Margins matter. As most Am Law 100 firms faced another year of revenue growth that was weak at best, profit margins–the measure of how efficiently a firm converts revenues to profits–became more important than ever. No longer able to count on a swelling tide of revenue to boost earnings, firms must do more with less to increase or even preserve their partners’ profits.

But when it comes to profit margins, Am Law 100 firms are not all the same. Our five-year analysis of the margins of this year’s Am Law 100 firms shows a striking chasm between the highest- and lowest-margin performers. The highest-margin firms in 2010, such as Wachtell, Lipton, Rosen & Katz (63 percent) and Quinn Emanuel Urquhart & Sullivan (62 percent), can rightly claim to be money-making machines. Those firms with the lowest margins, such as Edwards Angell Palmer & Dodge (19 percent) and Squire, Sanders & Dempsey (22 percent), see an outsize portion of their gross revenues disappear into the ether of overhead, discounting, or some other cost of business.

Deciphering the characteristics that divide the top performers from the stragglers is no simple task. It’s a motley crew at both the top and the bottom of the margin list. Many in the New York cabal–including Simpson Thacher & Bartlett and Sullivan & Cromwell–have high margins. But some non-New York firms, such as Goodwin Procter and Vinson & Elkins, also landed in the top quartile. Megafirms like DLA Piper and K&L Gates finished toward the bottom, along with such disparate entities as Mayer Brown, Duane Morris, and Foley & Lardner [for individual firms' margins, see "Living on the Margins, page 97]. Still, a close analysis of the numbers revealed surprising lessons about the influence of leverage, two-tier partnerships, lateral growth, and global sprawl–in some cases upending conventional wisdom.

THE DEATH OF THE PYRAMID

Leverage has long been viewed as key to profits: Cadres of worker-bee associates would bill high volumes of hours at a relatively low cost, lining the pockets of equity partners. But the recession has turned that notion on its head. Sluggish demand for legal services over the past three years turned associates into underutilized assets with high fixed costs.

Of the 39 firms with profit margins higher than The Am Law 100′s average of 38 percent, 62 percent (24 firms) reported leverage ratios lower than the average of 3.45. And while there are a bundle of highly profitable, highly leveraged exceptions–Paul, Weiss, Rifkind, Wharton & Garrison; Cleary Gottlieb Steen & Hamilton; and Cravath, Swaine & Moore had margins of at least 47 percent and leverage exceeding 4.6–firms with margins in the bottom quartile (at or below 32 percent) as a group had leverage that was 22 percent higher than the average ratio for the entire 100.

The real surprise is that the negative relationship between leverage and margins wasn’t only present during the last three years. We also saw it when we looked at results from the tail end of the boom, when in theory the associate money machine should have been in peak form. In 2007 the majority of firms with higher-than-average margins also had smaller-than-average leverage, and vice versa.

One explanation lies with big associate salary increases in 2006 and 2007 and clients’ growing reluctance to pay for junior asso­ciates’ time, says Ronda Muir, founder and principal of Law People Management, Inc. “Firms got nailed on the cost side going up and the revenue side going down,” she says. Between clients’ fixation on costs and the emergence of contract attorneys and legal outsourcers, there is little chance that the pyramid model will ever again make sense, except at firms doing the highest-premium work. Says Muir: “[Going forward] the whole leverage model will get tweaked, if not dramatically changed.”

TWO-TIER TROUBLE

The two-tier partnership is another profit-enhancing strategy that appears to be more of a myth than reality, according to our data. Through deequitizations, associate promotions, and lateral hires, the nonequity partner ranks of The Am Law 100 have grown more than 7 percent since 2005. In theory, the nonequity tier allows firms to preserve more of the profits for an ever-smaller equity partner base. But single-tier firms and those with only tiny nonequity classes have reported consistently higher profit margins over the past five years.

