The Firms

October 3, 2008 9:00 AM

Welcome to the Future: Heller Shock?

Posted by Paul Lippe

A law firm friend of mine told me many of his peers were "shocked" at the demise of Heller and its failure to find a merger partner. That put me in mind of the iconic scene in Casablanca, where Vichy police captain Louis Renault declares himself "shocked, shocked to find gambling going on [in Rick's Casino]" while pocketing his winnings.

So let me make a prediction: More Am Law 200 firms will Heller-ize over the next 18 months than will merge. Why?

1. Bigger Isn't Necessarily Better. How many large law firms really take advantage of their size? Most legal work is done by teams of ten or fewer lawyers, so how do clients benefit from scale, since 990 of the lawyers in a 1,000-lawyer firm don't touch that client? For 20 years, sophisticated clients have said, "We hire lawyers, not law firms," and they have spread their work around to many firms. Law is unique in having two structural diseconomies of scale: (i) conflict of interest rules; and (ii) lawyers' widely noted desire for autonomy (see David Maister's column "Are Law Firms Manageable"). If we consider the benefits of being "big"--shared knowledge, common methodologies, cost-saving investments, more sophisticated delivery systems--they're largely absent at most big firms (the U.K. firms are well ahead of their U.S. peers). So if a firm isn't doing an especially good job of managing scale, how does creating more scale through a merger create more value? See the excellent discussion in WiredGC about why law firm mergers create very little value.   

2. Everything Works in a Boom. I recently wrote that the "boom" large law firms found themselves in over the past decade has ended. One of the traps of a boom is that everything (e.g., mergers) works, so you don't learn much. Most of the profit gains associated with big-firm mergers are driven by, a) deequitizing some partners, which, if it is your goal, can be achieved without a merger, and b) price increases, which are probably only possible in boom conditions. It's not obvious to clients that law firm mergers create value for them. As Jeff Carr, GC of FMC Technologies wrote in a Legal OnRamp forum recently, "I've yet to see a law firm merger justified on the basis of a benefit to the client (other than the hubris-induced statement that 'this provides clients with services they need'). In fact, clients generally have already established counsel relationships--unless the merged firm offers a lower cost for service, then there's little if any reason to move that work. From the buyer side, I'm unable to think of any law firm merger that provides us, as the client, with any value." You won't find another industry where "cross-selling" per se is considered the synergy of a merger--normally, costs savings, or the ability to create new products, is cited.

3. Leverage. Excessive leverage was the number one reason behind the collapse of AIG, Lehman Brothers, Bear Stearns, etc. These firms each were betting $100 a throw at the casino, but only had $3 in their pockets. That kind of leverage is fantastic when you're winning, but you can't sustain very many losses, especially if the house decides to limit your credit for future bets. How well-capitalized are most large U.S. law firms? I suspect that, as measured by the ratio of firm earnings paid out to partners versus net capital in the firm, large U.S. law firms are at a historic low in capitalization. Simply put, most partners' economics are driven by their annual income, which is very vulnerable to a downturn, not their capital in the firm. Again, U.K. firms seem better capitalized, and under the Legal Services Act will have access to more capital. So once again, advantage U.K. (See "The English Advantage," in this month's issue of The American Lawyer.)

4. Insufficient Organizational Glue. As described in WiredGC, a decline of 10-15 percent in firm profitability relative to one's peers leads to partner defections. That is dramatically more fragile than most companies or professional service firms. If Bain has a 15 percent drop in profits relative to its peers, it doesn't lose partners to McKinsey; ditto for Sun and HP or Bank of America and Wells Fargo. Moreover, even the rawest start-up understands that the key IP and customer relationship assets belong to the company, not to the individuals, and that there must be some disincentives (like losing vesting) for leaving. But for reasons of customs and ethics, law firms have few strong agreements to discourage departures, such as retained capital or even seemingly effective antisolicitation (not of clients, but of firm colleagues) agreements. Also, to far greater degree than almost any other type of firm, the intellectual capital and client relationship capital belong to the individual partner, not the firm. It's no surprise, then, why partners leave.

5. The Dog That Didn't Bark. While some employees and commentators have described Heller's situation as "tragic," there is no such concern expressed by clients. Why? Because for the client, it's not a tragedy. Clients have grown accustomed to lawyers switching firms, or firms merging without any particular impact (good or bad) on them.

6. The Lake Wobegon Effect. In Lake Wobegon, all the children are above average. In law firms, at any moment some partners contemplate leaving because they believe that they should be paid more and would be at another firm. Since many firms have been willing to pay top dollar for laterals or mergers (an example of "winner's curse," identical to the M&A market as shown by deals like Wachovia-World Savings, which brought down Wachovia), many of those partners are correct. So from a simple Prisoner's Dilemma model, the partners who can make more money as free agents have a financial incentive to move, and those who will be harmed by the departure of the top producers also have a financial incentive to move, since they would be "unmasked" if the top performers leave before they do. Which means any firm with lots of unstable partners will seek out a merger, unless...

