Since 2000, law firm PEPP (profits per equity partner) have increased on average 11% for Amlaw 100 firms and 8% for Amlaw 200 firms.  Some observers fear that, like other markets that have sustained growth periods at or near double digits in the past 10 years, the law firm partner profit "bubble" may soon burst as well.

Looking at Amlaw 200 data, PEPP increased by 2% in 2001.  In 2002, the increase was 7%.  2003 saw an increase of 11%, 8% in 2004 and 2005, and 10% in 2006.

This increase doesn't only apply to Amlaw 200 firms.  Looking at the differences from 2005 and 2006 for the top respondent firms in the Law Firm Economic Survey  by Juris Inc. and LexisNexis, respectively (the only two years available), firm PEPP increased 11%.  It is likely that most firms in the mid-market and small market increased incomes by respectable if not similar percentages over the same period.

What can you do to prepare for a stunt in the growth (or decline) of PEPP?  Bruce MacEwen posted an article May 5th  on his blog Adam Smith Esq., titled A "Bubble" in PPP? that looks at some short term ideas to help "mitigate the downward trend" and predicts a change in the las firm business model over the long term:

Short term ideas:

• Redeploy lawyers in troubled practice areas to healthier ones;
• Use the opportunity of "shared pain" with your key clients to get closer to them;
• Adroitly stand by while the normal waves of attrition take their toll;
• Build or at least safeguard capacity in selected practice areas that you anticipate will emerge strongly from the downturn;
• And always, always, keep a sharp eye on costs–although, truth be told, you don't have much material flexibility here. You're not moving your offices to Brooklyn and you're not paying less than market for partners and associates.

Long term predictions:

• the billable hour, lamented by many but eliminated by few, will eventually replaced with a more "value-based" model, though MacEwen stresses that he is not "holding [his] breath" on this;
• the traditional associate/partner model changes to include more non-equity partners and more contract attorneys;
• at least fundamentally, "the core processes by which law firms manage cases and deals must and will change" (ie, more project management, more team philosophy centered around practice groups to become more efficient).

Ultimately, MacEwen believes that due to increased demand (at least for Amlaw 100 firms), finding work won't be the problem.  However, he sees the traditional model as being unsustainable based on the limits placed on things such as productivity (>2,400 hours?), rates (>$1,000 per hour?)and realization (>100%?).  Because of this, if PEPP does suffer a downturn for an extended period of time, the long predicted changes to law firm dynamics may happen.

If this occurs in large law firms, it is incumbent on smaller firms to adapt quickly.  The predictions above are all point towards efficiency that allow firm profits to increase through efficiency rather than increased rates and worked hours.  Much has bee written about the "unmanageability of law firms".  Despite this, firms have continued to make exceptional profits - due in no small part to their enviable margins.  With good management, law firms can see profits that far exceed anything that firms receive currently.   And if partner profits start decreasing, your firm will be in crisis -  just as it is not a good idea to go to the grocery store on an empty stomach, it isn't a good time to contemplate an overhaul in processes during a crisis.

Much of the allure of smaller firms is quality service at a lower price.  Some large firm partners charge rates in excess of $1,000 per hour.  If large firms realize they can offer similar services at lower prices and still increase profits, smaller firms can be squeezed out of the marketplace.

Think Walmart.  As Walmart entered the scene, small businesses were unable to compete based on their lack of purchase power.  Walmart could offer more product selection at a lower price.  Home Depot and Lowes did the same to small hardware stores.  The small shops that survived did so by using their secret weapon - customer service and personal engagement.  Still, you won't find many of these shops who don't struggle on a monthly basis and have to watch as their clients often come to them for advice, then go to Home Depot to buy the big-ticket items.

For small and mid-size firms to compete in this changed environment, they will have to embrace workflow efficiencies that meet or exceed that of the larger firms - and use their "secret weapons" of personal engagement with clients and responsiveness.  However, without the fundamentals of an efficient business in place, your firm will suffer under the weight of your processes.  

There will always be individual clients available, but more dependable sources of income often come from business clients and their leaders.  These clients are already demanding more cost certainty.  If larger firms are able to provide this value to business clients first at a price that isn't so different than yours, your firm may be in trouble.

The time to act is now.

Related posts

• Survey Targets Business Development In Law Firms
• Reflections on the 2007 ALM Billing Rates & Practices Survey
• Law Firms with Non-Lawyer Management Achieve Higher Per-Partner Incomes
• Law Firm Survey Shows Link between Leverage and Partner Income
• Law Firm Business Model: Margin

This is the second in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis.  The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability.  This article is focused on pitfalls of some firms' methodology in allocating costs to partners.

Some firms have chosen to exclude costs all together from billable hours worked by partners.  Generally it has been requested for one of two reasons: the firm would like to keep actual partner compensation out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where partner compensation is simply a distribution of firm profits.  While this methodology does accomplish those goals, from a client profitability perspective, it introduces its own set of issues.   

