A quick question: By how much did average profits per equity partner at Am Law 100 firms increase last year–10.6 percent, 6.9 percent, or 1.5 percent?
If you chose 10.6 percent, we have some hot Internet stocks we'd like to sell you. That was the rate of profit growth at Am Law 100 firms in 1999, the last full year of the stock market boom. But the 1.5 percent figure is wrong too. That was the rate of profit growth at Am Law 100 firms in 1992, the last time the economy languished in the second year of a downturn. The correct number is 6.9 percent–much closer to the 1999 rate than the 1992 rate. And The Am Law 100's other results are strong too: Gross revenue increased by 8.5 percent and revenue per lawyer rose by 4 percent. (In 1992 revenue per lawyer at Am Law 100 firms grew by 4 percent as well, but gross revenue rose by only 3 percent.)
How, in the face of a lingering economic downturn, did The Am Law 100 manage to rack up robust numbers? It's not that law firms are immune to economic trends–just ask refugees from Brobeck, Phleger & Harrison, which makes its final Am Law 100 appearance this year, having disbanded in February. Instead, it's a story of contingency planning. With the dark days of the early nineties in mind, law firms planned for the worst in 2002 and scaled back their ambitions. Call it the year of living modestly.
With mergers and acquisitions work down, managing partners sang the praises of practice-area diversification, as their firms relied on countercyclical bankruptcy and reorganization practices, as well as steady income streams from litigation and regulatory work. But 2002 was also a year in which expansion took a backseat to cost control. Head count slowed (that 8.5 percent increase in gross revenue was achieved with only a 4.2 percent increase in the number of lawyers), and firms held the line on expansion of their equity partnership ranks.
The healthy composite averages mask deep pockets of pain, most notably on Wall Street and in Silicon Valley. This year's sharpest decrease in revenue per lawyer–the best measure of a firm's ability to command premium fees and top billing rates–was at Cravath, Swaine & Moore, one of the premier Wall Street firms. Of the 15 firms where revenue per lawyer declined last year, seven were New York firms and two were Silicon Valley firms.
Even at the firms where revenue per lawyer dropped, the bottom line stayed strong, thanks to careful expense management. Nine of them showed increases in profits per equity partner, and at the other six, the decreases in profits per partner were not nearly as steep as the drops in revenue per lawyer. (Cravath's 22 percent decrease in revenue per lawyer, for instance, translated into an 8 percent drop in profits per equity partner, and Cravath continues to be The Am Law 100's second most profitable firm.)
So the question remains: In a year in which the average gross revenue of Fortune 500 companies declined by 6 percent, how were so many Am Law 100 firms able to increase their revenue per lawyer? Rate increases were primarily responsible. Despite the sour economy, most firms succeeded in raising billing rates 3Ü6 percent last year. "We obtained appropriate rate increases in certain markets where we were billing well below our competitors," says Hogan & Hartson chairman J. Warren Gorrell, whose firm had a 10 percent increase in revenue per lawyer.
Higher margins paid off, too. "We focused on obtaining high-value work," says R. Bruce McLean, chairman of Akin Gump Strauss Hauer & Feld, where revenue per lawyer increased by 13.7 percent last year. Many firms also took a hard line on collections, decreeing that what Hildebrandt International consultant William Johnston calls the "willy-nilly write-offs of the past" couldn't continue.
Cost controls ensured that revenue enhancements went straight to the bottom line. "Early on, it was quite clear that 2002 was going to be slow, so we instituted a fair number of cost controls," says Latham & Watkins managing partner Robert Dell, whose firm had an 8.1 percent increase in profits per partner and a 1.5 percent drop in revenue per lawyer. Latham identified areas where purchases could be deferred, Dell says; only expenses affecting client service and business development were exempted from review. Says Dell: "If I thought I could stall [an expenditure], I did." Firms delayed major technology purchases and took advantage of the soft commercial real estate market by renegotiating leases. "Landlords still see law firms as desirable clients, despite the fact that their assets walk out the door at night," says Andrew Lechter, senior vice president at the commercial real estate brokerage Julien J. Studley Inc.
