Editor’s Note: this is the second in a three-part series looking at issues related to peer selection. Part I looks at a new approach to selecting peers. Part III will be published next week. Part III looked at the drivers of profit per equity partner.
The previous article described a data-driven method for identifying financial peers for a selected law firm. To recap, revenue is combined with two additional metrics: revenue per lawyer and profit margin %. Peer firms are identified as those which are most similar to the selected firm on all three metrics combined.
Over time, the selected firm, other firms and indeed the legal industry do undergo changes in financial performance. We would then reasonably expect that a firm’s peer set should also change to incorporate such variations.
Law firms typically choose peers on a manual basis. Our experience has been that firms seldom modify peers over time, despite changes in the firm, peers or the industry. This inertia is understandable, as it can be a difficult exercise to create new peer sets manually each year. By contrast, the data-driven approach can readily identify peers which are more reflective of the firm’s performance in any given year.
King & Spalding
As an example, we consider King & Spalding, which has seen remarkable enhancement in financial performance in just 8 years. The firm’s revenues in 2010 were $675 million, RPL was $850,000 and profit margin was 32%. In 2017, revenues had increased 56% to $1.05 billion, RPL had moved up 24% to $1.05 million and profit margin had improved to 46%. Key financial peers identified by our methodology in 2010 were Winston, Hunton and Akin Gump. Similarly in 2017, Paul Hastings, Goodwin and Dechert comprised the top peers. Indeed, the list of firms in the peer set did change each and every year, in line with King & Spalding’s dramatic transformation. In any particular year, our methodology identified those law firms whose performance matched King & Spalding. We see that only two firms, Akin and Cooley remained in the peer set in both 2010 and 2017 (see Figure 1).
What if King & Spalding had maintained its original peer set in 2017? It would appear that the firm far exceeded those firms on size, RPL and profit margin (see figure 2). However, we may wonder if this comparison is appropriate. In 2017, the firm’s financial profile had changed so significantly, that a comparison with a different set of law firms was warranted. Indeed, the 2010 peer set would not be relevant at all. These new 2017 peer firms would have revenues, RPL and profit margin which are more aligned with King & Spalding’s recent 2017 performance. When compared to such firms, King & Spalding’s financials are seen to be similar to the peer average.
Peer Set Changes
Why does a firm’s peer set change over time? Imagine each law firm has a specific position defined by its performance on the three metrics. This position varies over time, thus carving out a firm’s trajectory across the years. To identify peers in any year, we choose other firms closest to the selected firm. In a sense, we are taking an annual snapshot of all such trajectories. It is possible that firms which were historical peers could take a path which distances them from the selected firm. Conversely, firms which were not historical peers could approach closer and become current peers. In our example, King and Spalding’s original 2010 peer, Winston and Strawn diverged and has a very different set of its own peers in 2017 (see figure 3). Paul Hastings, which was not even in consideration in 2010, has sufficiently converged to become a top peer in 2017.
Firms use peer comparisons and benchmarking as key inputs into many management decisions. Annual lawyer rates increases are guided by indicative rate adjustments in peer firms. Lawyer and staff headcount increases or decreases take into account peer ratios. Many law firms conduct financial and operating analyses to understand PPP and expense differences with peers. Firms set strategic growth goals in line with performance levels of peer firms. If a firm does not have an appropriate peer set, it is likely to make misleading comparisons and take potentially incorrect business actions on rates, FTE or expenses.
Keeping relevant peers across years is especially important for firms whose financial performance is rapidly changing. They should be including firms who are more reflective of their new situation. Even if a firm’s performance is stable, there may be variations in peer and industry performance. And as any firm evolves over time, its billing rates, revenue per lawyer and cost per lawyer do change. Benchmarking should be done with firms who are at such a performance level.
Comparing to a lower-performing peer set may lead to complacency. Comparison to higher-performing peers may instill a false sense of unapproachability. In this light, having the right set of firms in the peer set is crucial. The inertia to modify peers in the manual approach can be handled elegantly by the data-driven approach. Peer sets can be quickly assembled, and deep analysis becomes possible.
Reviewing peer sets periodically to incorporate any changes in the firm, other firms and the industry is a worthwhile effort. Analyzing variations in historical and current peers can lead to smarter strategic and business decisions. The process of selecting peers can become a dynamic exercise based on careful consideration of other firms, and lead to engaging internal discussions.
In our next article, we will look at PPP, the metric that we did not consider in peer identification and show how differences in firm PPP can be translated into operating metrics.
Madhav Srinivasan is the Chief Financial Officer at Hunton Andrews Kurth LLP, leading the global finance and pricing competencies. Madhav is also an adjunct faculty at Columbia Law School in New York and University of Texas at Austin School of Law.
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