What results is a model where client profitability is maximized by only using partners to perform the billable time.  In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% margins.  Any hour that the Associate performs for a client will in essence drag down that client’s profitability and a matter manager might be tempted to use a Partner where an Associate would suffice in an effort to ‘game’ his clients profitability.  This is contrary to the proper use of leverage and economic theory which would have the partners working on tasks for which lower level timekeepers are not qualified such as originations and the management of matters and attorneys.  For this reason alone, there needs to be some cost associated with each billable hour of a Partner’s time, if not for any other purpose than to represent the opportunity cost of them not performing these other tasks.  Besides, every firm that we have encountered expects their partners to perform a certain quantity of billable hours for their clients which would imply that some of their compensation should in fact be allocated to the client.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$0	100%
Dept. Manager	$500M	$200	$0	100%
Associate	$80M	$100	($44)	66%

 

 

 

 

 

 

 

 

 

Another methodology that has been requested in an effort to support a closed compensation is what we call a fixed (or capped) partner cost.  In this scenario, every partner is given the same direct costs.  Aside from the privacy of actual compensation, firms make their case by stating that above a certain point, all partner compensation is for contributions besides the billable hour.   However, since billable rates vary significantly even in the upper echelons of partners, it is hard to justify those hours having the same cost rate.  Regardless, like the methodologies we have already examined, this too creates some unfortunate outcomes. 

The biggest concern with this methodology is the reversed leverage that it creates (similar to having no costs at all).  In the example illustrated below, we see a firm that has chosen $270,000 as the partner direct costs.  Any partner whose compensation exceeds this threshold has their compensation limited and as a result, all have a $150 cost rate for their time.  The result is that the highest rate timekeepers have the highest profit margin, 40% in the case of the Rainmaker, while those with lower compensation, like the Jr. Partner, have minimal (or zero) profit margin for their work.  Certainly, the cost to the firm for these 3 timekeepers is not the same.

The alternate version (and preferable to the former) is to use the dollar amount as a limit to partner compensation and not a flat amount for every partner.  In the example below, we see the Jr. Partner whose actual compensation is below the $270,000 mark.  In the fixed methodology his profit margin is 0% but if it were capped, his direct costs would be his actual compensation and therefore would have a more favorable profit margin of 44%. This still does not relieve the cost similarity between the Dept. Manager and the Rainmaker but it is a slight improvement over having all partners at one cost rate.  Of course this methodology does not meet the requirements of a closed compensation system (unless the firm is primarily interested in the privacy of Sr. Partner compensation).

 

Role	Compensation	Std Rate	Fixed Cost	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$270M	($150)	40%
Dept. Manager	$500M	$200	$270M	($150)	25%
Jr. Partner  (Fixed)	$150M	$150	$270M	($150)	0%
Jr. Partner  (Capped)	$150M	$150	$270M	($83)	44%

 

 

 

 

 

 

 

 

 

 

 

 

The next installment will focus on better ways to calculate partner cost in measuring client profitability.

 

Related posts

• Client Profitability: What Is The Cost Of Partner Time?
• Why Law Partners Hoard Work?
• What Corporate Clients Read Into Law Firm Bills
• Measuring Your Law Firm's Billing Cycle
• Working with the Law Firm Business Model to increase income

ALM Research recently released the 2008 Law Firm Business Development Practices Survey, which targets two "tiers" of law firms:  those listed in the AmLaw 200, The Global 100, and the NLJ 250 (Tier 1) and those not listed (Tier 2).   Though the survey is mostly focused on large firms, the average number of attorneys for Tier 2 firms was 85, within the higher range of the mid-market. 

Business development is difficult to assess in mid-size firms simply because many don't track it.  However, firms do see the importance.  In the 2007 Law Firm Economic Survey by LexisNexis, 25% of respondents claimed business development was the best strategy to improving profitability, second only to increasing rates.  Likewise business development is one of the 5 highest rated factors for financial growth in the ALM survey.  The extent to which these activities are tracked and measured will determine the extent to which firms can gauge the effectiveness of their methods.

Some other key findings:

• More firms are dedicating resources to business development that are separated from a marketing role;
• Budgets for business development have increased over the past year;
• Around 50% of respondents employ client interviews and surveys (the highest rated business development activity among respondents);
• Just under 50% employ "client service teams" focused on clients who generate the most revenue;
• Over 50% receive some sort of sales training;
• Nearly a third of Tier 2 firms reported that they were "not sure" if revenues increased, decreased or remained flat in the past year.

The last finding listed is surprising.  If your firm is not tracking revenues, there is no way of knowing whether your firm is in trouble financially or not.  Further, you can't accurately forecast if you don't benchmark.   The importance of measuring performance can't be emphasized enough. 

The above is just part of the findings of the survey.  To purchase the survey, visit the ALM Research site by clicking here.

Related posts

• The Case Against Income Partners
• Reflections on the 2007 ALM Billing Rates & Practices Survey
• For Long Term Increases To Income, Partners Must Delegate Work
• The End of Generally Accepted Accounting Principles?
• Law Firm Strategic Planning - An Overview Of Models