More for less: The impact of leverage on succession planning

The key to the greatly increased profitability of equity partners in US law firms over the past 50 years have been adoption of the billable hour system and the greatly increased utilisation of leverage.

However, they have also been a major source of increased costs to clients and a major contributor to the degradation of the lives of lawyers at large law firms.

My June Managing Partner article 'Services rendered' examined the challenges to the billable hour system and how to fix it. This article explores the negative impact high leverage can have on succession planning in law firms.

Leverage is used within this context to mean the ratio of the number of law firm employees whose time is billed to clients compared to the number of owners ?(equity partners).

Leverage and loyalty

As many large law firms have increased in size and leverage, working conditions have declined and lawyer dissatisfaction with their professional lives has increased.

When law firms gradually raised their leverage over the past few decades (see box), it became inevitable that senior lawyers would find it increasingly difficult to know well each of the people they worked with and to take a personal interest in them and in their families.

It became necessary for firm management to rely on information that could be easily quantified, standardised and communicated, such as hours billed, fees collected, clients attracted and the like. Consequently, the relationship between the firm and its lawyers became less personal and more a matter of numbers and reports.

The prospect of a career-long relationship with their first firm also disappeared over time for most lawyers. Increasing, associate leverage meant that the percentage of associates making partner had to be greatly reduced as firms grew in size.

Today, hiring and supervising a rapidly-growing workforce of lawyer and non-lawyer employees requires growing amounts of time and attention from partners. However, it has become increasingly difficult to motivate partners to devote the time and effort to train and develop their younger colleagues when the odds are very low that associates will remain with the firm as partners or otherwise. Time is too scarce and valuable to waste on a transitory asset.

Most partners choose to invest their limited time in lawyers who are likely to remain with the firm in the years ahead. Even in the smaller major firms, few of the senior partners develop a working relationship with an associate. It is hard enough to get to know their partners.

The larger a firm, the more quickly a new associate is assigned to a narrow practice area. Indeed, many associates are recruited by departments of larger firms rather than by the firms themselves and, ?in some cases, by subgroups of departments, so they only ever work with a few of the firm's senior lawyers (if they work with any at all).

For partners, the increase in leverage has changed both the nature of their work and increased the amount of work to be done. When leverage was low, each partner only had to find enough work to keep himself fully occupied, plus some additional work to occupy all or part of ?one associate's time. When leverage increased with the hiring of more associates, it became necessary for partners to find additional legal work to usefully occupy and train the newly hired and expensive associates.

The decision to add more lawyer employees is also a decision to add more office space, equipment and additional support staff. All the additional overheads must be paid for with even more legal work that the partners must find and supervise.

It has become a tremendous challenge for partners to find and secure large amounts of additional legal business while trying to keep up with changes to the law in specialist areas and managing an increasing number of employees.

 

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The rise of leverage in US law firms

In the decades immediately following World War II, most of the larger law firms had little leverage. It is easier to make the preceding statement than it is to document it because, in 1950, few New York City firms that are major firms today listed their associates in the Martindale-Hubbell directory.

Fortunately, a few did: Skadden had two partners for each associate, Stroock had four partners for every three associates, Debevoise had almost one-and-a-half associates to each partner, and Patterson Belknap and Weil Gotshal had slightly more than one associate for each partner.

More detailed information is available about the major firms in Atlanta, Georgia, in 1950. Based on a comparison of the size and configuration of four Atlanta AmLaw100 firms in 1950 to their size and configuration in 2012, the experience of the Atlanta firms roughly parallels the experiences of many of the AmLaw 200 firms and reflects the transformation that occurred for most of these firms, except for the small number of elite firms based mostly in New York City.

The four major firms in Atlanta that provide the basis for this comparison are: Alston & Bird; Kilpatrick Townsend & Stockton; King & Spalding; and Sutherland. The extraordinary increase in size and leverage of these four firms could not be more obvious. In 1950, these firms were tiny; they averaged 10.5 lawyers. In 2012, a composite of these four firms was 62 times larger than they had been in 1950. They averaged 645 lawyers.

In 1950, Alston & Bird’s leverage was 0.33 (one associate for every three partners), Kilpatrick’s leverage was 0.83 (slightly less than one associate for every partner), King & Spalding’s leverage was 0.11 (one associate for ten partners), and Sutherland’s was 0.29 (approximately one associate for every four partners). All of their billable personnel were lawyers; approximately two-thirds of their lawyers were partners. Most of the associates became partners within five to six years. Each associate had a close working relationship with several of the partners.

By 2012, Alston’s lawyer-employee to equity partner ratio had grown from 0.33 to 4.63, Kilpatrick’s from 0.83 to 2.45, King & Spalding’s from 0.11 to 4.18 and Sutherland’s from 0.29 to 2.95. The increase in their average leverage of 0.39 in 1950 to 3.55 in 2012 constitutes an increase of slightly more than 800 per cent. These increases do not reflect the additional leverage created by the employment of contract lawyers and non-lawyer billable employees.

