There has been a significant amount of debate on the subject of leverage over the past few weeks, and there appears to be some passion around the concept. Articles have attempted to show that it does not work, while others tout its value. My belief is that regardless of economic conditions, more leverage is better than less leverage if the end goal is generating the maximum possible Profit Per Partner ($PP).
In order to discuss leverage, it is important to establish some groundwork, so that we can build examples to illustrate key points.
All examples discussed assume 100% utilization unless otherwise noted. There are many variables in the leverage equation, so in order to keep things orderly and understandable some of the variables, such as utilization, will be kept fixed until it makes sense to free them up.
Leverage is defined in several ways depending on who is discussing it. For this discussion we don’t get into specific leverage ratios, so a standard mathematical definition isn’t required, however, we do need to establish the upper and lower extremes of leverage.
The lower limit of leverage (ie. the least leveraged) is a firm that is made up of one partner and no associates. The maximum Profit per Partner ($PP) that can be generated in this case is however much the one partner can bring in.
In order to determine the upper limit of leverage (ie. the most leveraged a firm can be) we need to consider the main constraint that limits leverage, managerial effectiveness. There are other relevant constraints that limit leverage but for now we are assuming that we can find associates to hire and offices for them to sit in. Managerial effectiveness is simply the measure of how many people each level at a firm can manage effectively while still delivering on their other responsibilities. In our examples we are assuming a partner can effectively manage 3 Sr. Associates, and a Sr. Associate can effectively manage 1.3 Associates and 1.7 Jr. Associates. When a firm is structured so that each level is managing their effective maximum number of subordinates and they have in place all levels that are applicable (ie. Partner, Sr. Assoc., Assoc., Jr. Assoc.), the firm is considered fully leveraged and will be generating the maximum possible amount of $PP.
Why is this true? Because each incremental non-partner employee will bring in some incremental $PP given that their billing rate is higher than their cost rate and utilization is at 100%. This structure has the maximum number of employees bringing in their maximum $PP contribution, which generates maximum possible $PP. This is the upper limit of $PP, the upper limit of leverage and I refer to it as the “Managerial Maximum”. If firm structure was viewed in the shape of a pyramid (shown below), it would be the size and shape that maximizes $PP. There would be no other size or shape (ie. structure) that could deliver more $PP and in fact, most changes to the structure would negatively impact $PP.
Note: There are a variety of reasons why this theoretical “Managerial Maximum” may not ever be reached, but it provides a yardstick to measure other potential structures against. Regardless, given 100% utilization, more Leverage will generate greater $PP than will less Leverage.
The above pyramid displays the organizational structure that will generate the greatest $PP given sufficient hours demanded to deliver 100% utilization. But what happens when hours demanded declines and the firm can no longer maintain 100% utilization? This situation is what many firms today are facing and there are two conceptual approaches to how they can handle this. In both approaches, firms are attempting to better match their supply of legal work to the newly lowered demand for legal work.
Approach #1: De-leveraging
This is the approach that most firms have chosen during these down times. In de-leveraging, a firm pulls work back from some levels (and reduces headcount) in order to keep other levels fully utilized. In this example and in reality, it is usually the case that the higher on the pyramid a fee earner is, the more $PP per hour they are generating. That is, a Sr. Associate will generate more $PP for an hour worked than an Associate will, etc. Because this relationship exists, the optimal approach to leveraging is to always have work done by the highest level in the organization and only push it down to lower levels after higher levels have reached capacity. And when de-leveraging, the optimal approach is to pull work back from lower levels first in order to keep higher, more profitable levels fully utilized.
Note: This exercise is ignoring the impact of billing rates on demand for hours and the fact that legal work is not always fungible, but in the interest of gaining a conceptual understanding in a perfect world, this is how a firm would roll out and roll back leverage.
In the pyramid below, the color of the lowest level has been changed to indicate the removal of work and the reduction in headcount. This approach to leverage, both increasing and decreasing will generate the maximum $PP possible, for the hours demanded, for the group of
existing Partners.
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As I have explained the optimal approaches to leveraging and de-leveraging, I have been very careful to emphasize that optimal leveraging will maximize $PP for existing partners. Earlier in this blog I had presented a theory that the upper limit of $PP would be achieved only when a firm was leveraged to its “Managerial Maximum” and any deviation from this point would deliver lower $PP. Therefore the approach that most firms are taking, de-leveraging, is taking these firms further away from their “Managerial Maximum” and as a result they are leaving incremental $PP on the table. Later this week I will propose a strategy (Approach #2) that will permit firms to match their supply of legal work to existing demand while also chasing the more profitable “Managerial Maximum” and will permit them to recapture some of the $PP they left on the table when they de-leveraged. In the meanwhile, I welcome your comments.
–Scott Nickerson
Scott is an analyst in the Redwood Think Tank.
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