In Leverage: Friend or Foe of Maximized Profits per Partner I discussed an approach that a firm could use to address the dropping demand for legal work. In short, this approach suggested that a firm could reduce their supply of legal work to match current demand by cutting heads in its most junior ranks, the ranks that produce the lowest $PP contribution. This is simply de-leveraging. By doing so, the firm would ensure sufficient utilization and would generate the highest possible $PP for existing partners . At the same time I also hinted at a second alternative that would enable a firm to deliver greater PP$ than simply de-leveraging.
Previously I had described the firm structure that delivered the highest possible $PP, which I called the Managerial Maximum. In essence, the Managerial Maximum is the highest amount of leverage that a firm can effectively manage. By having the maximum # of associates working (Sr., Jr., etc.) per partner, they are generating the maximum $PP contribution which results in the maximum $PP, assuming 100% utilization. Any deviation from this maximum leverage ratio will deliver lower $PP. (see example pyramid below)
But what should a firm do if demand for legal work decreases and they can no longer maintain 100% utilization? What most firms are doing in today’s environment is de-leveraging, which is taking them away from the Managerial Maximum. I propose that firms should not be making cuts exclusively to lower level associates as the current de-leveraging strategy espouses, ie. cutting off the bottom of the pyramid. Instead I suggest that firms cut the side of the pyramid off, “thinning”, which entails cutting partners and the appropriate ratio of non-equity associates/staff until they reach a point where their supply of legal work matches the demand for legal work. (See example pyramid below)
By adopting this approach to matching supply and demand a firm is also ensuring that the maximum leverage ratio is maintained, which will result in the maximum $PP possible. For a given amount of legal work, this approach will generate more $PP than will de-leveraging. However, it will require cutting into the partner ranks, which may be culturally and politically challenging.
Below is an example that shows the impact to $PP of the different ways a firm can react to a decline in demand.
In the Base Case, demand is 200,000 hours. This firm is fully leveraged and is delivering $4,350,000 PP$.
Now demand has dropped to 140,000 hours and the firm cannot maintain 100% utilization or the Managerial Maximum leverage. The firm can de-leverage, “thin” or a combination of the two in order to increase utilization and improve leverage.
Below is a table that shows the PP$ result of the various lawyer combinations the firm can choose depending if they decide to de-leverage or “thin”.
If the firm chooses to address the decline in demand solely with de-leveraging the PP$ will drop to $3,600,000, however, if they also adopt a “thinning” approach their PP$ can increase back up to the $4,350,000 they had delivered in the past. In a vacuum, my recommendation to this example firm would be to “thin” down to 6 partners as this would permit the firm to stay fully leveraged while matching hours demanded as close as possible to hours worked (ie. supplied).
Overall, there are two ways a firm can react when demand for legal work declines: 1) they can de-leverage or 2) they can “thin”. De-leveraging will deliver the maximum $PP for existing partners, “thinning” will deliver the maximum $PP possible. Note: I recognize the challenges of eliminating equity partners from a firm. This recommendation is strictly the result of objective considerations.
--Scott Nickerson
Scott is an analyst in the Redwood Think Tank.
Posted
Tue, Apr 14 2009 1:02 PM
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