Make More Rain : economic outlook, policies/ procedures

Law Firm PEPP "Bubble" To Burst?

Admin — Fri, 09 May 2008 07:00:24 GMT

Since 2000, law firm PEPP (profits per equity partner) have increased on average 11% for Amlaw 100 firms and 8% for Amlaw 200 firms. Some observers fear that, like other markets that have sustained growth periods at or near double digits in the past 10 years, the law firm partner profit "bubble" may soon burst as well.

Looking at Amlaw 200 data, PEPP increased by 2% in 2001. In 2002, the increase was 7%. 2003 saw an increase of 11%, 8% in 2004 and 2005, and 10% in 2006.

This increase doesn't only apply to Amlaw 200 firms. Looking at the differences from 2005 and 2006 for the top respondent firms in the Law Firm Economic Survey by Juris Inc. and LexisNexis, respectively (the only two years available), firm PEPP increased 11%. It is likely that most firms in the mid-market and small market increased incomes by respectable if not similar percentages over the same period.

What can you do to prepare for a stunt in the growth (or decline) of PEPP? Bruce MacEwen posted an article May 5th on his blog Adam Smith Esq., titled A "Bubble" in PPP? that looks at some short term ideas to help "mitigate the downward trend" and predicts a change in the las firm business model over the long term:

Short term ideas:

Redeploy lawyers in troubled practice areas to healthier ones;
Use the opportunity of "shared pain" with your key clients to get closer to them;
Adroitly stand by while the normal waves of attrition take their toll;
Build or at least safeguard capacity in selected practice areas that you anticipate will emerge strongly from the downturn;
And always, always, keep a sharp eye on costs--although, truth be told, you don't have much material flexibility here. You're not moving your offices to Brooklyn and you're not paying less than market for partners and associates.

Long term predictions:

the billable hour, lamented by many but eliminated by few, will eventually replaced with a more "value-based" model, though MacEwen stresses that he is not "holding [his] breath" on this;
the traditional associate/partner model changes to include more non-equity partners and more contract attorneys;
at least fundamentally, "the core processes by which law firms manage cases and deals must and will change" (ie, more project management, more team philosophy centered around practice groups to become more efficient).

Ultimately, MacEwen believes that due to increased demand (at least for Amlaw 100 firms), finding work won't be the problem. However, he sees the traditional model as being unsustainable based on the limits placed on things such as productivity (>2,400 hours?), rates (>$1,000 per hour?)and realization (>100%?). Because of this, if PEPP does suffer a downturn for an extended period of time, the long predicted changes to law firm dynamics may happen.

If this occurs in large law firms, it is incumbent on smaller firms to adapt quickly. The predictions above are all point towards efficiency that allow firm profits to increase through efficiency rather than increased rates and worked hours. Much has bee written about the "unmanageability of law firms". Despite this, firms have continued to make exceptional profits - due in no small part to their enviable margins. With good management, law firms can see profits that far exceed anything that firms receive currently. And if partner profits start decreasing, your firm will be in crisis - just as it is not a good idea to go to the grocery store on an empty stomach, it isn't a good time to contemplate an overhaul in processes during a crisis.

Much of the allure of smaller firms is quality service at a lower price. Some large firm partners charge rates in excess of $1,000 per hour. If large firms realize they can offer similar services at lower prices and still increase profits, smaller firms can be squeezed out of the marketplace.

Think Walmart. As Walmart entered the scene, small businesses were unable to compete based on their lack of purchase power. Walmart could offer more product selection at a lower price. Home Depot and Lowes did the same to small hardware stores. The small shops that survived did so by using their secret weapon - customer service and personal engagement. Still, you won't find many of these shops who don't struggle on a monthly basis and have to watch as their clients often come to them for advice, then go to Home Depot to buy the big-ticket items.

For small and mid-size firms to compete in this changed environment, they will have to embrace workflow efficiencies that meet or exceed that of the larger firms - and use their "secret weapons" of personal engagement with clients and responsiveness. However, without the fundamentals of an efficient business in place, your firm will suffer under the weight of your processes.

There will always be individual clients available, but more dependable sources of income often come from business clients and their leaders. These clients are already demanding more cost certainty. If larger firms are able to provide this value to business clients first at a price that isn't so different than yours, your firm may be in trouble.

The time to act is now.

Partner Cost and Client Profitability (Part II)

Admin — Tue, 06 May 2008 07:00:21 GMT

This is the second in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. This article is focused on pitfalls of some firms' methodology in allocating costs to partners.

Some firms have chosen to exclude costs all together from billable hours worked by partners. Generally it has been requested for one of two reasons: the firm would like to keep actual partner compensation out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where partner compensation is simply a distribution of firm profits. While this methodology does accomplish those goals, from a client profitability perspective, it introduces its own set of issues.

