The American Lawyer has been reporting on law firm financials for more than 25 years. Through our annual Am Law 200 and Global 100 surveys, we utilize a slew of metrics—profit margin, revenue per lawyer, net income, profit per partner, and so on—to provide a detailed assessment of the financial health of the world’s legal elite. But one area we haven’t tackled is how much each firm is actually worth. That is, until now.

After discussions with more than 50 private equity and other investment professionals, merger and strategic consultants, and senior law firm personnel, including managing partners, chief financial officers, and treasurers, we developed a method for valuing a law firm.

Our procedure is based on the classic investment-banking technique of developing cash flow multiples to value companies. We started with each firm’s net, made deductions by assigning equity partners with a notional salary, then applied a multiple that varied depending on the firm’s size, its average growth rates in revenue and profits, and its brand strength [see "A Firm Valuation Glossary"]. We then used this formula to calculate values for our Global 100 list of the world’s highest-grossing law firms. [See chart, "The Valuation Calculation."]

So, who’s at the top? Baker & McKenzie? Skadden, Arps, Slate, Meagher & Flom? DLA Piper? Perhaps one of the Magic Circle firms? All wrong. It’s Kirkland & Ellis. The Chicago-based firm narrowly edges out Latham & Watkins to head the list, with a valuation just shy of $4 billion. The Global 100 as a whole—well, the 97 firms for which we have all the required data—is worth $97 billion. That’s more than the GDP of Slovakia, the world’s 62nd-richest country.

The results also show whether the combinations that created DLA, Hogan Lovells, and SNR Denton vereins have actually added any value (two have, one hasn’t; see "Adding Muscle—Or Fat?"), and reveal the high cost of the recession to the world’s leading law firms.

While we stand behind our ranking and our methodology, it’s important to recognize their limitations. Valuing any business is as much an art as it is a science. Each investor views things differently. In applying a one-size-fits-all formula to such a range of businesses as the Global 100, we had to make assumptions about their structures, the state of their balance sheets, and the way in which they accrue and distribute profit. Our work is intended to shed light on the issues an investor would face when analyzing a law firm target, and to paint a picture—albeit with a relatively broad brush—of how the market might be valued today.

Law firm valuation is a relatively new phenomenon. In the past, the legal industry has largely been geared toward delivering short-term profit gains and maximizing partner compensation. Little thought was given to each firm’s inherent value.

Following the introduction last December of legislation that allows law firms in the United Kingdom to accept external equity investment through a so-called Alternative Business Structure (ABS), that mind-set is beginning to change. The new law is expected to result in a glut of transactions within the United Kingdom, particularly among commoditized and process-driven practices, such as those dealing with consumer insurance claims, and has brought into focus the need to determine how much law firms are actually worth.

"Investors tend to look at everything through the prism of value—that’s our stock in trade," says Robert Colthorpe, a financial services expert at London-based corporate finance advisory boutique Europa Partners. "Law firms have never really been subject to that form of analysis before, but they’re starting to become more sophisticated and strategic in the ways they are seeking to quantify business value."

Part of the challenge in appraising law firms is the lack of existing investment deals to use as a benchmark. In two of the first post–ABS acquisitions of U.K. law firms by professional investors, for example, the apparent valuations differed wildly. In January technology and outsourcing company Quindell Portfolio acquired Liverpool-based personal injury law firm Silverbeck Rymer for £19.3 million ($30.7 million)—a multiple of less than four times the profit that firm accrues each year. Then, just a few days later, Australia’s Slater & Gordon—which in 2007 became the world’s first publicly listed law firm—bought another U.K. personal injury specialist, Russell Jones & Walker. Slater paid £53.8 million ($85 million) for RJW—more than 11 times the target firm’s annual net profits.

Complicating the process further is the fact that law firms have little in the way of hard assets. A firm’s chief revenue generators can leave at any time, potentially taking clients—and revenue—with them. (However, this is also true of other professional services businesses, many of which are publicly listed and have been valued and traded successfully for years.)

Then there is the issue of how a firm’s owners—its equity partners—are compensated. The way that most partnerships are structured means that they are effectively unable to retain any earnings at the end of each fiscal year. Except for any planned investments, all remaining profit—what the Am Law 200 and Global 100 surveys refer to as "net income"—is distributed among the equity partners in full. Compared to companies in other industries, this gives law firms an artificially high profit margin, since from an accounting perspective, equity partners receive no above-the-line salary and therefore represent no cost to the business. This arrangement precludes the calculation of almost any recognized valuation metric, such as EBITDA (earnings before interest, taxes, depreciation, and amortization), which is the favored tool for private equity investors.

