As usual, the start of 2016 has brought a flood of lateral partner announcements at big law firms across the country. Partners frequently time their moves for early in the year, once they’ve received their pay and year-end bonuses.
The lateral churn doesn’t just have firms juggling client business they’ve lost and gained. Amid the boom in lateral hiring, consultants say, they are seeing changes in how firms collect capital contributions from new partners—and how they return capital to those who leave.
Firms are asking more from their partners, whether as a lingering result of the recession or in response to the ever-revolving door between firms, according to several consultants and legal industry experts. They are also returning capital contributions more incrementally to partners who depart for other firms.
“In the wake of the great recession and the consequent downturn in demand, firms recast their balance sheets to reduce their financial leverage and to look more toward their partners for capital,” said Michael McKenney, managing director of Citi Private Bank’s Law Firm Group.
Capital contributions and commitments give partners an equity stake in their firms and fund the firm’s operations. Firms raise capital from partners in order to finance new investments, ranging from furniture upgrades and new technology to the opening of new offices. The amount that partners contribute is often calculated on the basis of their projected annual income, though that’s not always the case.
Between 2004 and 2007, contributions averaged between 20 and 25 percent of partners’ income, according to Citibank’s data. During boom years like those, firms frequently turned to banks to buttress their capital. But increasingly, instead of borrowing from lenders, firms are raising the amounts they ask their partners to contribute, McKenney said.
It’s a safer approach, he said, because firms are collecting smaller amounts of money from a larger pool. At the same time, increased capital requirements give partners a greater sense of ownership in their firm and its financial performance.
Of the firms Citi Private Bank surveyed, partners are now contributing an average of 30-35 percent of their earnings, McKenney said. At most firms, he said, partner capital contributions rise in tandem with partner compensation.
To be sure, there’s a great deal of variation in how much firms are demanding from their partners. Some set capital requirements as high as 50 percent, while others take 19 or 20 percent. Some only raise capital on an as-needed basis, when confronted with new expenses for real estate or other needs, McKenney said.
Then there’s the issue of what happens to a partner’s capital contribution when he or she leaves the firm. Consultants agree that it’s becoming more common for firms to return a partner’s capital in installments rather than in one lump sum, though the latter approach is not unusual.
Jeff Grossman, senior vice president of the legal specialty group at Wells Fargo, said that firms have found that it’s more sustainable to hold on to contributions a little longer. “The events of 2007 and 2008 really pointed out the need to have insurance … to cover extraordinary times,” he said.
McKenney said that that firms aren’t necessarily amending their partnership agreements. Rather, he said, since the recession, firms are adhering more rigidly to documents that already called for capital to be returned incrementally when a partner departs.
Out of 40 firms surveyed by Citi Private Bank, 30 percent return partners’ capital between one and two years after the partner’s departure. Twenty percent wait until two or three years have passed, and another 20 percent return partner capital between six months and a year of the move. The remaining 30 percent return capital within six months or—at the other extreme—between three and five years.
Of those same surveyed firms, about 15 percent return partner capital in a lump sum, while the rest return it in installments, McKenney said.
Arnold & Porter partner Jonathan Hughes, who represents partners and law firms in partnership disputes, believes that increased lateral activity has helped drive the incremental approach to capital returns.
For the firms, returning capital in installments has clear benefits. “If they want a full and complete return, [partners] have to be supporting the collection of the inventory and be very careful in how they’re handling client matters,” said McKenney.
The use of incremental payments can also serve as a form of golden handcuffs, forcing partners to weigh lateral moves more carefully, said Grossman—though it’s hardly enough to ensure that partners won’t leave.
Withholding capital from partners on the grounds that they breached some sort of duty is risky and rare, said industry observers, but it happens.
“If the firm thinks the partner has done something wrong while at the firm—competed with them unfairly, breached a duty—they might say, ‘We owe you $500,000, but we’re taking it as an offset against what you owe us,’” said Arnold & Porter’s Hughes. “That’s when they have to litigate.”
Hughes said that in his experience, when the return of capital triggers some sort of dispute, it’s the result of a breakdown of trust between the departing partner and his or her former partners. But that can be avoided.
“As a partner, you have fiduciary duties to one another,” he said. “You need to be open and transparent.”