Strategic structure: Optimise your law firm's organisational model

A cursory glance at industry reports suggests that everything in the legal sector is changing. Clients are said to be demanding better and more personalised yet cost-effective services. Competition between firms increases at an exponential rate. Employees are less accepting of traditional hierarchical structures; they want more meaningful work, early client exposure and greater career opportunities. Firms are exploring new markets around the world. Outsourcing abounds, and the traditionally-integrated value chain is breaking up. As a result, law firms are allegedly groping for radically different organisational designs. The classical hierarchy is increasingly out of fashion, giving way to new models of nimbler, more commercially-minded firms.

Upon closer investigation, these claims look grossly exaggerated. Certainly, the sector is in constant flux. However, it has been so for many years. There is continuity in change and some degree of change is normal in any sector. But, there is no indication that the rate of change in the legal services industry is increasing.

Compared to other industries, the forces that typically drive change - technological innovation (think of how smartphones have reshaped the telecommunication sector) or a shift towards new resources (shale gas in energy), for example - have played less of a role in the provision of legal services. Powerful institutional factors, such as the embeddedness of legal services in legislative frameworks, tend to slow down the rate of change in the industry.

There is notable change in the sector but, overall, in terms of their organisational characteristics, law firms are characterised by a remarkable degree of stability. In fact, many of the law firms widely considered to be the elite of the legal industry still follow organisational principles not too dissimilar to the ones that have characterised them for a long time:?

• a triangular shape, in which junior lawyers work their way up to partnership level, with limited ?lateral hiring; ?

• mutual monitoring among the ?partners to ensure that all of ?them pull their weight; ?

• the job of partners consists of ?both client-facing work and ?internal responsibilities;?

• decision-making that involves ?a lot of conversation but limited formalisation, and so on.

Firms such as Cleary Gottlieb Steen & Hamilton or Weil, Gotshal & Manges ?come to mind here.

There are alternative organisational models, to be sure. The very large, comprehensive service providers, for example, necessarily have more formal administrative structures reminiscent of those found in the corporate sector.

Linklaters, for example, has a divisional structure on top of which sits an executive committee that includes a chief finance and operations officer. Its secretariat is headed by a head of strategy and business transformation. Similarly, the management committee of Clifford Chance includes both a global chief operating officer and a chief finance officer. Then there are boutique firms that are highly specialised ?in a particular legal practice area or a ?client segment.

Nevertheless, each of these models has its own internal logic that keeps it together, and gives it a degree of stability. Firms that lack such logical glue - those that represent random collections of characteristics - have a disadvantage ?in their competition against others and, over time, they may fade in importance ?or disappear altogether.

Complementarity phenomenon

To an organisational theorist, this phenomenon is known as complementarity. This notion relates to the idea that different 'elements' - be they strategic decisions, resources, specific organisational choices or other such characteristics - mutually reinforce and enhance one another.

Complementarity is similar to 'synergy' or 'fit', but these terms are often applied in the context of mergers and acquisitions, whereas complementarity is used to analyse what's special about coherent organisational configurations.

The notion of complementarities is old - it is derived from the Latin term complere (to fill up) and has been used in different disciplines with various meanings. However, complementarity thinking in economics and later in business administration received a big boost through the work of Stanford economists Paul Milgrom and John Roberts in the early 1990s. Roberts' 2004 book The Modern Firm: Organizational Design for Performance and Growth, one of the most profound business books ever written, shows the power of this concept in a variety of situations and applications.

Together with doctoral students and colleagues from other universities, I have studied the nature and the performance effects of complementarities in professional service firms for several years now.

The organisational models found in the professional service sector tend to ?be so stable because the powerful glue ?of complementarities keeps the main design features together. There is value ?to be gained from making structural choices that fit other structural or strategic features of the firm concerned. Mix-and-match approaches, by contrast, don't help established firms to achieve their full performance potential.