7. Why Buy the Cow When You Can Get the Milk for Free? Any acquiring firm in a merger quickly figures out they can cherry-pick people rather than acquire the firm as a whole, and all its liabilities. In a boom, people overlook the worries, but in the current climate, fear of the unknown will loom much larger; compare the spree of bank mergers pre-Credit Crunch to the inability to get any done without government support in the current environment. When I managed buy-side M&A for a public software company, there were two fundamental things we learned by studying our own and others' mergers. First, if someone wants to sell you their company, there is something wrong with it that they know more about than you, so you better figure out what the problem is and how you can fix it better than they can. Second, once people know the company is in play, it destabilizes existing relationships. If the process continues very long, things can implode. The best people are in the most demand so they will either leave before the implosion or their departure will catalyze it. There's also the matter of...

8. The Free Agency Infrastructure. There is a large and aggressive infrastructure of consultants and headhunters who are actively engaged in encouraging interfirm mobility. A typical firm partner may hear every week from someone encouraging them to make a move. How often do they hear from someone inside the firm encouraging them to stay? These folks are highly compensated for driving moves, at the individual partner, practice group, or firmwide level. And if a headhunter sees a troubled firm in merger talks in which they don't have a stake, do you think they can figure out to contact a few partners whom they already know to encourage a move? And did I forget…

9. Underwater Leases. While law firms are retaining less capital, the biggest item on their balance sheet is probably the office lease. The combination of a decline in commercial lease rates, slower growth in head count, the collapse of the sublease market, and a dip in law firm revenues (i.e., exactly 2009's economic scenario) can mean leases are underwater, so partners may face an increased share of liability risk if they stick around an underperforming firm. My friend Craig Johnson is starting Virtual Law Partners, where everyone works at home. That kind of cost-advantaged strategy has hardly been common for law firms, but may start to be very compelling.

10. Failure Is the Norm. To predict some level of organizational failure is hardly the height of Nostradamus-like courage; in most businesses, some rate of failure is the norm. And when change accelerates, the failure rate increases. Every time a law firm fails (see, e.g., Testa or Brobeck, or now Heller), folks want to act as if it is an anomaly--but it's not. The anomaly has been the remarkable success of law firms during the law boom. Now that the boom is over, we'll see a "normal" failure rate, accelerated by the stresses of adjusting to a post-boom world.

So what are firms to do? 

As Tom Wolfe described in The New York Times on Sunday, hedge fund-ization is almost certainly the next step for the financial services industry, as most of the bankers who previously worked for the large financial institutions will devolve into smaller hedge funds. If Heller similarly breaks up into 15 small firms, is that a tragedy?

The question for those leading large firms is how to demonstrate that their people are better off in their current large organization, rather than in a different large organization or a smaller one. See Bruce MacEwen’s excellent post AdamSmithEsq. The answer to this will include demonstrating to clients how the firm brings superior value through scale to their work.

The scary part is that managing this change will require greater investments in capital and culture than firms made during the boom, investments that will likely be destabilizing in the short term. At the same time, we can safely predict the merger of big firms will be a very rare bird.

I for one will not be shocked by the next Heller, even while I hope to be pleasantly surprised by the vast majority of firms taking the needed steps to strengthen their institutions.

Paul Lippe is a founder and chief executive officer of Legal OnRamp.

Previous Columns in This Series:
Welcome to the Future: Law After the Boom

Make a comment

Comments (3)
Save & Share: Facebook | Del.ic.ious | | Email |

Reprints & Permissions


Report offensive comments to The Am Law Daily.

Excellent observations, and in general I concur, with some slight but potentially material different perspectives.

What is going to dampen the potential for mergers is the realization that not only do they add little value for the clients, they add negative value to most of the partners. For both the acquiring and acquired firm. (there is no such thing as mergers of equals in law firms)

Law firms sell talent. Talent is mobile. There is no need to take on infrastructure costs and offices when most firms have growth plans that provide adequate space for expansion with the "right" talent. Office space is plentiful, and relatively cheap compared to the cost of talent to fill it.

What is the "right" talent? The lawyers with books of business that raise the average PPP, and have perceived "synergies". Who are these partners? Break the team of partners into three tiers. Certainly not the service partners, the lower tier. They generally contribute far more than they are paid through large annual hours worked. Certainly the top tier of client book carriers. And with some careful research and due diligence, the hard charging "up and comers" with moderate books and lots of perceived potential from the middle tier. The rest in that tier are not valued much. They are typically well paid, but less than they contribute overall to the profits of the firm.

Most firms have found it easier to hire these top tier and up and comer attorneys rather than mentor and train them internally. Even with headhunter fees being what they are. Why? Impatience for immediate returns. And the hard work of growing your own which is not adequately recognized, measured, or compensated for.