"Partner remuneration is reported as one figure, but really it’s two things—it’s a payment for a day job and payment for putting capital into the business as a proprietor," says legal consultant and former Clifford Chance managing partner Tony Williams. "Firms have never really looked at it that way before, but that’s exactly what [external investors] would do."

Before a traditionally structured firm could attract outside investment, then, it would need to fundamentally change the way it compensates its equity partners. The firm would need to determine how much of an equity partner’s total compensation is essentially a salary paid to an employee and how much is profit returned to a shareholder. One of the first hurdles we faced in our analysis—and the first of many assumptions we had to make—involved this issue.

The simplest solution would have been to look at how much partners in other professional services businesses are typically paid and assign a comparable notional salary to all equity partners, irrespective of firm. This salary cost would then be deducted from net income to leave a pro forma cash flow that could be used to create a valuation. It seemed unlikely, though, that a rainmaker at Wachtell, Lipton, Rosen & Katz, for example, would receive the same base pay as a partner at labor law specialist Littler Mendelson.

We instead opted to divide net income into separate pots for compensation and profit. This may sound straightforward, but in an actual acquisition, this would be the subject of intense negotiation. For any deal to proceed, a balance must be struck that both gives investors a return on their investment and allows partners—many of whom may be skeptical about the need for external investment—to maintain their lifestyles.

"It’s critical for an investor to remain dispassionate when weighing an investment, but you also have to be sensitive of the fact that owners have an emotional stake in their business," says John Llewellyn-Lloyd, head of M&A at Espirito Santo Investment Bank. "The challenge for investors is to pay the lowest fee possible while still keeping the management happy."

Investors would likely demand that a sizable portion of a firm’s net income make it through to the revised bottom line. The exact distribution would vary with each deal, but on the basis of conversations with a wide range of private equity and other midmarket investors, we settled on an even 50-50 split. Half of each firm’s net income would be used to pay its equity partners in the form of a salary and bonus (the exact composition of which would be at the firm’s discretion), and half would be its pro forma cash flow.

That would not be an easy pill for equity partners to swallow. Although the current partners would benefit from seeing a portion of their equity monetized through the sale, and would continue to collectively receive 50 percent of net income as a salary, they would have to accept that at least in the short term, they would, on average, be making less money.

Once we created our formula for equity partner compensation and came up with a workable cash flow figure, we needed to apply a multiple in order to generate our valuation. This was the crux of the entire process, and the stage that had the greatest bearing on each firm’s result, relative to its peers.

Put simply, the multiple that investors are willing to pay depends on how attractive they believe the business to be. Much of this would come down to the perceived "quality of earnings" of each firm. This would encompass a wide range of factors and would vary depending on both the law firm and investor, but would commonly take into account such things as overall size and potential for further growth, the diversity of practice areas and geographic coverage, the strength of the firm’s client base and of its relationships with those clients, and whether it is considered a market leader.

"Investors are generally looking for growth, stability, and resilience," says George Beaton, executive chairman of Australian corporate advisory firm Beaton Capital Pty Ltd, which operates its own fund to invest in midsize professional services businesses. "If 30 partners leave a large, well-established business like McKinsey, life goes on. If you have a practice that is dependent on a handful of key people who could walk out the door at any minute, or that focuses on a really narrow sector that could just fall off a cliff like we saw during the recession, then that’s going to be worth less, as the risk is higher."

Applying this concept to large law firms can require some tinkering. Take international scope. Most global law firms are based either in the United States or Western Europe—markets that are mature, competitive, and, as things stand, offer little to no opportunity for growth. A higher percentage of overseas business could therefore reasonably be seen as something that would add value—both in terms of the "portfolio effect" of spreading risk across different sectors and countries, and also in providing better prospects for growth.

But simply awarding higher multiples based on the percentage of each firm’s lawyers who are based outside its home country would risk overvaluing such resources. Those international lawyers could be struggling to generate business within Eurozone or Middle Eastern offices—both areas that in recent years would be more likely to result in a discount, rather than an increased multiple. Even just crediting emerging-markets exposure has drawbacks, for while the presence of such practices could boost a firm’s growth potential, converting that additional revenue into profit is far from straightforward. Firms often encounter extreme pressure to discount fees in such markets, due both to undercutting from rivals and the fact that clients are unaccustomed to paying Wall Street or City of London rates. (Global firms have struggled for years to make money in China, despite rapid development and plenty of big-ticket transactions.) Similarly, it would be unrealistic to quantify the relative strength of all 100 firms’ client rosters, or to accurately assess how dependent each practice is on a small number of rainmakers.

