"Never Mistake a Bull Market for Brains," Or How Healthy is Your Firm Truly?

In my last post, I referred somewhat obliquely to "long-term threats to the privileged positions" of firms, pointedly including large and prosperous firms (not just the struggling, the stragglers, and the stagnant).  What exactly might those threats be?

Hildebrandt and the Citigroup private bank, in their annual year-end wrap of 2005, point towards many of the answers.  I've taken the liberty of highlighting the subjects I find most noteworthy, and since it's always easier to cite the prognostications of others as a premise to advancing one's own opinion, I intend to do so liberally. 

First of all, despite 2005 showing healthy growth over 2004 in both revenue and profits per equity partner, the rate slowed appreciably from the CAGR (compound annual growth rate) of the 2000—2004 period.  Nor do Hildebrandt and Citigroup view this as a temporary aberration:  "Notwithstanding the solid economic performance of most firms, there were signs in 2005 of growing pressures on the bottom line."

The most unsettling such "pressure" is the finding that, among the 30 most profitable firms in the country, realization rates actually declined—and among other firms they were at best flat.  Declining realization is symptomatic of firms' over-reaching in billing and/or of clients' pushing back harder:   Choose your poison, but neither of those is an auspicious leading indicator of financial performance in 2006.  Indeed, I view declining realization as virtually synonymous with restive clients or substandard work:  Either or both would be alarming.

Second, M&A among US law firms (not to be confused with M&A/deal work done by law firms!) accelerated dramatically.  While there were only two more completed acquisitions in 2005 than in the prior year (49 vs. 47), the attention-getting figure is that the average size of the "acquired" firm more than doubled, from 30 lawyers to 67.

Third (and this is where it gets really interesting), "analysis shows that the profits per equity partner of the 30 most profitable firms in the US are more than double those of other firms," and that the gap is widening as the leaders pull away from the pack (emphasis supplied).  Hildebrandt and Citigroup conclude—prematurely, in my view—that firms that have not already broken into the top economic tier "are highly unlikely to do so."

To be precise, our disagreement is one of shading and nuance, not one of black and white.   I believe firms with a potent, well-defined strategy, led by tenacious and determined management, can still excel no matter where they rank today.  (And the converse is true, as we have witnessed with the demise of several storied names.) 

But for most firms watching the leading pack accelerate into the distance, the observation is surely true that presuming and proclaiming that they'll catch up is unrealistic and only results in discontent within the partnership when the improbable prediction continually fails to come true.   These firms need to take a long, hard look in the mirror:

"There is an economic ladder in the legal market that has many rungs; finding the right one for a particular firm requires strategic focus and a healthy dose of realism."

Fourth, the attitude and perspective of Fortune 1000 General Counsel have changed markedly in just the past five years.  Now, global capability and "critical mass" are seen as essential to even have a seat at the table for many transactions, whereas those characteristics were not high on the priority list in the past.

Corporate counsel are also continuing to winnow their rosters of outside firms, with the average number of firms with whom they do business decreasing and the percentage of total outside fees paid to the top-billing law firms increasing.  Fully 60% of those surveyed say they are actively pursuing this increased "convergence."

Fifth, and next to last, I want to identify two developments that I view conceptually as different sides of the same coin, although Hildebrandt and Citigroup portray them as discrete:  The increased use of contract, or temp, lawyers, and the very different bargain that today's Gen Y associates expect to strike with their firms (different, that is, compared to the "work hard so as to have a shot at partner" bargain of the Gen X'ers and the Boomers).

Why are these connected?  They're both about the war for talent, and they're both about how to supply the bodies needed to do the grunt work if the ready ranks of mid- and senior associates toiling in indentured servitude can no longer be as readily taken for granted.  Interestingly, to keep Gen Y'ers engaged, firms have invested more heavily than ever in professional development programs, including the unprecedented (and deeply admirable) formal law firm/business school partnerships we've seen with the likes of Reed Smith/Wharton, and DLA Piper/Harvard.

Up to this point you may find yourself thinking, "Sure, there are challenges out there, 'twas ever thus, but we've dealt with them before, in the ordinary course as it were, and we'll deal with them now.  What's this 'long-term threat' MacEwen is talking about?"   It's this:

"During the past year, Hildebrandt consultants came across a number of firms that were doing quite well financially, but on many other measures (partner morale, internal trust, teamwork) they were failing and appeared very fragile. ... [T]here have been disturbing signs that a number of well-performing firms may be more fragile than they appear on the surface."

Add to this one of the key findings of a 2004 study of law firm dissolutions, and you may find yourself coming upon a suddenly-sobering perspective. And that finding was? That most firms that dissolve do so in a year when their revenues are at an all-time high.

Citigroup characterizes a firm's financial performance as a lagging indicator of overall health—and only a small minority of law firm failures are attributable to insoluble financial problems.  Most are caused by a collapse of partner confidence: 

"The seeds of collapse are generally sown long in advance of the actual dissolution – in most cases, even long before the firm begins to noticeably decline. It is clear that a firm’s unwillingness or inability to confront tough issues is an overarching reason for failure and one of the primary reasons why partners lose faith in their firm.  Too often, firms recognize their issues, including partner dissatisfaction, but only act after a “catalyst event” takes place. For most, this is too late."

In other words, it's not (primarily) about the money.  People—especially highly motivated, competitive, critical, analytic Type A's—need to feel there's purpose to their work, a vision at the firm, and that they're doing challenging work in a supportive environment that permits them to feel a genuine sense of accomplishment. As they conclude, "Law firm leaders - even leaders of economically successful firms - ignore these realities at their peril."

On reflection, how could it be otherwise?  Although they don't appear on your balance sheet as assets,  people are indeed the only material asset your firm has—everything else is, both in the economic sense and the securities-law sense, "immaterial." Under the calm surface of prosperity, there can be roiling currents.