”

Devaney adds that the firm has a large bonus pool, so a typical partner's bonus is one-third of their income. The partners, many of whom work for newer companies with startup cultures, tend to like the opportunity to knock it out of the park and are comfortable with the risk, he says.

The wide compensation spread is also due to the fact that the firm has offices in cities like Boise, ID and Anchorage, AK, where lawyers charge very different rates and have very different expenses than their partners in New York and San Francisco. Finally, the firm promotes a relatively large share of associates and counsels to partner, which Devaney says adds to the discrepancy.

“Goodwin's 27-1 compensation ratio includes both equity and nonequity partners since ours is a two-tier partnership,” Goodwin CFO Jon Kanter said in a statement. “Our equity partner compensation ratio is 8:1 and it has not changed since The American Lawyer started collecting this data in 2013. For all partners, if we remove from our calculation a few partners who have retired as of the end of 2016, our compensation ratio becomes 19:1, which we believe is a more accurate, true ratio to use for Goodwin in 2016.”

Some firms say their partner compensation spreads shrunk in 2016 because of the associate pay raises prompted by Cravath, Swaine & Moore last June and matched by many other Am Law 100 firms. One Am Law 100 firm leader said his shop also raised the pay of new partners in order to ensure that becoming a partner is financially worth it, but the highest compensated partners did not get a commensurate raise, meaning the firm's compensation spread shrunk.

So far, some lockstep firms have kept their compensation systems intact, but they have seen some big producers walk out the door. An example of that was when M&A heavyweight Scott Barshay left Cravath for Paul Weiss, which is not lockstep, last year. And the British firms, which were traditionally lockstep, have largely had to modify their systems in order to keep high earners, according to several consultants and law firm leaders.

Incentives for Collaboration? Maybe

Most law firms will say their compensation systems incentivize collaboration, but in reality this is hard to achieve. Partners are likely to push back when origination credits are de-emphasized in favor of a system that awards points to lawyers who do work for someone else's client, but legal consultants say this is important.

“It's always a key question: Am I better as a partner at the firm helping a fellow partner on a $2 million relationship or am I better off going out and chasing small clients on my own?” says Cara Rhodes, a legal consultant with the firm Hoffman Alvary. “The better thing for the institution is to grow the largest client.”

It's easier to know who helps whom and who only works on his or her own clients at a smaller law firm, where all the partners know each other, than at a large firm with offices scattered across the globe.

“The bigger the firm, the more you have to rely on the numbers,” says Altonji. “It's difficult for a managing partner to have intimate knowledge of everyone's work.”

One way to go about this is through questionnaires, which several top Am Law 100 firms use. The firms ask not only who you helped, but also who helped you.

But firms are trying to work collaboration incentives into their systems in a more structured way. A couple of years ago, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo tweaked its compensation system so that no one partner can get 100% of a client's origination credits.

“That's to reinforce the collaborative nature of what we're doing,” says Mintz Levin managing partner Robert Bodian. “In some instances, it means you have less incentive to try to originate a client by yourself.”

The firm also began awarding origination credits by matter, rather than client, so younger partners will be compensated for opening a new matter with an existing client.

Dorsey & Whitney's compensation system distinguishes between a “billing attorney,” who originates a matter, and a “responsible attorney,” who does the work on it. A partner could be a billing attorney on some matters and a responsible attorney on others, but the firm doesn't give credit for being both on the same matter.

Partners who might otherwise have been both the billing attorney and the responsible attorney are encouraged to bring another partner on to the matter and designate him or her as the responsible attorney, Cutler says.

The size of bonus pools is growing. Many firms set aside a percentage of their profits to distribute to a select group of partners who had a particularly good year. Consultants and firm leaders say they're seeing bonus pools grow and, as with shorter-term decisions on how to distribute profits, it's in part to keep rainmakers from leaving for rivals.

A typical bonus pool is between 5% and 15% of a firm's profits, says Lisa Smith, a consultant with Fairfax Associates. Some firms can go up to 20%, however.

Rewarding partners with a bonus, rather than moving partners to a higher tier on the pay scale, is easier for long-term planning purposes, says Jacqueline Knight, a recruiter at Major, Lindsey & Africa. If the partner is not as productive the following year, it's easier to simply not give them another bonus, than it is to demote them.

“I have seen an increase at many firms in the bonus structure,” Knight says.

Firms are paying attention to the profitability of partners' practices, not just their books of business. Since the recession, consultants say, firms have been forced to operate more like businesses in which every line item on their budget matters. That means simply making money isn't enough. Practices must be efficient and realization rates matter — a scenario only intensified in a low-growth market.

“Historically, most firms were, and still are, top-line oriented,” says Altonji. “They look at your book of business [when determining compensation.] I have to tell you, not all dollars were created equal.”

Profitability, in particular, has become a focus of compensation committees. Some firm leaders say they are generally taking more data into account when measuring a partner's performance.

“We are looking at using more analytics rather than anecdotal evidence,” says McDermott Will & Emery chairman Ira Coleman. When determining compensation, the firm “look[s] at all the clients this person touched or all the lawyers and professionals this person brought in to help the clients.”

Compensation and Culture

Having an open compensation system makes the firm's decisions about who makes what much more consequential.

“Because it's transparent, in addition to just deciding what each partner's compensation is, we're sending messages to all the partners as to what is being rewarded,” Weil's Wolf says.

But a chair whose firm has a closed system makes the case that if partners don't know their colleagues' compensation, they spend less time worrying about who makes what. A closed system is beneficial to culture because resentments are less likely to build, he says.

Decisions about every aspect of partner compensation from how to award points to who gets to see the final breakdown have an impact on another, more nebulous concept that law firm leaders love to talk about: culture.

“Compensation drives culture by far more than any other attribute,” says the chairman of a top Am Law 100 firm.

Culture and that historical understanding of the definition of partnership are often what have kept law firms from radically altering compensation or partnership structures. But they have also contributed to overcapacity at many firms.

If an Am Law 200 firm started anew today, would it be structured like the rest? The shifting partner compensation models are testing the bounds of a law firm's culture in the face of the business realities of running a partnership akin to a Fortune 1000 enterprise.

*****
Nell Gluckman writes for The Am Law Daily, an ALM sibling of this newsletter. She can be contacted at [email protected] or on Twitter @NellGluckman.