Reputation and non-equity partnership

To give an example, in a working paper, Anna Littmann and I are examining the question of why some law firms make greater use of non-equity partnership than others. Overall, non-equity partnership is a well-established organisational practice that can be traced back to at least the 1980s, if not earlier. It is used widely, ?but not by all firms, and among those firms that do use non-equity partnership, there is wide variation in the ratio between the number of equity to non-equity partners.

Non-equity partnership models are said to offer great advantages over 'rigid' two-tier hierarchies that distinguish more sharply between associates as non-partners and equity partners, without ?any intermediate layer between the two. ?For example, the literature on human ?resource management in professional service firms suggests that the option of non-equity partnership offers greater flexibility to associates and makes the career paths in law firms more attractive to a wider pool of recruits. Thus, law firms that make heavy use of non-equity partnership should enjoy an advantage in the labour market for young professionals and lose less of their valuable talent.

Our research was motivated by a ?puzzling observation: Many highly reputable law firms - the likes of Shearman & Sterling, Latham & Watkins and Germany's Hengeler Mueller - make more limited use of non-equity partnership than others.

We used a sample of large, international law firms active in Germany between 2003 and 2011 for our research. We found that the average ratio of non-equity partners to equity partners in those firms with a top reputation ranking was around 0.17, whereas in those firms with a lower reputation ranking there were significantly more non-equity partners in proportion to equity partners.

Our explanation for this puzzling finding is that a firm's reputation in the market - an aspect of what you could call its strategic positioning - and its internal organisational structure are mutually related to one another.

Firms with a high reputation have less of a need to attract highly qualified law school graduates: they tend to get good applications in any case. They also do better by keeping the nimbus of full equity partnership high, rather than using intermediate career stages that allow people to relax a little on their way up to that level. In less elitist firms, by contrast, non-equity partnership may well be supportive of their own, distinct organisational models.

The clue of this argument - and ?of the notion of complementarity in ?general - is that it does not label any particular organisational choice as ?good or bad per se. As with most things in life, there are pros and cons with any specific arrangement (in this instance, non-equity partnership), but it is hard to weigh these unless the usefulness of the arrangement is considered in the context of other circumstances.

After all, a firm's reputation is not simply defined by external forces unbeknown to us. As with non-equity partnership, a firm's reputation is the result of human choices - for example, the quality of the lawyers providing the services, the complexity of the cases accepted by the firm, and so on.

Again, each of these choices has its own pros and cons (for example, employing the most highly qualified lawyers incurs higher labour costs). Decision-makers may not be conscious of the implications of each of these choices, but choices they are nevertheless. Complementarity thinking suggests that, rather than looking to 'optimise' each of these choices or 'elements' on the basis of its own merits, it is making the right combinations of choices that matters.

Our quantitative research attests to this fundamental idea. Higher-reputation firms make less use of non-equity partnership. More importantly, high-reputation firms that make more extensive use of non-equity partnership have significantly lower performance (as measured by average fee earnings per professional) than those high-reputation firms that use non-equity partnership ?more sparingly.

By contrast, there is no statistically significant relationship between the use ?of non-equity partnership and performance in lower-reputation firms. Depending on the conditions, the same organisational choice (non-equity partnership) may lead to very different performance outcomes.

Of course, the use of non-equity partnership is just an example (and a relatively minor one at that) for a far broader perspective. Law firms are integrated organisational systems, where the whole (the overall organisational configuration) is more than the sum of its parts (its individual organisational design choices). Examples of such complementarities in the organisation ?of law firms abound.

Leverage and specialisation

Consider the pros and cons of a large versus smaller leverage ratio (the number of associates per partner). One may weigh the advantages and disadvantages of larger versus smaller leverage ratios on their own merits but, without due consideration of other factors (such as the degree of standardisation of the service provided or its specialisation), such an assessment is likely to be misleading.

