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November 24, 2008 5:45 AM

Welcome to the Future: Profits Per Partner, Hero or Culprit?

Posted by Paul Lippe

Is The American Lawyer's Profits Per Partner (PPP) measure the root of all evil in law?   

Some lawyers think so.

In a recent on Legal OnRamp, one law firm partner said:

The fact is our profession has become increasingly unhappy over the past couple of decades. I am convinced the vast majority of that unhappiness derives from a single seemingly innocuous event in the late 1980's: The American Lawyer magazine began publishing the Am Law 100, and listed the profits per partner of the 100 largest firms. Virtually all of the firms in this country immediately bought in to that statistic as the only credible measure of success. The game was on--we lawyers would now take our measure almost entirely from money, at least in terms of what was publicly discussed. Without question, integrity, service, and professionalism were important, but how we measured ourselves was money.

The broad critique of PPP can be summarized as follows:

1. Transparency is Bad

This argument strikes me as a clear loser. While many lawyers begin to articulate it with passion, they quickly run out of steam. Let's face it: transparency is the strong force in the universe. Of course, aspects of attorney-client communications must be confidential and privileged, and certain personnel and other matters are confidential, but law as a business has no particular claim to opaqueness. When you consider that most legal regimes--from the '34 Act to Discovery to statistical analysis of hiring patterns in discrimination claims--rely on transparency as a first principle, it seems more than a little silly that lawyers would reject the medicine they prescribe for others.

2. PPP makes everybody too greedy.

I'm not too persuaded by this argument either. Human capacity for greed is pretty strong, and if we look at a range of fields, from sports to entertainment, from academia to accounting, folks seem to have become more focused on money over the last few decades. I know many managing partners, and I can't imagine any of them sitting down in 1973 to write the following letter:

"Dear Mom:  I have decided to go to law school.  My dream someday is to help my firm move from 63rd to 54th in PPP..." 

Still, the innate competitiveness of lawyers, coupled with the lack of other metrics, makes them over-focus on PPP. If we want to emphasize more than money, we certainly have the tools to do it. Blaming PPP is like blaming the lamppost a drunk driver runs into.

3. PPP is not an especially meaningful measure.

I find this argument most interesting. As far as I know, PPP is unique in that it is not used primarily to communicate financial information to owners; instead, PPP is mostly used to signal to clients, potential lateral partners, and law students a firm's relative importance. It is a status measure, not an economic measure.

John Bogle, founder of the trillion dollar mutual fund complex Vanguard, was on NPR last week, and he said, "the amount of financial engineering that goes into corporate financial reports is breath-taking."

Is there any reason to believe that the amount of financial engineering in law firms is less than the "breathtaking" amount Bogle describes for industry? I doubt it, especially when you consider that law has none of the checks and balances (analysts, shorts, audit committees, etc.) that public companies do.

I am no expert on the myriad ways of financial engineering, but it strikes me it boils down to four things – pulling in revenue from the future, treating assets as revenue, deferring expenses, and using a “big bang” like a merger to clean things up. Because they are largely cash businesses, law firms can’t do much to pull in revenues or do “big bangs.” So most of the financial engineering in law firms, if any, would be treating assets as revenue (such as paying out distributions from loans), pushing out expenses (capitalizing lateral sign-on bonuses and headhunter fees), and under-estimating future liabilities like retirement obligations to partners or underwater leases.

Law firms can also engineer PPP by jettisoning medium performing partners who contribute to the total bottom line (and thus everyone's Profit Per Me) but not to the average. And PPP reporting provides an incentive for firms to under-invest: compare two firms that each nominally make $1million in profits. but one firm decides to invest $100K of that $1 million on major infrastructure and process improvements to benefit clients, and now has a ‘lagging’ PPP of $900K. Which one is better prepared for a downturn?

Michael Lewis, a great chronicler of Wall Street, has a new book called Panic, which he discusses at length in Portfolio magazine. As Kelly describes, one of the great problems with financial engineering is that companies lose sight of what's actually going on with their business as they work to generate numbers for external consumption.

Maybe I am missing it, but it seems like the only meaningful external consumer of financial information for law firms is the banker--the one who is focused on real cash flows to service debt and could care less about nominal PPP. As firms work through the inevitable shortfalls of the meltdown, their focus may shift to PABGP, or Profits After the Bank Gets Paid, as lenders will take on an increasingly central role in many law firms' finances. When that happens, many partners are likely to see a dramatic drop in pay-outs, especially in the first six months of '09, as banks tighten up. Thursday's Am Law Daily story about DLA seeking equity contributions from non-equity partners suggests the new reality--law firms are now to a very substantial degree owned by their banks (CitiGroup in particular) and the banks are to an unprecedented degree controlled by the government, which seems unlikely to view law firms as the most compelling recipients of government-supported financial largesse in a major recession.

So let me make a modest proposal: law firms should work with The American Lawyer. Together perhaps with some banks and consultants, to develop a more accurate set of numbers than today’s PPP. A less modest proposal is that they all get together and acknowledge that profits will be down a bunch, so now is a time for renewal, not pushing numbers. The biggest risk otherwise is that firms continue to put a lot of energy into engineering a number that’s not very meaningful, and that actually serves to mask for themselves the true nature of their financial position.

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Paul--wonderful discussion of something that inside counsel see as a big part of the problem. At the focus groups leading up the the launch of the ACC Value Challenge and at the launch itself, there was considerable discussion amongst the inhouse participants about the negative role PEP (Profits Per Equity Partner) play in the client relationship.

Beyond this concern, firms regularly manipulate PEP by restricting admissions to the "club" despite the negative impact this human resource policy has on firm assets (associates and income partners). Imagine how DLA Piper's numbers will look now, given it essentially was forced to admit scores of new members to equity ranks. Is the firm any different now than it was a week ago? Hardly. But the numbers will be lot different.

I wrote about this in my blog (In Search of Perfect Client Service, www.patrickjlamb.com) in a March 2007 post titled "The Chimera That Is Profits Per Partner." That post has received more posts than all but a few.

If AmLaw is smart, it will work to get ahead of the curve on this and create a more meaningful set of numbers.

Paul,

As a keen observer of the US legal system from the other side of the world it appears to me that the principle issue with the emphasis on PPP has been missed from your piece. While it is related to greed it is not quite the same.

The primary issue that I can see with ranking PPP in an intellectual capital environment is that it creates a market for perceived value and promotes lateral movements of partners. Thus, lawyers who are approached to join firms with a higher PPP are able to rationalise their decision to move on the basis that the new firm is offering the "appropriate measure of their value". This is similar to the rationalisation employed by founding directors in acquisitions or IPOs when they face the "legacy hurdle". In this context, clever deal closers often reframe the dilemma as a market capitalisation of their personal investment (ie "this is a true reflection of the value of your company and the investment you have made in building it from the ground up". The PPP ranking enables acquirers of talent to present a similar market captialisation story to partners and it is a compelling story when they feel undervalued in their current firm. However, as in so many company acquisitions, market capitalisation of talent is a poor measure of sustainable value and the trailing costs are rarely considered. The net result: an ever-increasing community of wandering laterals in search of the next capitalisation opportunity while managing their own brand.

My advice to clients: take steps today to build a truly sustainable firm where the reason people join and stay has more to do with a true market differentiation based on an integrated value proposition than their short term remuneration expectations.

By the way, don't get me started on the Cravath model.

Can somebody please explain why some people refer to PEP and other to PPP? the revenue figures for Profits per partner and for profits per equity partner are different...

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