We therefore decided to base our multiples on three core areas: total revenue, annual growth rates in both revenue and profit, and brand strength. We set out to achieve a multiples range of around 5–7, which mirrors the current-year trading levels seen at other professional services companies, such as Accenture; FTI Consulting Inc.; Huron Consulting Group Inc.; Navigant Consulting Inc.; and Towers Watson.

When it comes to size, it turns out that the adage is true: Bigger is better. A larger firm generally is more stable and resilient, and it offers greater opportunity for economies of scale in such areas as technology and support functions. (There are exceptions to every rule, such as the now-defunct Dewey & LeBoeuf.)

For the purposes of our survey, each firm started with a multiple based on its annual revenue. A firm with yearly revenues of less than $500 million received an initial multiple of 4; a firm with revenues of $501 million to $1 billion got a multiple of 4.5; and those with revenue exceeding $1 billion, a multiple of 5.

Next up, growth rates. It is fair to say that investors are principally concerned with profit—without it there can be no returns—but they would also be likely to consider growth in revenue, since steady top-line growth is crucial to achieving long-term profit gains.

Investors would typically look for projected figures over the next three to five years. Given that law firms don’t produce forecasts (other than short-term budgets, which they don’t tend to distribute outside the partnership), we had to rely on historic data.

The next question was how far back to go. Now, perhaps more than ever, this is particularly pertinent. With the effects of the deepest recession in decades still lingering, premium transactional work remains in short supply, and growth in virtually all developed economies has slowed to a crawl.

For most firms, the downturn was steepest in 2008 and 2009. Using either as a starting point would automatically lower annual growth rates across the board, and provide a natural advantage to firms with large countercyclical practices. Going back to the boom years before the recession would add some balance and allow the more deal-focused firms to shine, but would also introduce annual growth rates that would be almost impossible to achieve under current conditions.

On this question, the investors we spoke to were unanimous. "What I care about fundamentally is prospective performance," says Tarim Wasim, a director at private equity firm Hellman & Friedman LLC. "Growth may have been great in 2005, but I’m not investing in 2005. You make your assessment based on performance under the conditions at the time of investment, and we’re currently living in a slow-growth world."

Consequently, we based our measurements on each firm’s performance since fiscal 2009. An average annual growth rate in revenue and net income of between 0–5 percent resulted in a multiple bonus of 0.5; increases of 5–10 percent resulted in a 1.0 bonus; 10–20 percent, a 1.5 bonus; and anything over 20 percent, a 2.0 bonus. (Years in which mergers resulted in extraordinary increases were not awarded multiples.) Firms with average annual declines in either profit or revenue of more than 5 percent were discounted by 0.5.

The last—and perhaps most controversial—of our multiples is based on brand strength. One could argue that our formula already accounted for this: A brand is only valuable if it directly results in that firm receiving more and better work, which would be reflected in its revenue and profit growth rates. But most of the investment professionals we spoke to said that having a premium name would be worth a small additional bump to the multiple.

"One of the key things we look for is whether the company is truly the best at what it does, and brand strength can be a proxy for that," says Avin Rabheru, a venture capital investor at London-based Smedvig Capital Limited. "Many private equity firms will pay a premium for the market leader."

To quantify brand strength, we turned to the annual surveys published by global research company Acritas. Each year Acritas compiles rankings of law firm brands based on data collected from more than 600 general counsel, who judge firms on such criteria as "top-of-mind awareness." We gave a 0.5 multiple increase to any firm that placed among the top 20 in either the U.S. or global law firm brand indexes for 2011. (If a firm appeared on both indexes, it was only awarded one multiple, not two.) Only taking the Acritas top 20 does mean that some major names miss out. Firms such as Arnold & Porter; Quinn Emanuel Urquhart & Sullivan; Paul, Weiss, Rifkind, Wharton & Garrison; and Simpson Thach­er & Bartlett are all considered to be leading names in their fields, but we felt that altering the Acritas data would risk undermining its credibility.

Applying our final methodology to the Global 100 produced a multiple range of 3.5–8.5, with an average of 6—the midpoint of our target range of 5–7.

