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“Always live within your income,” wrote a 19th-century humorist, “even if you have to borrow money to do so.” How true for law firms. For many firms, cash is thin, and debt is king — into the summer months. But a less seasonal, more enduring increase in debt has some law firm managers biting their nails. During the growth spurt of the late 1990s, costs shot up as firms started to aggressively recruit lateral partners, launch new satellites abroad, and upgrade their technologies. Profits soared. But so did debt. According to a survey of top 10 firms by Citigroup Inc., the leading lender to U.S. law firms, law firm debt increased at a faster rate than capital from 1997 to 2000. In fact, debt per equity partner at the bank’s top 10 firm clients grew by an average of 150 percent. Debt growth in general — according to Danilo DiPietro, the head of Citigroup’s law firm lending practice — grew twice as fast as profits did. Three of the firms the bank surveyed — all among the country’s 50 highest-grossing — had total debt authorization of more than $200 million each, including long- and short-term debt. That’s how much debt the bank approved for each firm, not how much of it they actually used. Still, the increase reflects firms’ greater anticipated needs. “We used the word ‘dramatic’ a year ago to describe the increase,” DiPietro says. (Although DiPietro won’t name the firms with more than $200 million in authorized debt, he says that they are New York-based firms or firms with substantial New York offices.) In 2001, he says, debt increased again, though at a slower rate. But big debt and shrinking revenue can spell trouble if a firm isn’t managed wisely. And in 2001, revenue at nine of the Am Law top 50 was down or relatively flat (with revenue gains of 5 percent or less). Lawyers don’t typically learn about law firm balance sheets in law school; managing partners or firm chairs, sometimes even nonlawyer CFOs, handle the books. But every partner ought to be knowledgeable about debt. A balance sheet issue can scuttle a merger, cause internal rifts among partners, or put a firm out of business. Not to mention that individual partners are ultimately accountable for some of their firm’s debt. Firms finance costs in a variety of ways, among them cash from revenues, partner capital contributions and short-term and long-term debt. Expansion — whether in the form of new offices, increased lateral hires or new technology — costs money. And the temptation to pay new or longtime partners by using debt can sometimes be great. Although a lateral partner must be paid upon joining the firm, he or she generally does not generate profits for at least three months. Office renovations have become an additional expense. Historically, landlords calculated the cost of tenant improvements into the cost of rent; now more are apt to lower rent and let tenants pay for build-outs on their own. Expansion has its risks and, in some cases, can be a drain on balance sheets. In the San Francisco Bay Area, for example, firms bulked up on lawyers and staff and took on expensive space in Palo Alto, Calif., with long-term leases. Faced with lower revenue and profits, many firms that invested heavily in tech have cut their ranks and are struggling to find subletters. Many firms think using debt is a little like indulging in high-calorie desserts — it’s OK now and then, but too much of the stuff can cause a coronary problem. The more cautious, or conservative, firms — the diet fanatics in this analogy — view debt with disdain. But like real health nuts, there are very, very few who completely refrain from dipping into the cookie jar. So in these tight times, even conservative firms generally have to borrow in the first quarter to pay for costs, including staff and associate compensation. (Most say that they don’t borrow to pay partners, although consultants say that practice is on the rise at big firms.) Many firms continue to borrow and don’t pay down their debt to zero — referred to as being “out of the bank” — until December of any given year. “We don’t believe in debt,” says David Strumeyer, chief administrative officer for Cadwalader, Wickersham & Taft. But Strumeyer means that he doesn’t believe in borrowing to pay partners, which to some law firm leaders is a deadly sin. In actual practice, however, Cadwalader does use debt. It uses a line of credit to cover working capital, such as payroll and office supplies, if it needs to. The firm also has a mortgage on its posh downtown Manhattan building, which it purchased and built out in 1984. (Most firms don’t have mortgages, because they typically lease their office space.) For Cadwalader, taking the mortgage was more cost-efficient than taking a lease. The firm makes its mortgage payments using cash flow, Strumeyer says, not by borrowing. Capital withholdings are roughly 10 percent of earnings, which means, of course, that partners who make more get more held back. Some firms, but not many, have zero debt; they pay for everything with revenue and capital from partners. Glenn Graner, the CFO at Pittsburgh’s Kirkpatrick & Lockhart, says that his firm has a $7.5 million line of credit. “But we haven’t used it in the 14 years that we’ve had it,” he says. “We only like to spend money that’s ours, and not someone else’s.” Graner says that the firm also has a fairly steep capital contribution requirement; that money is used to pay for big expenses. Although using capital pay-ins to finance growth is an alternative to debt, Kirkpatrick’s no-debt policy is rare. In some cases, the penchant for borrowing is risky business. A growing firm can find itself quickly in trouble if its balance sheet gets out of whack. If it fails to pay down short-term debts on a yearly basis, it risks defaulting. A combination of factors can be lethal: Revenues dry up, partners jump ship, associate salaries spike, and office build-outs get out of hand. A recent case in point was Troop Steuber Pasich Reddick & Tobey, the Los Angeles-based entertainment firm that collapsed in late 2000. Just as some of the founding partners of the firms were leaving, work for movie studios started to taper off. Instead of ramping down, Troop ramped up, building out space in expensive, plush offices. But to make matters worse, the firm had not prepared well for the dip in work. The general partnership was not required to make capital contributions, says former partner Neil O’Hanlon, now a partner in the Los Angeles office of