For Partners, It's the Anxious Season

, The Am Law Daily

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ALM editor in chief Aric Press

For partners who keep up with the news, this has been a troubling fortnight. First, my colleague Sara Randazzo reported the sad story of Gregory Owens, a former equity partner at the disgraced Dewey & LeBoeuf who filed for personal bankruptcy at the end of December. Despite earning an annual income of roughly $350,000 in his new role as an income partner at White & Case, Owens admitted in court papers to buckling under the financial strain of a $10,000-a-month alimony and child support award and a lingering million-dollar claim filed against him by the advisers overseeing the Dewey estate.

A week later, the great Jim Stewart (Am Law ’83) devoted his New York Times column to Owens’ story. But instead of drawing lessons about the brutal economics of divorce settlements or the high cost of a New York life, Stewart told a waiting world what American Lawyer readers have known for more than a decade: Law firm partnerships no longer come with promises of lifetime tenure. Equity partners face deequitization; income partners face defenestration. This was the column that launched a thousand emails to law firm chairs, as in, Hey Harry, See attached from the Times. We’re not worried, are we, buddy?

Three more phenomena will surely fuel the anxiety. The Am Law Daily and its sibling publications have begun publishing the first round of financial reports for our annual Am Law 100 project. Those early returns show only modest gains for firms and their owners (and, in some cases, losses). Last week, the February issue of The American Lawyer featured an essay by academics William Henderson and Christopher Zorn, calling into question one of Big Law’s growth strategies: its mania for acquiring lateral partners. And in a few weeks, Major, Lindsey and Africa, the recruiting giant, and ALM Legal Intelligence will release their latest large-scale findings on the satisfaction of partners who have switched firms. That provocative study, coming in the wake of the Henderson-Zorn thesis, will undoubtedly raise the question: What are those partners who have tarried waiting for?

These are, to use the current cliché, high-class problems. With Big Law’s owner-partner class still comfortably averaging million-dollar profits, the nation’s finest clubs will not soon see a raft of rent parties for their lawyer members. But clearly some of the heads that wear crowns lie uneasy. How much fear is reasonable or even prudent?

To begin to answer these questions, we need to review what’s happened to law firms over the past several years. Simply put, The Am Law 200, the 200 top-grossing firms in the United States, have changed their composition. On a percentage basis, they’ve thinned their ownership ranks, even as they’ve increased the number of lawyers they label as partners.

Most big firms now operate as two-tier partnerships; in 2012, the last year for which we have complete numbers, 171 of the Am Law 200 had both equity and income partners. (By our definition, partners have nonequity status if more than half their compensation is fixed; if more than half their compensation depends on firm performance, they have equity status.)

It’s in the second tier where law firms have seen the most striking change. Since 2006, nonequity partners have been the fastest-growing category in the Am Law 200. During the seven years ending in 2012, firms increased their income partner group by 42 percent, their equity partners by 7.5 percent, and their associates and counsel by 14.9 percent. (In our census we lump associates and counsel together.) As a result, equity partners accounted for 24.7 percent of lawyer head count in 2012, down from 26.8 percent in 2006. Or to express it differently, despite the boom, bust and slow recovery Big Law has weathered since 2006, as a group tThe Am Law 200 has increased the percentage of lawyers who are working on behalf of the owners from 73 to 75 percent. You can think of this as a kind of law firm buy-back strategy.

As leverage has changed, so has the meaning of the title partner. Fully 40 percent are now nonequity. And about the only things they share in common are fixed salaries and a label. As my former colleague Amy Kolz explained two years ago in her report on the wide gap in compensation for nonequity partners, income partners come in at least five varieties:

• Young partners promoted into a final Hunger Games–like tournament where the survivors win equity shares and the losers leave;
• Young partners put on fixed salaries for a couple of years while they adjust to their new status and responsibilities;
• More or less permanent income partners who, like Gregory Owens, don’t have their own business but serve the clients of the firm or a particular partner;
• Lateral partners who during their first years at a firm have guaranteed incomes;
• Former equity partners who, because their performance has slipped or they are nearing retirement, have been put into income status.

Despite their varied circumstances, they share a third quality: They’re regularly blamed by observers and consultants for many undifferentiated firm woes. The current conventional wisdom warns that these lawyers have multiplied like hamsters, don’t work hard enough, occupy sinecures, block the path of ambitious younger lawyers, and generally represent a sentimental approach to law firm management and organization. It’s a damning indictment, yet one that ignores a confounding point: On average, these income partners seem to be rather profitable.