Instead of two categories of billable personnel, there were five or more categories of lawyers: equity partners; non-equity partners; counsel; associates; and contract lawyers. There were also two categories of non-lawyer billable personnel: paralegals (sometimes referred to as legal assistants) and other billable non-lawyer personnel. (Note: Because most firms do not publically list their contract lawyers, they have been left out of this analysis.)

The percentage of billable personnel who are equity partners has declined from 66 per cent to 17 per cent. The percentage that is associates increased from 33 per cent to 41 per cent. The remaining 42 per cent of the billable personnel are, for the most part, in categories that did not exist in 1950.

Approximately 13 per cent were non-equity partners or counsel and, significantly, approximately 29 per cent were not lawyers at all (17 per cent were paralegals and 12 per cent were other non-lawyer billable personnel).

In addition to paralegals, non-lawyer billable personnel include case assistants, contract administrators, data analysts, directors/managers of litigation, docket clerks, construction consultants, IP case assistants, investigators, patent agents, reference librarians and research project assistants. Some skilled services previously provided by secretaries (and not billed to clients) have morphed into billable services by paralegals and various consultants and advisers who did not exist in bygone eras.

The huge increase in the number and variety of law firm employee personnel who are involved in providing legal services to clients has greatly increased the percentage of law firm services provided to clients by employees and has very substantially reduced the percentage of services provided by law firm owners. These personnel increases have also added to the burden on the equity partners in managing, reviewing and approving the work for which they are ultimately responsible.

As a result, unlike the 1950s and 1960s when most of a partner’s income came from his own work, today each equity partner benefits from the work of more than five other persons whose time is being billed to clients. The profits generated for the equity partners by this combination of lawyer and non-lawyer billable employees are a significant part of the profits the equity partners receive.

Where did all of the work come from that is suitable for so many non-partners that did not exist in the ’50s and ’60s? The type of work done by law firms and who does it has been re-envisioned to produce a much higher percentage of a firm’s work that is suitable for non-lawyer employees who lack a formal legal education and for younger and more inexperienced lawyers.

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Client pressure on leverage

Growing client pressure to reduce leverage is creating the greatest threat to the profitability of many major law firms today.

Inflation since 1960 has been almost 800 per cent. As a result, a $20 hourly rate for a starting associate's time in the 1960s would be almost $160 an hour today. The actual rate of $250 (in Atlanta) has gone up by about 63 per cent in inflation-adjusted dollars. By contrast, the leverage of many of the major firms has increased by over 800 per cent; therein lies much of the explanation of the outsized growth in major law firm profitability.

Can such leverage be maintained or further increased? Both possibilities ?seem unlikely.

Leverage and higher hourly rates feed off each other and more billable employees paid at higher rates greatly increases the total cost to clients. As a result, many corporate counsel are working to both reduce leverage and restrain growth in law firms' hourly rates.

Clients' attempts to reduce leverage have been more promising and successful than their effort to control hourly rates. Most corporate law departments have adopted a range of strategies that are steadily reducing the application of leverage to their legal projects and, in ?the process, their legal costs. These include disaggregation, outsourcing, insourcing, standardisation and commoditisation, the application of technology, the use of lower-leveraged law firms and the utilisation of armchair roles for the experts they need. Some major firms are responding by increasing the hourly rates of their leading experts.

For associates, higher leverage means diminished opportunities to make partner. Because in most major firms partners cannot generate enough high-quality work to keep everyone happily occupied, associates tend to receive less supervision and training and get less meaningful and challenging work.

Large firm sizes and high leverage also mean that associates have less of a personal bond with senior lawyers in their firm. Greater effort by the senior lawyers cannot solve the associate nurture and training challenge, because time is an essential and limited ingredient. There is no way a partner could do a better or equally effective job of training and supervising two or more associates than he could do with only one.

Because the odds are better that an associate at a lower-leveraged firm will remain with the firm, partners should be more willing to make the necessary effort to train their associates well. And, because there would be fewer associates to train relative to the number of partners, the partners could more easily and better accomplish the task. The lower ratio increases the chances that an associate will get challenging work early in his career and ultimately make partner. All of these factors work together to make life in ?the lower-leveraged firm more attractive ?for associates.

Clients will continue to try to contain the hourly rates charged by law firms at all levels, but they will also continue to reduce the opportunities of their outside law firms to grow their profits by the utilisation of leverage. Clients are likely to be more willing to acquiesce to increasing the hourly rates for true experts and truly efficient service providers than to provide more opportunities for their outside law firms to charge for the time of their growing cadre of employees.

?Michael H. Trotter is a partner at US ?law firm Taylor English and the author ?of Declining Prospects ?(www.trotterlawandeconomics.com)