To achieve a top valuation with a perfect multiple of 9.5—the highest available in our analysis—would require a firm to be large and profitable, with revenues of more than $1 billion; to be seen as a leading brand; and to achieve annual revenue and profit growth of more than 20 percent. That’s a tall order, but Kirkland; Latham; Allen & Overy; Gibson, Dunn & Crutcher; and Clifford Chance weren’t far off.

Kirkland was one of only two firms to achieve a survey-topping multiple of 8.5, thanks to solid annual growth rates in both revenue and net income. (The other was Quinn Emanuel, which did so even without a 0.5 boost for brand strength.)

Kirkland was also one of the most efficient at converting buck into bang, needing just 44 cents of revenue to generate each dollar of value—a performance beaten only by Gibson Dunn, at 43 cents per dollar, and Quinn Emanuel, at just 37 cents. (At the other end of the spectrum, Squire Sanders needed more than $3.20 to create each dollar of value.) It was enough to push Kirkland to the head of the charts, despite generating lower absolute cash flow than both Latham and Skadden. Kirkland’s margin over Latham was particularly narrow. If either of Latham’s average annual revenue or profit growth rates were just 2 percentage points higher, its increased multiple of 8 would have seen it head the rankings with a valuation of over $4 billion.

The upper echelons of our ranking have a distinctly U.S. hue. North American firms constitute 13 of the top 20, or 16 if you include DLA, Baker & McKenzie, and Hogan Lovells. It’s a stark contrast to 2007, when three of the world’s four most valuable firms would have been based on the other side of the Atlantic. At that time, Linklaters and Freshfields Bruckhaus Deringer would have topped the list, with valuations each in excess of $5 billion. Under our analysis, their values have each fallen by more than 50 percent during the recession. This is largely due to a sharp decline in revenue and profit growth rates, and the subsequent impact on their multiples, both of which have shrunk by three—from 9 to 6 for Link­laters, and 8.5 to 5.5 for Freshfields. (The results of Linklaters, Freshfields, and the other non–U.S. firms were also heavily influenced by fluctuations in currency exchange rates. According to the U.S. Federal Reserve System, the average pound-to-dollar exchange rate in 2011 was 1.6043. If we recalculated each of the Magic Circle firms’ current values using the exchange rate in 2007, when the pound was worth just over $2, A&O would leapfrog Skadden into third place, Clifford Chance would overtake Gibson Dunn into fifth, and Linklaters would rise to sixth, followed by Freshfields in seventh.)

Linklaters and Freshfields are far from alone in seeing their value diminish during the recession. Almost two-thirds of 2012 Global 100 firms are worth less now than they were in 2007. Overall, the faltering global economy has in the past five years wiped some $13 billion—approximately 12 percent—off the Global 100′s combined value. That’s equivalent to The Am Law 100′s four largest firms by revenue—Baker & McKenzie, DLA, Skadden, and Latham—all going bust.

But while most have struggled, some have thrived. Arnold & Porter, for example, has increased its value by over 150 percent since 2007, while Quinn Emanuel’s valuation more than doubled during that period. Despite its relatively small size—revenues of $723.5 million put it in 36th place in this year’s Am Law 100 gross revenue rankings—its rapid growth and high profitability gave it a valuation of $1.96 billion, using our methodology, making it the world’s 14th-most-valuable firm. That means the effective stakes held by its 111 equity partners are worth more than $17 million on average—almost $5 million more than those at any other Global 100 firm, and 14 times those of bottom-ranked Nixon Peabody.

Looking at the valuations on a per-partner basis reveals an interesting split across the Global 100. The majority of the largest international firms, such as Baker & McKenzie, Hogan Lovells, CMS Legal, and Norton Rose, rank lower by value per partner (VPP) than they do for absolute value—in many cases by more than 50 places. The opposite is seen at the more elite practices, such as Wachtell; Cravath, Swaine & Moore; and Schulte Roth & Zabel, which all have VPP ranks far exceeding their positions by total value. Kirkland and Gibson Dunn are the only two firms to rank in the top 10 on both metrics.

Value, as determined by our formula, is not a constant. Our figures are merely a snapshot. Each firm’s value—and that of the market as a whole—is in a permanent state of flux. As the market consolidates, it’s likely that the world’s largest law firms will continue to grow and increase in value. (Without significant strategic adjustments, those at the other end of the spectrum may find life progressively more difficult as a result.) It’s striking just how substantial the top firms have already become. The Global 100 may primarily be advisers to major corporations, but they are now major corporations in their own right. According to our methodology, 33 firms have valuations exceeding $1 billion. Now that’s very Big Law indeed.