Washington, D.C.’s Hogan & Hartson. “We were doing so well,” he says. “There was really nothing that needed to be fixed — or so it seemed.” But, facing a significant bank debt and dwindling revenue, the firm set out to find a merger partner or face closing its doors. Each partner had personal liability at stake: Each was on the hook for at least some of the firm’s debt, and needed a merger to absolve them of that debt. In the worst-case scenario, if the 120-lawyer firm’s receivables didn’t cover the firm’s $10 million bank debt and real estate liability, the bank could go after the partners as individuals. In January 2000, the firm was absorbed by Dallas’ Akin, Gump, Strauss, Hauer & Feld, which took on the firm’s debt. Troop is hardly the most extreme example of a firm choked by debt. The once high-flying Finley Kumble firm is the poster child for how not to run with debt. In the late 1980s, the New York firm borrowed money simply to pay its partners for projected earnings, when in fact revenue was quickly drying up. The firm had to file for bankruptcy in 1988. But today’s managing partners stress that high costs and lower revenues don’t always equal high debt. “I feel good about where we are,” says Donna Petkanics, the managing director of operations at Palo Alto’s Wilson Sonsini Goodrich & Rosati. Instead of relying on debt, says Petkanics, “we finance expansion and technology through cash … and retained earnings.” As Wilson’s debt level has increased “modestly,” its partner contributions have, too. In addition to holding back 3 percent to 5 percent of partner compensation for capital — a percentage range used by many big firms — the firm pays its partners far less in the beginning of the year, when the firm’s cash is lower. “Partners get paid like associates until the final three months of the year,” says a former Wilson partner. The strategy keeps costs down during the thin months. Consultants say that the strategy is not uncommon among big firms. Palo Alto’s Cooley Godward also plans to keep costs in check. “We don’t expect to be borrowing [long-term] this year,” says Richard Bradshaw, the firm’s executive director. The firm generally does draw from its line of credit, especially in the first two months of the year, when it makes its bonus distributions. But Cooley says it’s careful not to go overboard. The firm started looking at debt from a long-term perspective just as the economy began to wane in late 2000. “We were undercapitalized,” says Bradshaw. A new capital policy written into the partnership agreement says that the ratio of bank debt to partner paid-in capital will not exceed a 1:1 ratio, meaning that debt will never grow beyond what partners put in, generally 3 percent to 6 percent of their compensation. The partnership agreement requires the firm to measure that when borrowing is at its peak, at the end of January. In addition, Cooley, like most firms, used to have a more relaxed schedule for partners buying into the practice. But now Cooley cracks the whip, forcing partners to take on costs up front. “We would allow partners to pay in over several years,” says Bradshaw. “Under the new program, you’ve got three months to put money on the table.” Cooley helped facilitate payments by arranging for partners to take out personal loans from Citigroup. (Cooley’s lead bank for its debt facilities is Bank of America Corp.) Another stipulation protects the firm if partners leave: Partners get paid back in three installments over three years, which is common for a firm of Cooley’s size. Partners don’t get interest back on their capital investment when they leave. (This varies from firm to firm — some capital accounts accrue interest; some don’t.) Overall, says Bradshaw, tightening the reins helped lower the firm’s debt. Today its ratio of debt to capital is within its limits, at 0.9 to 1. “We have a greater debt load each year,” says R. Bruce McLean, the chair of Akin Gump. Due to large lease renegotiations and build-outs in the firm’s major U.S. offices, the increase in associate salaries, and technology upgrades, Akin Gump’s debt per equity partner has increased overall during the past five years. To offset that rise, the firm has increased overall capital by about 20 percent during the same period by holding back a higher percentage of its partners’ income. Rather than reduce the firm’s debt, which would force the firm to increase partner contributions by an unreasonable amount, “the critical thing,” says McLean, “is to balance the debt-capital ratio.” Other big law firms have also recognized that now is not the time to plan for new offices or other big expenses. Both Cadwalader and Los Angeles’ Gibson, Dunn & Crutcher say that they will probably spend less this year than they did during each of the boom years. “Gibson has been debt-free almost forever,” says Ronald Beard, former chair of the firm and a consultant at Newport Beach, Calif.’s Zeughauser Group. To finance most capital improvements, he says, “we have pretty hefty capital accounts.” Senior partners with the maximum number of shares in the firm end up contributing $1,000,000 at most over the entire course of their careers at the firm. At Gibson Dunn as at Cooley, partners get their contributions back, but those contributions don’t bear interest. Clearly, there’s no standard template for law firm balance sheets. Every firm is different. The expert advice is simple: A little debt never hurt, as long as it’s part of a balanced plan. Turns out that 19th-century writer could have been a modern-day law firm consultant.
Get a Clue What you may not know about your firm’s debt situation could hurt you. Here are the top five questions you should ask your managing partner.
1. “What is our total debt? And how did you decide that that was the right amount for us?” Some firms are more transparent than others. It’s in your best interest to know. 2. “Is our debt recourse?” In other words, if the firm defaults on its debt, are partners liable for the debt, and for how much of it? 3. “If our debt is recourse debt, are we all equally liable as partners? Or are we liable only to the extent that we share profits or share capital?” 4. “What is our obligation to each other?” Banks generally go after top rainmakers, not junior partners. “Should our debt be collateralized?” 5. “Are departing partners still on the hook for the firm’s debt? If, for example, 20 partners leave, what happens to my personal debt liability?” — Laura Pearlman

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