What results is a model where client profitability is maximized by only using partners to perform the billable time. In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% margins. Any hour that the Associate performs for a client will in essence drag down that client’s profitability and a matter manager might be tempted to use a Partner where an Associate would suffice in an effort to ‘game’ his clients profitability. This is contrary to the proper use of leverage and economic theory which would have the partners working on tasks for which lower level timekeepers are not qualified such as originations and the management of matters and attorneys. For this reason alone, there needs to be some cost associated with each billable hour of a Partner’s time, if not for any other purpose than to represent the opportunity cost of them not performing these other tasks. Besides, every firm that we have encountered expects their partners to perform a certain quantity of billable hours for their clients which would imply that some of their compensation should in fact be allocated to the client.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$0	100%
Dept. Manager	$500M	$200	$0	100%
Associate	$80M	$100	($44)	66%

Another methodology that has been requested in an effort to support a closed compensation is what we call a fixed (or capped) partner cost. In this scenario, every partner is given the same direct costs. Aside from the privacy of actual compensation, firms make their case by stating that above a certain point, all partner compensation is for contributions besides the billable hour. However, since billable rates vary significantly even in the upper echelons of partners, it is hard to justify those hours having the same cost rate. Regardless, like the methodologies we have already examined, this too creates some unfortunate outcomes.

The biggest concern with this methodology is the reversed leverage that it creates (similar to having no costs at all). In the example illustrated below, we see a firm that has chosen $270,000 as the partner direct costs. Any partner whose compensation exceeds this threshold has their compensation limited and as a result, all have a $150 cost rate for their time. The result is that the highest rate timekeepers have the highest profit margin, 40% in the case of the Rainmaker, while those with lower compensation, like the Jr. Partner, have minimal (or zero) profit margin for their work. Certainly, the cost to the firm for these 3 timekeepers is not the same.

The alternate version (and preferable to the former) is to use the dollar amount as a limit to partner compensation and not a flat amount for every partner. In the example below, we see the Jr. Partner whose actual compensation is below the $270,000 mark. In the fixed methodology his profit margin is 0% but if it were capped, his direct costs would be his actual compensation and therefore would have a more favorable profit margin of 44%. This still does not relieve the cost similarity between the Dept. Manager and the Rainmaker but it is a slight improvement over having all partners at one cost rate. Of course this methodology does not meet the requirements of a closed compensation system (unless the firm is primarily interested in the privacy of Sr. Partner compensation).

Role	Compensation	Std Rate	Fixed Cost	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$270M	($150)	40%
Dept. Manager	$500M	$200	$270M	($150)	25%
Jr. Partner (Fixed)	$150M	$150	$270M	($150)	0%
Jr. Partner (Capped)	$150M	$150	$270M	($83)	44%

The next installment will focus on better ways to calculate partner cost in measuring client profitability.

Law Firms Pass On Arbitration In Employment Disputes

Admin — Fri, 04 Apr 2008 07:00:36 GMT

In an article for the upcoming issue of the National Law Journal (NLJ) posted yesterday on their site, law firms are not taking their own advice when it comes to arbitration clauses in employment disputes.

Is this a case of what's good for the goose isn't good for the gander? Why would arbitration be a good idea for other businesses but not good for law firms? The answer brings into question the utility of arbitration.

The arguments for arbitration come from those who have been burned in litigation. Litigation can have you sitting in front of a jury that likely has no experience in the subject matter at hand and may in fact have motives other than the subject matter at hand to deliver a large award to a plaintiff. Arbitrators, on the other hand, are picked from within the industry from which the dispute arises and ostensibly provide a more fair, though equally binding, resolution at less cost than litigation. Where litigation can hinge on perception, arbitration decisions are meant to be grounded in experience-laden fact.

According to the NLJ story, however, only 10% of 200 law firm respondents to a 2003 survey had "mandatory arbitration in place". I assume this means that equity partners were bound by it through the partner agreement and that other employees were bound by it as a condition of employment, though it isn't specified in the article. One reason cited is that arbitration clauses may have a detrimental effect on the workplace. Said a partner with DLA Piper, "Your attorneys can perceive that you are materially changing their position vis-a-vis the firm and attempting to circumscribe the rights they might otherwise have."

I believe that statement holds true to any situation where arbitration exists, not just when applicable to law firms. Any other reason to not have them? The article paraphrased a partner in the New York office of Greenberg Traurig, writing "Arbitration [] no longer offers the benefits of a speedier, cheaper resolution, as proceedings have become bogged down in discovery and quasi-motion work that mirrors litigation."

If that is truly the case, then arbitration has a gloomy future indeed, and not just with law firms. I brought up the article to an attorney I know who defends clients in arbitration and he told me some of his concerns with it:

Arbitration has become very inefficient, with no control over evidence admission (ie, evidence can come in at any time);
The arbitrators do not have the same fear of appeal that judges do and thus are unafraid to ignore precedent;
The quality of arbitrators has declined.

This indicates some serious problems with the arbitation system for dispute resolution. As the attorney I spoke with said, "Our clients used arbitration to get away from runaway juries. Now they are going back to the courts to get away from runaway arbitrators".

We have begun taking submissions for the 2008 Law Firm Economic Survey. If your firm is interested in participating, please contact Brian by clicking here.