No doubt about it, leaders of Am Law 200 firms are upbeat about the future. Eighty-nine percent of respondents to our annual firm leaders survey said they are optimistic about 2006, almost exactly the proportion who expressed optimism last year and the year before that. Only 11 percent of the respondents to our latest survey said they were uncertain about the future, and none said they were pessimistic.

That’s not to say that there aren’t plenty of frustrations too. For the first time, this year’s survey asked respondents to name their greatest disappointment with their firms in the past year. The result was a host of woes: soft demand for transactional work, a dearth of qualified lateral partners, the inability to open offices in London or China, a failure to grow enough in New York, and lawyer productivity that fell short of expectations (especially grating after increases of more than 9 percent in gross revenue and profits per partner in 2004).

But one of their most frequent laments concerned their failure to connect with a new generation of lawyers. “Associate satisfaction continues to be lower than we would like,” wrote one respondent. “Could not find as many high-quality lateral associates as we needed,” wrote another. “Number of associate resignations,” responded a third.

Associates have been complaining for years that partners don’t pay enough attention to their needs and make them feel dispensable. In fact, the whole economic structure of nearly all large firms is built around hiring large numbers of first-year associates and winnowing them down as they advance in seniority. As an associate at Shearman & Sterling put it: “It’s part of the game. They hire 100 associates and lose a vast percentage.”

Here we present a special report on the outlook for 2006. It includes the results of our Leaders Survey, and in our print version, an essay by Citigroup’s Danilo DiPietro on his bank’s projections for this year and next, and a look at four recent surveys of general counsel. The report underscores that one pressing topic for firm leaders is dealing with the revolving door for associates, along with such areas as billing rates, expansion, and expenses-and, naturally, hitting profitability targets.

We conducted the Leaders Survey in October, asking the heads of Am Law 200 firms to complete a confidential online questionnaire. We received responses from 147 firms. Despite the worry about associates, most of the leaders who responded to the survey forecast improved conditions for 2006. Seventy-two percent said they expect the economy to grow slightly. Seventy-eight percent said they expect deal flow to increase, albeit moderately. (Results are available at americanlawyer.com.) Other responses provide a snapshot of what firm leaders anticipate 2006 will be like at their firms:

Billing rates will continue to go up. Fifty-three percent of respondents expect to increase billing rates by 5 percent or less; 46 percent anticipate raising them by more than 5 percent.

Profits will keep rising, too. Sixty-eight percent of respondents expect profits per partner to grow more than 5 percent; 27 percent think profits per partner growth will be 5 percent or lower.

Litigation will remain the number one practice area. Thirty-eight percent of respondents see it as next year’s fastest-growing practice area, while 30 percent cited corporate work. (A year ago, 49 percent of respondents predicted that litigation would be 2005′s fastest-growing area, while 33 percent opted for corporate work.) Forty-seven percent said they expect to see head count grow the most in litigation, while 28 percent said they expect more hires in the corporate area.

Nobody’s changing their associate hiring patterns. Thirty-four percent of respondents plan to increase the size of their first-year classes by more than 5 percent, but 37 percent plan to keep the class size the same. Those are roughly the same percentages as in our survey a year ago.

Firms embrace temp workers-at least domestically. Seventy-seven percent of respondents said their firms are using contract lawyers or plan to do so. But just 6 percent said they currently offshore work to a foreign country or plan to do so.

Firm leaders still aren’t spending much time getting feedback from their clients. Forty-eight percent said they had met with five or fewer of their 20 top-billing clients in the last 12 months to discuss the firm’s performance. Six percent said they hadn’t met with any.

While firm leaders mull over improving their relationships with associates, they clearly don’t believe in throwing money at the problem. Thirty-seven percent of respondents said they did not plan to raise associate salaries, which have been frozen since 2000, when top-tier firms boosted first-year pay to $125,000. For one thing, associates receive an annual boost in pay as they move up in seniority-fourth-years earn $165,000 at most top-tier firms, a 10 percent annual pay raise that few other professions guarantee. For another, overall compensation has gone up, since firms have been increasing their associate bonuses, an approach that is encouraged by Citigroup’s DiPietro.

Associates, though, sometimes paint the issue as one of pay equity. “Associates are definitely getting fed up with how flat salaries have been,” says an associate at O’Melveny & Myers. “It’s not because we don’t think we’re paid enough, it’s watching the partners’ share increase while ours stays the same. We’re more like regular employees as the years go by and not partners in training.”