Since firms in a merger now will not easily take on large numbers of attorneys they really do not want, and infrastructure they do not need and which will impair immediate returns, there is no real incentive to burden current earnings which are under severe stress with a merger. The partners of the acquiring firm who vote, usually on a supermajority requirement, won't approve it, if it involves a potential dilutive effect on income currently, even if an argument can be made it is for the long term good. And the partners in the acquired firm, other than the top tier, will not want to vote for the merger at all, knowing full well in today's market what it means to step into the room that has drains in the floor and no windows.

Partners have begun to understand that for the great majority of them, they are devolving into employees at will and not partners in the classic sense. Mergers become the vehicle through which change that the organization does not have the courage and support to attain will be worked. The newcomers will be cherry picked. But the merger also presents the opportunity to do the same internally with the acquiring firm partners. New standards, new policies, and new reductions in force, equally applied to all ranks of both firms. And by and large, most of the big mergers of the last decade have clearly not been a resounding success for the clients, certainly not for many of the partners. But there have been huge costs, dislocations and headaches, and the management limitations of law firm leadership have been highlighted in effecting the post merger operations.

More and more the quest for higher and higher profits is resulting in the de-equitization of partners, and their conversion to highly compensated employees at will.

The lowest tier is always at risk, but retained as long as they deliver strong and profitable hours. There is not much to be extracted from them beyond what is taken on a current basis. They cannot really leave voluntarily and keep their pay; they are appended to the top tier partners that use them. The top tier is getting what the firm defines to its partners as a "fair market" compensation, because if it does not they may leave, seduced away by promises of market rate pay. (Not surprisingly, it is the "top tier" that creates these definitions and assigns the fair market compensation to themselves). So that leaves the middle tier, the "engine room" of the firm and in many cases its future of leadership and expertise to support the top tier. The problem of course is that such attorneys are fully mobile. And when the tithe to stay in the firm becomes too high...they leave. Usually they do it independently, and quietly, but quickly and in numbers.

The wealth transfer machinery thus impaired, the firm proceeds quickly to collapse. The top tier partners have no longer a host to feed from, the remaining service partners have nothing more to give, and they move to another organization eager to have them come. Some of the service partners will be protected as essential components to taking care of key clients, and others will be replaced by the acquiring firm service partners designated as "keepers".

The abandonment of firm culture, the focus on profit above most other intiatives (including pro bono, diversity, community service, and professional organization support), absence of attention to operating fundamentals, the willingness to exploit the community of partners to feed the compensation ambitions of top tier partners, and failure of leadership characterizes many of the firms that have gone through a flash disappearance. Altheimer, Brobeck, Heller, Graham, are but a few firms of the past with golden heritages that have been lost outright, and others effectively have had the same happen through merger and disappearance.

But do we find an overwhelming response from clients that think these consolidations and mergers are a great thing? Have they received better service at lower rates? Do they lament the loss of the old firms?
How about a consensus or even majority of partners of merged firms? Have they received a better compensation, quality of work life or balance of work and life? The answer to these questions in most instances is clearly a "no".

The storm that is coming is that the famous inertia of lawyers to do anything involving change is becoming pressured enough that alternative approaches to practice are about to become worth considering. And when the ease of doing it successfully becomes apparent, the absence of the "glue" that holds big firms together in the past will become clear, and there will be no reason for many to exist. That dissolving of the need for such firms may result in a new order of excellent caliber lawyers finding each other in other structures, and providing equivalent or better service to clients at significantly reduced billing rates, and with much better working and private lives. It is not far away when the overwhelming consensus of bright professionals at the top of their craft hold forth with the view that "anything has got to be better than this."

Brilliant article. It highlights the fact that many lawyers don't understand how to run their own law firms as businesses. As the article says, the boom times are apparently over. An octopus with four injured tentacles will not long survive.

Fantastic article. Also, fantastic comment by "Broct." As a direct hire recruiter and now also as director of a contract attorney agency, I see more deeply now than when in practice what is really going on in law firms. I don't see how the current structures can survive, but I similarly do not see any end at all for the notion of law firms per se.

I think it is important to point out that yes, in-house counsel (the clients!) don't care (much) one way or the other what law firm their favorite lawyer calls home, BUT, let's not forget the huge drive among the most important clients to consolidate and decrease the number of firms they work with. Quite frankly, I believe that the only economies of scale advantages in law firms actually accrue to the relative power of their clients. IOW: big firms means lower rates, better control over logistics, time savings, and ease of enforcing policy decisions across various disciplines. The days of the large firm are not and will not soon be over.

Yes, the fundamental argument here is that law firms are currently lacking "structural integrity" and perhaps need better partnership agreements. Certainly, the cultural reasons behind the lack of even the concept of firm loyalty, etc., will not soon change.

In the meantime, it is indeed a tricky time to be a law firm partner.


The comments to this entry are closed.

By: TwitterButtons.com

[email protected]

From the Newswire

Sign up to receive Legal Blog Watch by email
View a Sample