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Debt was the fast and easy way for law firms to pay for new partners, scores of additional associates, and posh new offices during their 1990s expansion. But flat or declining revenues at firms have forced bankers to take a closer look at firms’ balance sheets to determine if the legal business is still an attractive market for lending. To gussy up for their financiers, firms have pumped partner capital contributions to reduce their dependence on debt, slashed costs by cutting employees, and are renegotiating leases and firing under-performing partners. That’s particularly true at technology firms, which took on debt faster and fell farther than other firms during the boom. They have been especially under pressure from their bankers to cut costs and slow borrowing. “There’s no question the tech firms are pulling down the performance of the industry this year,” said leading law firm banker Danilo DiPietro. “But on the positive side, they were the firms to react more quickly in a relatively nimble fashion to the expense situation.” On the whole, DiPietro and other bankers who cater to the legal sector believe the industry has made the right moves to protect their relationships with lenders. DiPietro, who heads Citigroup Inc.’s law firm group in New York, which lends to more than half of the nation’s 100 top-grossing firms, said that when the downturn took hold, he started a dialogue with clients about potential problems. For most firms, heading off financial problems was a simple matter of cutting discretionary spending, he said. But for firms that were in high-growth mode, like the big West Coast firms, it wasn’t quite so simple. “You’ve got firms caught in the timing disconnect where you’ve made commitments for build-outs and you get hit with a slowdown,” DiPietro said. In other words, firms went on a real estate spending spree and had locked into expensive, long-term leases that still must be honored. Still, DiPietro said law firm borrowing has slowed, and he’s finding more conservative debt-to-capital ratios at firms. Plus, he’s anticipating industry-wide revenues to grow by 8 percent during 2002. “Concerns about the legal industry are overblown and overstated,” DiPietro said. “If this were a sector that was reporting publicly, the legal industry would have a buy recommendation.” BIG BUSINESSES Law firms are now big businesses and major employers, bankers said, and consequently, they’ve become more sophisticated about their finances. Some are looking beyond the simple short-term loan or line of credit and considering private placements and syndicated loans where groups of investors put up the capital and the firm repays the loan over a longer period of time, said Stephanie Barrell, a senior vice president at Bank of America. Morrison & Foerster, for example, raised about $30 million in the past year by staging two private placements with Bank of America. Keith Wetmore, MoFo’s chairman, said the firm’s stable balance sheet — both its capitalization and its steady financial performance — helped the firm sell the debt offering to a handful of insurance companies. The debt, which is unsecured and non-recourse, meaning the partners aren’t on the hook personally for the loan, will pay for capital improvements at the firm, Wetmore said. “I think the partners would generally conclude that given the small amount of risk and small amount of debt, it’s easier,” Wetmore said. “As opposed to asking the partner to put in that much additional capital.” At the firm level, managers are becoming more skilled at cutting and controlling costs, bankers said. The more adroit firms have sliced under-performing partners from their payrolls as a cost-cutting measure, bankers say. Partner departures top a laundry list of law firm activities that bankers watch to monitor the health of their clients. That can cut two ways. On the one hand, financial institutions applaud firms that show low-earning partners the door. On the other, they still get alarmed when large groups of partners exit for other firms. Brobeck, Phleger & Harrison’s experience during the last year is perhaps the most visible example of the issues bankers watch. The firm has lost at least 50 partners in 2002 and carries a hefty real estate burden in East Palo Alto and Palo Alto. Brobeck managers did not return calls for comment, and a spokeswoman said the firm’s financial affairs are private. But law firm managers and bankers say that kind of partner exodus usually leads to a meeting with bankers. “Partner departures are key; that’s the assets of the firm,” said Russ Colombo, senior vice president at Comerica Bank in San Francisco. Colombo works with a handful of local law firms and says that so far, they’re weathering the downturn. But he checks with his clients regularly, monitoring receivables, partner distributions and outstanding expenses in comparison to the firm’s level of business. In fact, most bankers get monthly and quarterly reports from clients that list receivables, collection rates and outstanding obligations, like leases. “Just because we’re comfortable with it doesn’t mean that we’re not nervous,” Colombo said. “You have to make sure you’re in touch and that they’re maintaining the level of business you want to see.” TRIMMING DEBT Some firms have been able to wean themselves from debt by increasing capital accounts. That generally means asking partners for a bigger chunk of their paychecks. The firms then use the influx of new cash to pay for lease commitments or renovations that were already in the works when the market tanked. Thelen Reid & Priest this year increased the capital contributions expected of partners by 2 percent in part because the firm had moving expenses coming. With leases in three major offices all expiring in November, firm managers knew at the beginning of the year that capital needs would increase, said Richard Gary, Thelen’s chairman. “It was prudent to increase our firm’s capital base,” Gary said. “We’re in this for the long term, and capital is important to a law firm’s capital structure.” Cooley Godward also bumped up its capital contributions from partners in the last two years, said Richard Bradshaw, the firm’s executive director. After the increase in capital contributions, the average paid-in capital for each partner is $225,000, Bradshaw said. At the same time, the influx of cash will make it easier for the firm to negotiate terms with bankers and, for that matter, with landlords as the firm looks at long-term leases, Bradshaw said. “If you have more paid-in capital, not only can you have less debt, but it also allows you to borrow on more favorable terms,” Bradshaw said. Despite the downturn, Silicon Valley Bank, which created its law firm banking group three years ago, is still targeting tech-law firms. Steve Empey, managing director of professional services at Silicon Valley Bank, said that because the bank traditionally lends to entrepreneurs, lawyers are more enthusiastic about meetings. “They are looking for a bank that can provide them with other meaningful products, like referrals,” Empey said. “They’ve become much more inclined to use a bank like us.”

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