Law Firm Debt Levels Shrink as Partners Put More Skin in the Game

"The debt load carried by firms today is quite a bit different from the debt load that was carried by firms in 2008 and 2009," McKenney says, looking at a sample of 60 law firms in the Am Law 100, which does not include any firms that completed significant mergers or acquisitions in the past 10 years.

Among that sample, he says, bank debt per equity partner was $94,000 at the end of 2008. At the end of 2018, bank debt per equity partner was $57,000 at the same 60 firms.

But on the flip side, McKenney says, capital contributions per equity partner have jumped, from $330,000 in 2008 to $549,000 in 2018. The increase is due in part to law firms' success in recent years, he noted, as capital contributions are often taken as a percentage of a partner's earnings. It's also not as risky as bank debt, McKenney says, because "the only way a call occurs on partner capital is if a partner leaves the partnership. Firms have become much more deliberate about how they respond when a partner leaves the firm."

Of course, under certain circumstances partners are taking on a good bit of risk, as shown by one recent example. At LeClairRyan, which announced its plans to close in August, sources said there were at least 50 partners who gave the firm up to $100,000 for an initial capital contribution and will likely never be repaid.

Legal industry consultant Brad Hildebrandt also notes that law firm lending banks include lending to individual partners, including funds for their initial capital contributions, but that has long been the case.

As McKenney notes, part of the shift toward partner contributions has been driven by overall strength in the economy in more recent years.

"Because profits have been pretty strong in the last three years, firms have been in a good position to call in capital from their partners," Hildebrandt says.

Meanwhile, some firms are holding back from distributing the fruits of a good year, using that as another source of capital, according to McKenney. He says undistributed income represented about 11% of law firms' total assets in 2008. That has doubled to 22% in the decade since, he says.

On the whole law firms' changing attitudes surrounding debt is a good sign, McKenney says. "In my view, firms have significantly improved their balance sheets. It leaves them more resilient in the event of a downturn than they were last time around," he says.

Lessons Learned

The recession was followed by half a dozen high-profile law firm collapses within just four years. In the aftermath, it became clear that some were carrying tens of millions of dollars of bank debt. See, "30 Years of Law Firm Collapses: An Annotaed Timeline," The American Lawyer (Oct. 29, 2019).

"Every time there's a major dissolution, people get nervous about debt because the banks tend to be tough about loan repayment," says Hildebrandt, who has been a trustee on a number of law firm dissolutions. Law firms willing to take on more debt are far fewer in number than they once were, he says.

"When you have a cataclysmic event like a financial crisis, there obviously were lessons learned," says Jay Benegal, a senior vice president and legal industry specialist at Citizens Commercial Banking.

Change is sometimes difficult to come by in the law firm environment, where decision-makers must get buy-in from numerous partner stakeholders, he sas. But something like a recession can be an "impetus for change."

In recent years, that change has been a move away from borrowing. Law firms even use debt-free status as a way to attract lateral hires, Benegal notes. Bank debt has become "something firms think about after they've exhausted all their other options of satisfying their capital needs," Benegal says.

McKenney says some law firms found themselves in a bind during the Great Recession because of their reliance on demand lines of credit, or uncommitted credit. Under those agreements, lenders were able to call for repayment or refuse to lend further. More firms have shifted toward committed credit, McKenney adds.

And, as Citi's numbers show, they're looking to other sources of capital, including partner contributions and undistributed income, he says.

Those options also include, simply enough, making a more continual year-round push for collections to keep cash flowing in the door, Benegal says. He says law firms have also become more open to selling their receivables, turning to litigation funding entities to make those deals, though they have not wanted to openly advertise that they're doing so.

Still, McKenney hasn't seen a great increase in selling receivables among law firms, and he would estimate that only a handful of Am Law 100 firms will be completing those transactions at year-end. He cautions that selling receivables one year may handicap firms in the next year, unless they know of other upcoming events that will fill the gap.

In general, McKenney says, firms are "much more favorably positioned" now than they were before the Great Recession.

"Firms are more profitable now than they were in the last recession," he says, and they're "much more thoughtful" about sources of capital.

At the same time, he cautions that the fallout of any downturn still comes down to "a question of demand," and firms that see their hours drop are going to experience stress. With regard to lessons learned from the last recession, he says firm leaders must make transparency a priority and, when this happens, be "open and candid" with partners about the firm's performance.

"When I think about the law firm failures that occurred during the recession and post-recession, a lot of those failures occur because partners start to leave and it starts to spiral," McKenney says. "In many of those firms, leadership was holding information very tightly, very closely. And, when the status of the firm became known, there's a flight."

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Lizzy McLellan writes about the business of law for ALM. She can be reached at [email protected], and on Twitter @LizzyMcLell.