Law firm leverage and non-equity partners

Bruce MacEwen has a superb post about law firm leverage that is must reading for anybody who is practicing law or at all concerned about the market for legal services. 

Bruce was kind enough to start with a link to my Friday post arguing that “we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.” The basic problem, as Bruce and I argue (though Bruce got there way before me), is that law firm associates with high fixed salaries act like debt in non-law firms. Associates are great when the firm is raking in profits because you don’t have to share those profits with them. But not so great in times like these when the profits are gone but the associates are still there. This is a simple explanation for all the layoffs.

But Bruce takes it a step further. He notes that law firms’ real leverage problem isn’t partners/associates, but equity/non-equity partners. That's partly because associates are more productive than non-equity partners. Those striving for full partnership have stronger performance incentives than those who have accepted a permanent fixed-wage deal.

The more general point here that is sometimes ignored in the “leverage” analogy is that, unlike conventional debt, which can be used to buy anything, human leverage bundles the asset with the liability. Moreover, the bundle is tightened by the fact that the debt aspect, by affecting incentives, also helps determine the value of the asset.

So why are firms firing associates but not non-equity partners? Bruce points out that associates are simply easier to fire – non-equity partners usually have contracts that bar termination at will. Indeed, from this perspective, it’s not clear that associates even are debt. You have to pay back debt. Technically, you can fire associates at any time.

The usual problem with firing associates is that it sends a very bad signal about the firm – to clients, the hiring market, etc. But as I pointed out last month, the current market reached a “tipping point” where the equilibrium shifted and the reputational penalty for firing associates dropped precipitously. In this market, associates are no longer the leverage that they used to be.

The good news is that the long-term market for big law associates may not be quite as bad as it looks. Law firms do need associates in the long run. 

The bad news is that the trend toward non-equity partners may sharply reverse. Law firms won’t want to be saddled with the big-time debt represented by non-equity partners. Especially when you consider, as Bruce does, the morale problem of having bunches of disincentivized workers hanging around.  Law firms went to non-equity partners because in flush times firms had more work than they had senior associates to do it. Not so anymore, and probably not for a long time.  The even worse news is that non-equity partners may be the next to get laid off, contract or no (might be a good time to be an expert on partnership law).

Bruce thinks that law firms now are going to need a serious “intervention” to get on track. However, as I pointed out in my last post, this is going to necessitate "dropping regulatory restrictions on law firm structure and letting them be run like real businesses." As discussed above, lawyers are leverage if you can’t easily get rid of them. Yet at will employment (to the extent this category still exists) is not a panacea. You want your workers to care about whether the firm succeeds, not always looking around the corner for the next job. An answer might be unbundling the incentives from the job – something like stock options, where the compensation reflects the long-term value of the firm and not just how you did last year. Employees with options care about how the firm as a whole is doing even if they know they don't have tenure.

But stock option type compensation requires a market for the firm’s stock – something that is illegal today for law firms in the US. (Bruce has proposed a workaround through derivatives, but that was always a regulatory minefield, particularly so now.) In other words, the space for “intervention” Bruce suggests is currently limited by regulation. That’s unfortunate, because law firms today need all the space for change they can get.

Comments

[bob]

I don't fully understand your assumption that reversing the trend towards non-equity partnership is bad. Isn't a simple answer that firms need to actually give equity to their partners?

[Larry Ribstein]

I meant "bad" from the standpoint of those who become non-equity partners, since I assume that this deal was a good option for them (or they wouldn't take it). I agree that it may not be a good idea taking all interests into account. Indeed, in the long run it may not even be a good idea for non-equity partners because it would be better if law firms didn't have this option and had to stick to the original up-or-out deal.

[Doc]

I don't think it's a given that law firms need an intervention. Businesses expand as demand permits (creating or tolerating cost strata which may make sense only in an expansionary environment), and contract as demand declines (eliminating expendable cost strata as they go). Neither is a marker for a failed business model, though the former admittedly isn't hyper-efficient. Trouble occurs when the expansion is not executed with an eye to the likelihood (in most lines of business, the inevitability) of an eventual recessionary contraction. Most law firms are naturally conservative about debt and other fixed obligations, and will weather the current contraction without serious problem because, while they may have realtively low paid-in equity, they also have low levels of unamortized capital costs, low levels of debt, the capacity to shrink personnel cost quickly, and the capacity of partners to absorb lower profits for a longer period and to a far greater degree than external equity owners would ever tolerate. Too soon to bury them or the model.

[Doug Cornelius]

I think you may be over-simplifying the non-equity partner/long-term associate. In my experience, most of them are highly skilled practioners. They just lack the business development skills/desire expected of an equity partner.

These are the subject-matter experts and niche practioners that a big law firm needs to stay operating at a high level.

The problem with the survey is that it equates billable hours with productivity. According to the survey, these senior people are working fewer hours than associates. I that is because they are more efficient than associates. Although it is true that they are not burying themselves like the equity partners.

Perhaps there is a mistake in compensation. Perhaps they are not sufficiently motivated.

But if a big law firm is going to move to a more normal business structure, they need to move away from the two level structure of associates and partners. They need to focus on skill sets and matching people to different roles in the organization. That means focusing on retaining skilled lawyers and not living on associate attrition.