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As California law firms continue to post their 2007 financial results, their leaders say back-to-back associate salary increases bit into partner profits. “The fact is that we only passed on much less than half of the associate salary increases onto the clients, and the partners have absorbed more,” said Guy Halgren, the chairman of Sheppard, Mullin, Richter & Hampton. “The partners made less money.” While most California firms, including Sheppard Mullin, still reported steady increases in profitability, leaders acknowledged that returns could have been higher without the double hit of salary increases. There’s only so much you can pass on to the client and associates, leaders said, and that means partners had to absorb more in 2007. “We’re seeing increases in our costs � there’s no doubt about that,” said Mark Helm, the co-managing partner of Munger, Tolles & Olson. “I suppose it did take away from what we’d have otherwise seen.” In early 2007, many big firms raised starting pay to $145,000 in California after the scale went to $160,000 in New York. Months later, as California competitors began paying New York wages in the Golden State, leading firms followed suit with a second round of raises. For law firms, real estate and associate compensation are the two biggest costs, equaling roughly 80 percent of total expenses, said Arthur Culvahouse Jr., O’Melveny & Myers’ chairman. “When you have substantial increases in one of the big expense drivers, it has to affect profits,” he said. “It has an impact, without question,” said Kenneth Doran, Gibson, Dunn & Crutcher’s managing partner. “It’s a direct deduction.” When net income shrinks, PPP shrinks, he said, especially when first-years are getting an extra $25,000 raise that ripples up the associate scale. “Many were surprised by two increases in a single year,” he said. The pinch was probably felt more by the equity partners, since those in the nonequity ranks often cut a deal in advance, much like salaried employees, said Alan Miles, an L.A.-based recruiter with Alan Miles and Associates. “They take the money to pay these raises out of the profits the firm generates,” Miles said. “Therefore, lawyers relying on those profits for their main cash flow are affected. It’s now being diverted.” But some firms had plenty of revenue to cushion those withdrawals. While Latham & Watkins’ Scott Haber, the managing partner of the San Francisco office, acknowledged there were additional expenses because of the salaries, it didn’t dent Latham’s sky-high profits. “The numbers speak for themselves,” he said. “But I would agree that this year had a bigger effect.” SALARY STRATEGIES Firms took varied approaches to sucking up the added hits. Manatt, Phelps & Phillips adopted a two-pronged strategy, only raising the salaries once in a year. The second increase � to $160,000 � was announced in 2007, but not implemented until this year. That’s because the firm is of the belief that one raise a year is sufficient, said William Quicksilver, Manatt’s managing partner. “It worked out fine � we were able to continue to recruit and retain folks,” he said. San Diego-based Luce, Forward, Hamilton & Scripps used the news of more increases as impetus for adopting a merit-based salary schedule � removing itself from the follow-the-leader lockstep approach. But other firms simply accepted the double whammy. “We can’t control associate compensation or real estate,” said Gibson Dunn’s Doran. “It’s a cost of doing business, and we’re committed to positioning ourselves in a certain part of the market.” Halgren said the partners at Sheppard Mullin realize that, too, and take the hit to their paychecks to ensure that the firm gets top talent. AN UNCERTAIN FUTURE One thing is certain � leaders are optimistic that runaway associate compensation will stabilize. Historically, salaries don’t go up at a steady rate, Munger Tolles’ Helm pointed out. They jump, they flatten and they jump. “One hopes it will even out,” he said. And the current climate might encourage that, Doran said. To the extent that firms are less busy, the supply-and-demand curve may shift a bit, alleviating the upward pressures on salaries, he said. But, when it comes to associate pay, it’s anyone’s guess. “Who knows?” said O’Melveny’s Culvahouse. “There may be a firm out there having a great year that decides to give itself a recruiting edge. And then we could be off and running again.”

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