26% of Your Profitability Is In Your Hands

Questions for your managing partner, executive committee, and executive director:

Is your  firm as profitable as it could be?   How does it measure up vis-a-vis its peer group?  And what defines that "peer group," precisely?  Do you ever wonder what you could do to improve its margins?  Structurally or strategically, precisely what would that entail?

If you're reasonably typical, the answers are:

• In all honesty, probably not
• I'd rather not comment
• Uuuuh, instinct; we know them when we see them
• All the time
• If I knew, I'd change my answers to #1 and #4

The rest of what you're about to read won't answer those questions, certainly not in any glib and snappy way, but read on if you'd like to learn about some ground-breaking empirical research into the structure and profitability levels of the AmLaw 200.

What follows is a highly selective and distilled excerpt of and extrapolation from a paper forthcoming in the University of North Carolina Law Review (84 N.C. L. Rev. __ (2006), draft version available at SSRN), by my good friend Prof.  William Henderson of Indiana University Law School at Bloomington. 

The paper is titled "An Empirical Analysis of Single-Tier vs. Two-Tier Partnership in the AmLaw 200," and among a host of other fascinating findings is the creation of a statistical model attempting to explain the level of Profits per Partner (the "dependent variable," in statistics-land) based on an extremely limited number of quantifiable factors (the "independent variables").

If you were creating such a model, what would you nominate for your universe of independent variables?  What, in other words, drives PPP—what is most relevant and determinative?

Brainstorm for a moment. [...]

Time's up.

• Leverage?  Defined strictly as [total # of lawyers/# of equity partners].  Yes; it's in the regression analysis, although with a counter-intuitive and surprising caveat.
• Average billable hours per lawyer?  Yes again.  (That was an easy one.)
• Whether the firm switched to a two-tier model in the past decade in order to boost reported PPP?  Sorry.
• "Prestige" of the firm, based on annual Vault and American Lawyer surveys?  Yes again.
• Size of firm?  Bzzzz; nope.
• How about "associate satisfaction," as measured annually the The American Lawyer, which tracks such measures as open-ness about firm finances, candor about prospects for partner, and a firm's commitment to professional development?  Yes; but see my remark about leverage.
• Percentage of lawyers who are in New York?  Yes—so let's hear it for the home town.
• Composition of practice areas?  Not in the equation, partly because it's not readily quantifiable.

This leaves us with five independent variables:

• Leverage
• Average hours billed
• Prestige
• Associate satisfaction, and
• % of lawyers in NYC

Together, these five variables explain three-quarters (74.2%) of firms' profitability:

So relatively "immutable" factors, at least in the short to medium term, account for all but 26% of the size of the average AmLaw 200 firm's bottom line in terms of PPP; the most enlightened or brilliant management in the world (plus our fair- and foul-weather friend, luck) affect only one-quarter of the average AmLaw 200 firm's results. 

We can say more:  Being above the regression line means your firm is outperforming expectations; being below it, the converse.  Out of a sense of charity, Bill did not identify any firms below the line by name (although if you contact me directly, we can talk...).  On the other hand, some of the firms identified above the line enjoy particular circumstances that explain their unusual performance.  I'll select a few from the top right down (I know it's hard to read, but I have a larger copy):

• Cahill-Gordon:  An outsized presence in junk-bond issuance, plus a notoriously tight-fisted cost control culture.
• Simpson-Thacher and Davis-Polk:  Unbeatable prestige, making them law-firm-land's equivalent of "bulge bracket" investment banks.
• Kirkland & Ellis:  The go-to brand in high stakes litigation, especially antitrust.  (And an unusually canny twist on the two-tier partnership model, which I'll discuss another day.)
• Gibson-Dunn:  Supreme Court practice.

You get the idea:  It is extremely difficult to establish, or sustain, a position "above the line."

The good news is it's less difficult, given enough time and a consistent strategic approach, to move up the line.   To move up the line, you dial in changes in those famous independent variables:  Leverage, % of our lawyers in NYC, average billable hours, prestige,  and associate satisfaction. 

For which of those do you get the biggest bang for the buck?  Back to our friend, the regression analysis.  The following table displays the value, in annual profits per partner, of a one-unit increase in each of our variables.  A few explanations and caveats first:  Remember first and foremost that these are values derived from the entire universe of AmLaw 200 firms.  As they say, "your mileage may vary." 

Second, the meaning of a "one-unit increase" depends on which variable you're talking about.  A one-unit increase in the leverage ratio, or the average number of hours billed, is fairly self-evident, but a "one unit" increase in prestige, and in associates' likelihood of staying for the next two years, reflect the subjective scales on which they were measured.  For "prestige," Vault uses a 10-point scale.  (For example, in 2003, Cravath and Wachtell each scored a stratospheric 8.93, Davis-Polk 8.12, and Simpson-Thacher 7.78.)  For "likelihood of staying," The American Lawyer used a 5-point scale.  Finally, for "% NYC/Global," Bill simply divided the AmLaw 200 into four roughly equal cohorts: 0%; < 10%, 10—50%, and > 50%.  Jumping from one cohort to the next one above is our "unit" increase. 

The envelope, please:

Variable	Single-Tier Firms	Two-Tier Firms
Leverage	$134,854	$42,637
% NYC/ Global	$413,534	$400,618
Likelihood of Staying	[not statistically significant]	-$249,057
Avg. Hours Billed	$35,534	$50,982
Prestige	$340,293	$161,787

The more you think about these numbers (at least if you're like me), the less surprising they are—except for the third row.  This says, beyond a reasonable doubt, that for two-tier firms, the more likely associates judge they will be to stay two years, the less profitable the firm:  And you're taking it in the teeth.  A one-unit increase in associate satisfactions costs you a cool quarter of a million dollars a year. What on earth is going on here?

I have my own theories, which I'll discuss, again, another day.  Suffice for now for me to toss out this (I hope) pregnant thought:  Paraphrasing Tolstoy, "all single tier firms are alike; each two-tier firm is two-tier in its own way."  Single-tier land is a flat, homogeneous landscape.  Two-tier land is heterogeneous geography, full of recently thrust-up peaks and cleaved valleys. 

Posted by Bruce at January 27, 2006 8:15 AM | TrackBack
Posted to Compensation | Cultural Considerations | Finance | Globalization | Leadership | M&A | Partnership Structures | Practice Group Management | Strategy

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