How do the economics work? To answer that, we looked at data from our annual Am Law 100 and 200 reports buttressed by annual surveys conducted by the two leading bankers to law firms, Citibank and Wells Fargo. In addition we interviewed heads of law firms and reviewed internal documents from several firms. On average, the story is a positive one. After accounting for hours billed, salary and overhead, the average income partner appears to contribute $274,074 to his or her firm’s profit pool.

Here’s how we reached that number. From the Wells Fargo survey of law firms we learn that the average nonequity partner billed 1534 hours in 2012. The average hourly rate was $651. Multiplying those two figures yields a gross revenue of $998,634. (Wells Fargo draws its data from roughly 200 participating law firms, including “more than 70 Am Law 100 firms.”) From that gross we subtracted the average compensation for nonequity partners, which was $450,000.

Of course, these partners have overhead. For that number we relied on the Citibank law firm survey. Citi regularly samples 173 firms (78 Am Law 100 firms, 46 Second Hundred firms, and 49 additional firms) and found an average overhead per lawyer of $274,560. (I know we’re mixing surveys and averages, but hey, it’s an imperfect world.) After subtracting wages and overhead, the final sum is $274,074. (And I know that this doesn’t factor in discounts or realization issues. You are welcome to move that needle as you like.)

That’s a profit margin of 27 percent, which is healthy for wealthy law firms, even if it's less than many may reap from their high-billing midlevel and senior associates. And that’s where the criticism—and vulnerability—of nonequity partners is concentrated. In its reporting, Citibank points out that leverage is now more expensive for firms: Over the past decade, “the growth of higher-cost timekeepers has been significant.” By its measure, the income partners and counsel categories went from 17 percent of those leveraged to 29 percent.

That’s a huge jump, but who is actually at risk? Of the five Kolz categories mentioned above, the new laterals and the newly promoted seem bound for firm glory, and as such are safe. The third category—made up of those on the up-or-out ladder—is populated by lawyers so deeply in the competitive game that ousting them prematurely wouldn’t make much economic sense. That leaves only two likely targets: the permanent income partners and those who’d been demoted.

But many of them are secure; namely, those performing at or above their firm’s or the Wells Fargo average are likely secure. When I asked two law firm leaders last week whether they would be inclined to unload their mates who are throwing off 30 cents on every dollar, they sounded befuddled. Why would I do that? each asked. Or, as Jeff Grossman, senior director of banking at Wells Fargo Wealth Management, puts it, “A well-managed income partner group can be a profit center. The key words are ‘well managed.'”

Which brings us to those partners who have reason to worry. In The American Lawyer’s annual survey of the heads of The Am Law 200, only 15 percent of the respondents said they didn’t plan to ask at least one partner to leave this year. And 27 percent said they expected to push out six or more. The questions now are only when, who and whether the reasons will be fair and explicable.

This suggests several things to me. First, most partners will survive, including some of those who appear to underperform their peers. For one thing, clients appear willing to pay for them. And for another, while demoting or dispatching partners has become more routine, it’s not an easy or welcome task; one that partnerships and firm chairs would rather avoid.

Second, it’s time to look again at partner compensation. Given the uneven nature of the recovery, are some wage packages ripe for a reset? This inquiry should not be limited just to income partners. For these purposes it’s not the title that’s the issue; equity or income, no one outside a firm cares what modifier is put before the word partner. For everyone inside the firm it’s the contribution and how it’s rewarded. We know that most equity partners came of age knowing only good times; six years after Lehman died, it may be time to stop living in the past.

Third, with 85 percent of firms expecting to demote and/or dispose of at least one partner this year, these dramatic acts clearly don’t threaten to disrupt firm cultures the way they might have, say, two decades ago. Firms are managed more and managed better now. But they remain caught at an awkward stage, self-defined as partnerships, yet behaving increasingly like corporations. That’s confusing for those inside and those who watch from afar. It makes clarity of expectations and consequences even more important. Adding several degrees of difficulty is that some lawyers continue to regard themselves as members of a profession, not just toilers in “the legal industry.” That’s appropriate and noble. And reason for them to continue to manage for other values including pro bono, public service and training their young.

Finally, the hubbub about the fate of partners can be seen as an invitation to ask another broad question: Is the law firm system optimally designed to serve the firm’s clients? Are layers of lawyers funneling work and profits up through a hierarchy the most deft and efficient method of meeting legal needs? We know it’s a lucrative structure. But perhaps, while times are still relatively good, and the fate endured by Gregory Owens remains relatively rare, it’s a moment for partners to start pursuing a different inquiry, this one focused not on themselves but on their customers.

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