The results for 2010 show stark differences among tiered firms. The average margins for the 19 single-tier firms and the 20 firms where nonequity partners constitute less than 30 percent of the total partnership were 46 percent and 43 percent, respectively. In contrast, the average profit margin among the nine firms where nonequity partners constituted more than 60 percent of the partnership was 27 percent. For the twenty-four firms with nonequity partners constituting between 46 and 60 percent of the partnership, the average margin was 32 percent.

Once again, part of the answer is the high fixed costs of nonequity partners, a significant drag on profits in a recession. But an equally critical component is the weak performance of nonequity partners as a group, a phenomenon that dates back to at least 2007. “Even including the boom years, nonequity partners have consistently been the least productive,” says Dan DiPietro, chairman of The Law Firm Group of Citi Private Bank. According to Citi’s data, nonequity partners at Am Law 100 firms worked an average of 1,557 hours last year, compared to equity partners’ average of 1,597 hours, and associates’ average of 1,701.

“In far too many cases, nonequity partnership has been simply a way to avoid awkward conversations [with underperforming lawyers],” says consultant Bruce MacEwen. And then there’s the potential cultural and competitive influence of tiers. The implicit non-negotiable standards–the up-or-out mentality–at single-tier firms might be a competitive advantage in winning clients and high-paying bet-the-company work.

LATERALLY LOSING

Just as the two-tier partnership was (mistakenly) thought to enlarge equity partners’ slice of the pie, lateral hiring has been seen as a way to buy a bigger pie altogether. Firms reasoned that with the right hires, they could capture new clients and more lucrative work, boosting their revenues and margins, despite the recession. (The lateral market hit a new record in 2009.)

This reasoning made sense–until we saw the data. Firms with margins in the highest quartile in 2010 were those that showed the most restraint in the lateral market the year before. They hired laterals representing an average of less than 4 percent of their equity partnership at the time. In contrast, firms with margins in the bottom quartile in 2010 hired laterals that represented an average of 18 percent of their equity ranks. The three firms where lateral hires represented the largest percentage of the equity partnership in 2009, K&L Gates, Sonnenschein Nath & Rosenthal (now SNR Denton), and Duane Morris, reported profit margins of 26-27 percent.

Some of the negative impact may be due to timing. Laterals incur expenses immediately, but they may not generate maximum revenues for months or even years, consultants say. Even hires who successfully lure key clients to a new firm don’t begin collecting that revenue for several months. Perennially acquisitive firms such as DLA Piper could argue that their low margins are simply a near-term cost for investing in a more profitable future. But there’s also a good argument that many firms are simply overpaying for laterals who are a crapshoot. “I still see a lot of rich [lateral pay] packages,” says consultant Peter Zeughauser. “And everyone freely owns up to at best a 40 percent success rate [in lateral hiring].”

THE COST OF GLOBALIZATION

If lateral growth crimps margins, we reasoned, so would a big footprint, especially during a recession. After all, a network of far-flung offices is expensive to maintain. And firms with a larger number of total offices did tend to have lower margins than those with only a handful. The 18 firms with more than 20 offices had an average profit margin of 34 percent, while those with fewer than seven offices had an average margin of almost 46 percent.

But the notion that a greater proportion of international offices would hurt profitability didn’t hold up. The 34 firms with at least half of their offices outside the United States had an average margin of 41 percent. For the roughly one-third of Am Law 100 firms that had fewer than 20 percent of their offices outside the U.S., the average margin was 33 percent–even though this group includes such highly profitable firms as Wachtell and Williams & Connolly.

“The firms that are genuinely global firms seem to be performing better in terms of revenue and profit growth versus firms that are more national or regional,” says Hildebrandt Baker Robbins senior vice president James Jones. Emerging markets, such as China and Brazil, have not seen the same decline in demand for legal services as the U.S. has, so firms with a presence in those countries have successfully hedged their exposure to the U.S. market.

At the same time, some of the most lucrative practices–capital markets and money-center work–have gravitated away from New York and London, due to the advent of emerging markets and the growing importance of private equity, sovereign wealth, and hedge funds. “The money has dispersed,” Zeughauser says, “and [the most profitable firms] realize they need to follow it.”

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Illustration by Scott Bakal