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June 1, 2011 3:44 PM

The Am Law 200: A Chasm with Consequences

Posted by Aric Press

From the June 2011 Issue of The American Lawyer

Let's start with one fact: There is now a $1.1 million gap between the average profits per partner of the top 23 firms on The Am Law 200, as ranked by PPP, and the average of the next 27 firms. In 2001, the gap between them was about half that, or $590,000. Both grew their profits at roughly the same pace--about 88 percent over the decade--but the gap in absolute dollars became a chasm.

This chasm has consequences. It has put the firms at the very top--let's call them Tier 1 firms--in a position to cherry-pick those just below (Tier 1A) in ways almost unthinkable a decade ago. It has forced the firms in Tier 1A and below to react, to further distort their partnership pay in the hopes of retaining star performers while picking off a few others from tiers below them. And, combined with a developing set of economic and technology factors, it has set the stage for law firms to approach differently the way they work for and relate to their clients. The first two consequences are already being felt. The third? Not so much.

Eighteen firms placed in the top 23 on the profits chart in both 2001 and 2010. These repeat performers do not follow a single pattern, save one. They're single-office deal or debt powerhouses and multinational, multioffice operations. They run the gamut from extremely low (1:2) to extremely high (1:7) leverage. They boast of single-tier and multitier partnerships, with lockstep and eat-what-you-kill compensation plans. What do they all have in common? Their clients pay more and pay more often.

The five newcomers share that trait plus something else: an uncommon degree of focus. Quinn Emanuel, Irell & Manella, and Boies, Schiller have first-degree litigation pedigrees. Dechert and Paul, Hastings are broader-beamed but no less relentless in their pursuit of upmarket business, rapidly pruning lawyers and slowly building relationships.

Poaching laterals is hardly new. It's the targets that appear different. On americanlawyer.com, The Churn—the twice-weekly account of partner movement—tells the story in its matter-of-fact, head-spinning way. Paul, Weiss takes two partners from Shearman & Sterling and five from O'Melveny; Latham recruits five from Wilson Sonsini and four from Vinson & Elkins; Gibson, Dunn takes four from Orrick (as does Dechert) and four from V&E; Kirkland snares three from O'Melveny.

What's happening here? With nary a by-your-leave, the superrich have converted the merely rich into farm teams. As one chair of a poaching firm who asked not to be identified for obvious reasons puts it: "It's the law of the jungle working. We have needs, and we can fill them." Like Tolstoy's unhappy families, every lateral move is different. As the recruiting firms never tire of saying, some lawyers really do move for bigger platforms or new opportunities. But no one is naive here. Seldom is money not part of the equation.

As the climate warms, the poached have reacted. As part of the Am Law 200 survey, we ask firms to report their partner compensation spread. The average from the 118 who responded: 10:1. In fact, the spread can reach 30:1. "We know the market price," says the head of one firm who has adjusted to losing a few partners to higher-bidding firms. "And we're going to meet it. Our [stars] can stay and, just as important, not go someplace else where they'll have a target on their backs." On one level, that's just prudence. On another, though, it can be a cultural challenge: When some partners really are more equal than others, Animal House can become Animal Farm over the course of a long partnership retreat.

Two caveats. This analysis only describes what's happening. It doesn't imply that the firms who have fallen behind are bound to collapse. These are strong institutions who have lost some ground and a few key players. By most standards they are in enviable shape. But as we'll see below, they face real challenges. Second, this analysis assumes the accuracy of our numbers. We can quibble forever about an outlier here or there and/or the prospect of intentional misleading on the part of some firms. The profits per partner numbers can be, well, manipulated, by how firms categorize their partners--equity or nonequity--or by blatant exaggeration. We are confident that they are directionally sound and, there is confirmation in the revenue-per-lawyer results. The average RPL gap between the top 23 and the next group has also grown over the last decade to about $260,000, the biggest quartile-over-quartile discrepancy among the Am Law 200 firms.

A Scarce Commodity. As everyone knows, over the past decade Am Law 200 head count has grown to unprecedented heights. The rush into New York, London, and other client-rich markets has been fueled by the notion that there was substantial unmet demand for top-tier lawyers in all these places. Now it appears that the premise may be wrong: There may be unmet demand, but for the moment at least it doesn't appear to be for unlimited, price-is-not-an-issue billing. But that's what most firms were built to do.

The $85 billion market served by The Am Law 200 is not a monolith. It varies—from the privileged New York suites where "for services rendered" bills still go out, to provincial capitals where good lawyers help clients solve problems for rates that won't pay for a nine-course dinner at Per Se. After listening to firms describe their work, we've concluded that the market divides into five categories:

• Critical strategic work: a deal of a lifetime, a subpoena to the CEO;

• If you want us, you'll pay our fees: The client needs a law firm's imprimatur;

• Important operations support that the client can't manage in-house;

• Ordinary operations support that the client can't manage in-house; and

• Commodity work that is more efficient to outsource.

Virtually every firm would like to live and work in the first two categories, which, by the way, are no longer immune to price pressures. By our estimates, those premium-priced categories account for about one-third of the market, or $28 billion. We believe that all Am Law 200 firms get some of this premium work; there are too many good lawyers with good clients in a splintered market for that not to be true. We also include in the premium category contingency scores.

Based on the financial results we've reviewed, it seems that the best billing work goes disproportionately to the most profitable firms. For this discussion, assume that at the top-earning firms, roughly 60 percent of work falls into this high-billing category. That means that roughly $11.6 billion is divided among the top 23 firms and the other 177 compete for the remaining $16.4 billion.

Sound too high? Cut the share of the high-billing work at the most profitable to 50 percent, and that leaves $18.5 billion for the partners at the other 177 firms. There isn't enough to keep everyone in Beluga: Premium work turns out to be a rather scarce commodity.

If the premium market isn't rapidly growing and there is a slow but steady movement of star players to those who dominate that sector, that still leaves a $57 billion market of important work to be divided among The Am Law 200. That's the good and bad news. With more law firms competing for this work and more clients resisting routine fee increases and demanding discounts, pricing models have come under increasing pressure. Is that pressure permanent? Or once the national and global economies heat up again, will lawyers' fees return to their comfortable status as rounding errors on gigantic balance sheets?

We don't know the answers to those questions; we are more comfortable reporting the news than predicting its course. But two observations seem appropriate—and safe. First, having grown used to a culture of discounting, it's hard to anticipate clients returning fully to their old habits, even in a time of plenty. Second, what's striking about the behavior of many law firms over the past two years is that they managed their way to profitability by shedding colleagues who did not have enough work, not by examining how the work itself is done.

CLICK HERE to continue reading "A Chasm with Consequences."

CLICK HERE to access the complete Am Law 200 package.

 

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