They were casualties of the high cost of doing business: In a year when The Am Law 100 posted tepid year-over-year financial gains, Second Hundred firms bested their bigger rivals in most metrics but still came up short on the bottom line. While the Second Hundred’s revenue per lawyer jumped 5.3 percent and value per lawyer rose 4.7 percent, profits per partner increased just 2.2 percent, a bit less than The Am Law 100′s 3.0 percent. The culprits? Steep expenses and a sharp drop in leverage.

The Second Hundred’s total gross revenue in 2011 was $17.93 billion, a 2.7 percent increase that was outpaced by The Am Law 100′s increase of 5.3 percent. Each group had roughly equivalent profit margins (37 percent for the Second Hundred and 38 percent for The Am Law 100, both unchanged from 2010). But the Second Hundred was much less adept than its bigger counterparts at translating top-line growth into profits: While The Am Law 100′s growth in profits per partner (3.0 percent) exceeded its growth in revenue per lawyer (1.9 percent), the converse was true for the Second Hundred, where average profits per partner grew 2.2 percent, and average revenue per lawyer increased 5.3 percent.

Leverage was a big part of the explanation for the disparity. The Am Law 100 expanded its ranks in 2011, recording a 3.3 percent increase in overall head count, a 1.4 percent increase in equity partners, and a 5.7 percent rise in nonequity partners. At the Second Hundred, though, head count fell 2.5 percent, with most of the shrinkage occurring in nonpartner ranks, traditionally the sweet spot of law firm profitability. (The total number of equity partners at Second Hundred firms fell by just 0.7 percent.) The result was that average leverage at Second Hundred firms fell to 2.04 from 2.10, while Am Law 100 leverage grew to 3.49 from 3.4.

THE BIG PICTURE

“Firms in the Second Hundred have not been aggressive in hiring associates; they’ve been restrained in terms of recruiting,” says Mark Hinderks, managing partner of Stinson Morrison Hecker, number 166 on The Am Law 200. His firm used to hire new asso­ciate classes of 15 or 20. The past few years it’s hired groups of seven or eight. “We may be up around 10 or 11 this fall, but it’s still not where it used to be,” he says.

A CRUCIAL DIFFERENCE

The Second Hundred’s decline in leverage has nudged the average seniority at firms up a bit. That has shifted more work upward, says Hinderks. Partners are doing work that might normally go to associates. The work gets done, but at a higher cost.

Clients are also indirectly promoting lower leverage by requesting that only senior lawyers handle their matters, says David Antzis, managing partner of Philadelphia’s Saul Ewing, where leverage dropped to 1.64 from 1.75. “They say, ‘Your rate may be twice an asso­ciate’s, but you’ll do it twice as fast.’ ” (In our most recent law firm leaders survey ["Building a Breakout Firm," December 2011], 54 percent of respondents said they have had clients who refuse to pay for work by first- or second-year associates.)

“There are some types of legal work where the best value is attained by having a first-year associate do that work, but more and more clients are doing that work in-house or having that work done in other ways that they consider a good value,” says Emily Parker, managing partner of Dallas’s Thompson & Knight, where leverage dipped to 2.27 in 2011 from 2.55.

GROWTH AT THE TOP

Second Hundred firms traditionally have lower leverage than Am Law 100 firms. The bigger firms need more associates because they handle huge deals and litigations that require armies of associates for document review, says Antzis. “In the Second Hundred, your deals and litigation just aren’t as big, so you don’t need lots of junior lawyers,” he says.

Nonetheless, Second Hundred firms felt some of the same pressure to raise associate salaries and bonuses, which had been stagnant during the recession, that Am Law 100 firms did. “We kept our associate salaries kind of low for a few years, but raised associate starting salary this year,” Antzis says. “There was pent-up demand [for compensation increases] from 2008, when firms weren’t increasing salaries,” he says, “but now the market is getting better and firms are responding.”

The same was true at Stinson Morrison, says managing partner Hinderks. “We were more cautious about raises and bonuses in 2009 and 2010,” he says. But in 2011, as the economy steadied, his firm awarded nonpartners at his firm larger bonuses, he says. And even though there were fewer associates receiving these raises and bonuses, on average, the increases still ate into profits.

RPL GROWTH LEADERS

In other areas, such as back-office costs, expenses rose in 2011 because 2010′s frugality simply couldn’t be sustained. After drastically cutting expenses in 2010, which produced a 3.4 percent increase in profits across the Second Hundred, firms found that there were few steps to be taken to further reduce expenses. As the economy recovered, some let their cost-savings initiatives expire. Stinson Morrison, for instance, saw an 8.2 percent bump in profits in 2010, which Hinderks attributes to a series of measures. “We’d battened down the hatches in 2010 and saw a onetime expense savings of about $7 million. None of that was repeated in 2011,” he says.

Parker, of Thompson & Knight, saw her firm’s profits jump 11.1 percent, to $950,00 in 2010. This year they sank 2.6 percent. “If you look across the two years, 2010 and 2011, our PPP was slightly down, but that’s in comparison to a very dramatic increase in 2010,” she notes.

THE PER-CAPITA VIEW

NEWCOMERSDespite the decline in leverage, Second Hundred firms continued to pick up lawyers from Am Law 100 firms, a trend that we noted a year ago ["A Rebuilding Year," June 2011]. One of the most aggressive was Ogletree, Deakins, Nash, Smoak & Stewart, a labor and employment shop with 41 offices across the country. The firm, which posted a 17.9 percent gain in gross revenue in 2011, had a net gain of 69 lawyers, a 14.6 increase. “We added a significant number of partners in general practice who’d been priced out of their firms,” says managing shareholder Kim Ebert. (Ogletree’s revenue per lawyer increased 3.1 percent, to $495,000, and its profits per partner rose 8.6 percent, to $505,000.)

Saul Ewing’s Antzis, whose firm opened a Boston office in June 2011, noted the same trend in its hiring. (Saul Ewing’s equity partner head count grew by 3.8 percent in 2011.) “Lawyers in really big firms are very disenchanted by rate pressure,” he says. “Lots of lawyers don’t have practices that can support $700-plus rates. Partners are gravitating toward smaller firms where they can receive some rate relief. It’s an enormous recruitment opportunity for us.”