By early November, two Los Angeles firms-Irell & Manella and Quinn Emanuel Urquhart Oliver & Hedges-had boosted first-year associate pay to $135,000, although it hadn’t set off a larger round of salary increases. Nonetheless, Sullivan & Cromwell chairman H. Rodgin Cohen says that if a top Am Law 100 firm raises associate salaries, everyone else will follow. Morrison & Foerster chairman Keith Wetmore agrees. “You can bet most of us will be there if the market moves,” he says. “The jungle drum suggests that there probably will be an increase.”

While firms are reluctant to open their wallets to boost associate salaries, they have been financially conservative in other areas as well. Most notably, firms are avoiding debt. Nearly one-third of leaders (32 percent) said their firms carry no long-term debt, while 26 percent said their debt load was less than $5 million. Seventeen percent said their debt load was $5-10 million, and 24 percent said it was more than $10 million.

Hogan & Hartson and Quinn Emanuel are among the firms in the no-debt club. Hogan chairman J. Warren Gorrell, Jr., says that over the past three years his firm paid off debt it incurred from expansion and has not borrowed on its line of credit since June. Quinn Emanuel’s John Quinn said his litigation shop has never had any debt. “Our clients pay, and we don’t live beyond our means,” he says. Thomas Clay, a principal at the consulting firm Altman Weil, Inc., attributes that to large firms’ high profitability. “The Am Law 200 have printing presses in their basements, so they can afford to be conservative,” he says. “If you can run a business and avoid debt, you should do it.”

A pay-as-you-go philosophy can force partners to invest more capital to cover firm expenses. Lee Miller, joint CEO of DLA Piper Rudnick Gray Cary, says his firm raised its capital requirements over the last three years to help pay for information technology costs, which were around $20 million last year, and for the firm’s expansion. “I think you will see a trend” of firms increasing capital requirements, Miller says. “Many firms [have been raising their requirements] in the 20-25 percent range.” Still, 59 percent of respondents to our survey said they do not plan to increase partners’ capital contributions next year, up from 50 percent in last year’s survey.

One reason for firms’ reluctance to borrow is the lingering ghost of Brobeck, Phleger & Harrison. That firm had $80 million in debt when it self-destructed in 2003. More recently, Coudert Brothers owed its banks $22 million when it shut down in August.

Debt makes firms unattractive merger partners. Yet that doesn’t appear to be a factor in firms’ reluctance to borrow. Only 24 percent of respondents said they are looking for a merger partner, about the same proportion as in last year’s survey. That surprises Clay. He distinguishes merger deals from acquisitions, a term firms avoid using since it acknowledges that one firm is being consumed by the other. He estimates that more than three-quarters of Am Law 200 firms are considering acquiring a firm one-half to one-quarter of their size.

Just as firms are financially conservative, they are also wary of new trends. Although offshoring has gotten a lot of ink in the financial press in the past few years as a way for companies to save money, firm leaders reject the idea. Ninety-four percent of our respondents said they do not send work overseas and had no plan to do so. When firms did send tasks overseas, they primarily involved document management, contract and brief drafting, and discovery work. But in 2005 a few firms, most notably Pillsbury Winthrop Shaw Pittman, began offshoring patent prosecution work at the request of a few clients who were looking to reduce legal costs.

Pillsbury managing partner Marina Park declined to identify the clients that asked the firm to pursue offshoring, but Silicon Valley-based Cisco Systems, Inc., and LSI Logic Corp. are known to have asked their outside counsel to send patent application work to India. Park says her firm isn’t advocating offshoring, but says that if clients find it beneficial, Pillsbury would experiment more with it. She says she regularly gets calls from companies that provide services-primarily litigation support, but also some intellectual property work-in India, and she says she suspects that general counsel get similar calls.

Leaders are also sticking to the status quo in the area of firm management. Seventy-nine percent said five or fewer lawyers in the firm spend more than half their time on management, about the same proportion as in last year’s survey. Wetmore says that’s to be expected, since pulling partners away from their practices slows their careers. “In law firms your credibility comes from practice,” Wetmore says. If partners cut billable hours down to 700 or 800 hours annually to take on management duties, their “credentials . . . are being eroded,” he says. “You probably should have as few [in management] as possible because you’re destroying their careers.”

Despite their conservativism, firm leaders ultimately are confident in the ability of their firms to beat the overall economy. Although 94 percent of respondents predicted that the nation’s economy will be flat or grow only slightly next year, 89 percent said they are optimistic about their firms’ prospects, and 99 percent said they expect to raise rates. That may be a tribute to the recession-proof nature of large, diversified firms. “Lawyers are pretty cycle-neutral,” says Hildebrandt International consultant Joseph Altonji. “Firms seem to do well no matter what. . . . It’s a complicated economy, and lawyers are there to help navigate transactions and sort out messes.” For that, firm leaders are eternally grateful.

E-mail: bsandburg@alm.com .