Two-Tiers Increase PPP? A "Moneyball" Analogy from Prof. Henderson

I had an interesting conversation with Prof. Bill Henderson, who recently authored an empirical study of single-tier versus two-tier partnerships in the AmLaw 200.   I summarized his presentation in an earlier post.  Essentially, Bill's paper found that:

• two-tier firms experienced lower profits per partner than single-tier firms, adjusting for all pertinent variables, in all market segments;
• two-tier firms nevertheless had higher leverage; and
• two-tier firms were less "prestigious" (based on Vault surveys) than single-tier.

Bill is willing (indeed, eager, to hear him tell it) to have the thrust of his paper scrutinized by AmLaw 200 lawyers.  Yet, Bill reports that many of the skeptical comments he's received from lawyers are at odds with what the data actually shows. 

This is where it gets interesting:  “To what extent,” Bill asked me, “Is my interpretation of this data a law firm analogue to Moneyball?”

For those of you who don’t follow baseball (which I don't, really, until September), or who don't follow the writings of Michael Lewis (which I do, passionately), Moneyball is the title of a renowned book by Michael Lewis that chronicled how Billy Beane, the general manager of the Oakland Athletics, used detailed statistical analysis to identify inefficiencies in the market for baseball talent.   Specifically, Moneyball elaborates on how Beane decided that certain factors major league teams typically paid very very good money for, based on scouting reports and other traditional information sources, were simply not cost-justified based on how players with those attributes performed.

In other words, Beane identified a disconnect between the conventional wisdom and what the statistics on player performance actually showed.  As a result, he was able to assemble consistently winning Oakland A's teams for years on a relative shoestring budget.

Beane's reward?  Scouts, other team managers, the baseball press, and other baseball insiders sneered at Beane’s numbers-driven approach even after the A’s fielded a championship caliber team on one-third the budget of their large market rivals.  (Lewis discusses the Billy Beane story in this excellent NPR interview.)  The scouts et al. couldn't contradict Beane's data (baseball, as we know, is as data-intensive a sport as there is); they could just denigrate his approach, without offering an alternative approach of their own consistent with the same data.

The advantage of statistical modeling (a technique that is utterly mainstream in finance and biomedicine) is that we can go beyond well-reasoned theories—the lawyer’s greatest strength—into the realm of falsifiable hypothesis.

Here is a simple example.  Bill asks, “What are the determinants of a firm having one versus two or more partnership tracks?”  Using multivariate regression to predict the tier structure, Bill includes four variables (i.e., possible determinants) in his model:

1. Percentage of lawyers in New York .  Single-tier status may be influenced by cultural factors that are more common in New York. After all, New York still has a disproportionately large concentration of single-tier firms.
2. Firm size.  As a firm gets bigger, a two-tier structure can improve the monitoring of nonequity partners and reduce admission mistakes into the equity tier.
3. Profitability.  Lower PPP presumably puts pressure on the firm to limit the number of equity partners, thus necessitating a non-equity track.
4. Prestige.  Firms with lower indices of prestige have a harder time (a) attracting clients based on firm reputation, (b) and recruiting capable associates and laterals. A nonequity tier can thus reduce harmful attrition and consolidate the power of rainmakers—who might otherwise leave the firm.

Remarkably, prestige, as measure by the Vault rankings, was the only variable that emerged as a statistically significant predictor of tier structure (and it is highly statistically significant—less than a 1 in 20,000 chance that the pattern occurred by random chance).  The other three theories had NO empirical support.

So are most lawyers like the disbelieving scouts in Moneyball?  In the Adam Smith poll on switching to two-tiers, the most common reason for switching to two-tiers is “To retain valuable associates we would otherwise have had to lose.” 

But what’s driving this perception?  Prestigious single-tier firms, like Cravath or Sullivan & Cromwell or Covington & Burling, are—to judge by their behavior—unconcerned about this cost.  To the contrary!  Another of Bill's findings is that, at a very high level of statistical significance, every rating of "associate satisfaction" (likelihood of staying two years, "family friendliness" of the firm, transparency of firm finances, communications with partners, straight talk about career prospects) is strongly negatively correlated with profits per partner. 

Or, as one of my correspondents succinctly put it:  "The more I'd like to be partner at firm X, the less I could stand being an associate there."  Precisely.

So why does any associate put up with this?  In hopes of winning the partnership "tournament" in a very prestigious firm.  In contrast, a less prestigious firm may need a non-equity tier to mitigate harmful attrition.  The non-equity tier provides more of a "lifestyle" choice to associates who would wash out of single-tier firms on quality or productivity grounds, or who simply don't have the client-development skills needed in any AmLaw 200 firm.  Why don't firms solve the attrition problem simply by promoting all excellent technicians to equity partner?  Obviously, because that would upset the firm’s financial ratios and impair the loyalty of its rainmakers. 

Citing these dynamics, Bill claims that non-prestigious single-tier firms are “inherently unstable,” and thus Bill believes that his theory explains the massive migration to the two-tier format over the last two decades.  (In 1985, essentially the entire AmLaw 100 was single-tier; today, 80% of the [expanded] AmLaw 200 is two-tier.)

So we return to the Moneyball question:  If you agree with Bill's theory, let me know.  If you disagree, also let me know—but tell me what your alternative theory is for the two-tier migration, and, most importantly, make it comport with the existing data. Professor Henderson is more than willing to test any alternatives.