For example, research by Edgar Ennen and myself has shown that the performance-optimal leverage ratio in highly specialised law firms tends to be higher than in more diversified firms. If we compare two law firms of the same size, the one that specialises in one or very few narrowly-defined legal practice areas can generally pre-define particular processes and routines more tightly, and thus afford to have a greater number of associates 'leverage' the knowledge and client contacts of relatively few senior lawyers as partners, thus implying a high leverage ratio. The other firm that provides a broader, more diverse set of services to its clients will need to have partners look more often over the youngsters' shoulders, so their optimal leverage ratios tend to ?be lower.

As with the example of the merits of non-equity partnership in high- versus low-reputation law firms above, the complementarity between the degree of specialisation and the choice of the right leverage ratio involves a strategic choice (how many legal service fields to cover) and one traditionally regarded as an organisational one (how steep a firm's hierarchical structure should be). A good structure is one that follows the firm's strategy, and a good strategy is in line ?with its structure.

Problems with complementarity

Overall, complementarities in organisations are powerful performance drivers. They generate value above and beyond what individual 'best practices' can do for a firm. Complementarity thinking makes plausible why a certain decision (such as to use a high or a low leverage ratio) may work perfectly well ?in some circumstances, but backfire ?in others.

There are problems with the complementarity argument, however. A more practical one is its sheer complexity. Complementarities cannot simply be implemented; they do not follow a standard recipe. Recognising complementarities in organisational design requires reflection, even introspection. The examples above (reputation and non-equity partnership; leverage and specialisation) are not trivial, but they are mere binary ones. Imagine what happens ?if you add more factors to the mix.

Another problem with complementarities is that they inhibit change, or at least make it more difficult. If one aspect of organisational design is closely connected with another one, changing the first will require changing the second one too, or it may well lead to a decrease in performance, rather than the hoped-for performance increase. And, of course, firms will then interpret such a performance loss as negative feedback on the change they have made and revert to their original state.

Alternative models

Change in sectors where the established players embody strong complementarities thus tends to come from the edges of the industry, rather than from within. Industry incumbents often fail to pay attention to the emergence of new business models that encroach on their territory simply because they do not regard the organisations concerned as belonging to their relevant competitor set. Even if they see them, they cannot easily copy them or adapt lessons from them.

There are examples of such alternative models in legal services. Some of them have emerged from within the industry but have branched out into other sectors. For example, Rödl & Partner, founded in 1977 by solicitor Bernd Rödl, has become a highly international firm providing a diversified portfolio of legal, tax advisory, accounting and business consulting services, primarily for German mittelstand (mid-sized) companies working abroad.

Other firms with alternative organisational designs have arisen from outside the legal industry in the strict sense, but have taken on work in the legal space that might otherwise be provided by the more conventional law firms.
For example, there are economics consultancies such as FTI Consulting (founded in 1982) whose work on matters such as regulation, risk, securities and intellectual property has led it into litigation, arbitration, compliance and other legal matters. With revenues of about $1.6bn and 3,000 professionals, FTI is organised as a corporation whose shares are listed on the New York Stock Exchange. Or, take the example of Berkeley Research Group, which was founded by a group of economists in 2010. Its 500-plus employees provide expert testimony, litigation and regulatory support, among other services.

This is not to say that each of these models will necessarily succeed in the long term. In fact, the predecessor organisation to Berkeley Research Group, a company called LECG Corporation (short for Law and Economics Consulting Group), went bankrupt when it could not service its debt obligations, and was liquidated in 2011.

These organisations will not easily replace the law firms that we have come to know. In fact, they work together with them in many instances. However, their mere existence suggests that alternative organisational models are possible.

At its core, however, the legal service industry is a slow-moving one, and for good reasons. The organisational models used therein have been tried and tested, and they draw on years, often even decades of experience. The complementarities embodied in these firms are powerful, even if they come at the disadvantage of reducing nimbleness. Firms that have benefited from them for long will not give them up easily.

Professor Ansgar Richter is chair of management at the University of ?Liverpool Management School ?(www.liv.ac.uk/management)