The largest single expense at law firms is personnel, and there, managing partners held the line as well. During the late nineties, average annual head count increases of 9Ü10 percent were common, and in 2001 the average size of Am Law 100 firms grew by 11 percent, despite the downturn. "Firms did a good job of aligning their number of lawyers with demand [in 2002]," says Hildebrandt consultant Lisa Smith, "much more so than in past downturns." Johnston notes that many Am Law 100 firms actually reduced their associate ranks, either through forced layoffs or by encouraging attrition, but kept hiring replacements, leading to the small increase in head count. "That is a different pattern from the layoffs in the early nineties," he says, when firms did not hire replacements, and were caught short-handed when the economy recovered.
The slow-growth policy was not confined to the associate ranks. In cutting the size of their equity partnerships, law firms continued a process that we first noted in the Am Law 100 results for 2000 ["Life on the Bubble," July 2001]. In 2002 the size of the equity partnership declined or remained flat at 34 Am Law 100 firms. Overall, the number of equity partners at Am Law 100 firms grew by just 2.8 percent in 2002. (That figure does not include three firms that completed major mergers in 2002–Bingham McCutchen; Katten Muchin Zavis Rosenman; and Mayer, Brown, Rowe & Maw.)
In contrast, Am Law 100 firms continued to make nonequity partners at a healthy clip. Average growth in the nonequity ranks was 13.4 percent in 2002, more than four times the average growth of equity partnerships. In 1994, the first year that we began tracking nonequity partners, 45 Am Law 100 firms had a nonequity tier. In 2002, that number had grown to 76, and of those 76 firms, 52 increased their number of nonequity partners last year.
The result of all of this attention to the bottom line is that, Brobeck notwithstanding, 2002's Am Law 100 firms are on a much firmer business footing than 1992's were. The best proof of that is our profitability index, which we calculate by dividing a firm's profits per partner by its revenue per lawyer. The index singles out firms that both command the highest fees that the market will bear and provide their equity partners with the highest possible compensation. A firm that scores well on the profitability index is one that bills high and keeps costs low, allowing an uncommonly large proportion of its gross revenue to go into the equity partnership's draw pool.
When The American Lawyer introduced the profitability index in 1985, the magazine asserted that a firm's score should be "significantly above" 1.0–maybe 1.2 or 1.3. Anything lower than 1.0, the thinking went, was an indication that a firm may be spending too much of its gross revenue on expenses or paying its partners more than is justified by their billing rate.
To see the profitability index in action, take a look at Brobeck. In 1998 the firm's profitability index score was 1.08. But as the firm prospered during the technology boom, its score improved, to 1.47 in 1999 and 1.78 in 2000. When the tech bubble burst, Brobeck's profitability index score declined to 1.17 in 2001, and last year, it slid to 0.57, the lowest of any Am Law 100 firm. Analyzing Brobeck's performance solely on the basis of revenue per lawyer would have been misleading: Last year the firm had a 26.5 increase in revenue per lawyer, the second-highest jump of any Am Law 100 firm. That revenue-per-lawyer increase, caused by lawyers leaving the firm, didn't capture the expense load that drove the firm's profits down 38.6 percent. Only the profitability index showed a full picture of Brobeck's condition.
For managing partners, then, here is the good news: In 2002 only 16 Am Law 100 firms had a profitability index lower than 1.0. That's the lowest number of firms ever. It's evidence that when consultants say that more than ever, law firms are being run as businesses, they're right, and that when managing partners say they've taken the tough steps necessary to hold the line on expenses, they're right too.
But here's the bad news: This year, clients are slowing payments and demanding discounts. The price of malpractice insurance is escalating. And with little left to cut, managing partners may find that 2002's solution won't do the trick in 2003. What the industry needs is a broad-based economic recovery–and when that will come is anyone's guess.
–With research by Michael Ravnitzky and Sara Yoon
