Leverage: Friend or Foe? (Or Noncombatant?)

According to The Recorder,

"Law firm leaders throughout California identify increasing leverage as a key strategy in their business model."

We are here to ask the time-honored question, "What can they be thinking?"

Let's back up.   Common sense would tell you that in a labor-intensive service industry, where revenue is driven primarily by sheer tonnage of hours worked, the higher the ratio of associates (and non-equity partners) to (full equity) partners, the higher the revenues and thus the profits per partner.  Right?  It turns out this is one of those cases where it's not as simple as it seems.  The beauty of what we're starting to learn about leverage is that the knee-jerk assumption (which held good, or at least held unchallenged, until just the last few years) that more leverage was a per se good is at long last submitting to quantitative analysis, which in turn enables us to ask subtler and more probing questions about what's really going on here.

For the skeptics in the audience, I submit two charts.  This from The Recorder:

...which is fairly self-explanatory.  Just doing the math, it tells the following story:

High leverage firms "enjoy" more than twice as much leverage as the low leverage firms, and for this they are rewarded with profits per partner not even one-third as rich.  [Granted, these firms were presumably not selected at random, but if the proposition under debate is whether more leverage is a per se good, proponents of that view have some explaining to do.]

And this from my friend Professor Bill Henderson:

Bill developed this data series for a slightly different purpose, but it serves ours nicely nevertheless.  He was exploring the relationship between leverage and the profitability of single-tier vs. two-tier partnerships, and at the same time adjusting for the (important) variable of what proportion of a firm's lawyers are in New York or "global" cities (read:  London, Paris, Hong Kong, Frankfurt, Brussels, Singapore, Tokyo, and Beijing). 

As you can see, across the board single-tier firms have lower leverage than two-tiers in the same market cohort, yet single-tiers are consistently more profitable (on a PPP basis).   Other factors turn out to far out-weigh the blunt instrument of leverage in determining profitability.  After all, some of the most highly leveraged work of all in law-land is commodity stuff like residential real estate closings and mortgage refinancings.  Do you still think "increasing leverage [is] a key strategy"?  Be my guest.

But wait, there's more! 

Leverage varies intrinsically with the nature of a firm's areas of practice concentration.  Litigation, especially big-bucks trench warfare litigation, is innately highly-levered as associates can be drafted into document production and review almost as massively as the Western Front consumed recruits in 1918.    High-stakes tax, private equity, and venture funding, by contrast, serve clients who by and large want a partner across the table or on the phone, so leverage opportunities are few. 

Then there's the evil twin of high leverage:  Low utilization.  It doesn't help that your leverage ratio is through the roof if nobody's busy; indeed, welcome to the worst of both worlds.

Of course, if the work is there for the taking, it's nice to be able to add capacity to handle it.  DLA Piper's co-managing partner in the US, Terence O'Malley, thinks he's noticed that "firms are focusing more on matching staffing with work flows and adjusting more quickly to surges in work by hiring laterally. DLA, for example, has hired upward of 100 lateral associates this year."  If you read this the same way I do, you wonder whether such rapid-response staffing flexibility isn't a double-edged sword.  How long would DLA (or any sophisticated firm) carry inactive associates when the work flow stops?

So where does this leave us on leverage?

We'll give my friend Rich Gary the last word (emphasis supplied):

"While leverage is a part of a law firm's overall health, using it as a measurement of success can be overrated, said consultant Richard Gary.

"In and of itself, it doesn't tell you a lot about a firm -- it's probably a symptom of something else," he said. "It's dependent on a lot of things."

Next time someone is selling your firm the elixir of leverage, sharpen your pencils.