In 2006 Dechert was facing a potentially budget-busting task: During the next 18 months, it would need to relocate its three largest offices. Capital expenses were expected to skyrocket from single-digit percentages to a third of annual earnings. But instead of turning to a bank loan to cover the cost of the moves and gut renovations, the firm went to its partners. For three years before the moves, partners kicked in more capital, producing a surge in cash on Dechert’s balance sheet. The firm didn’t have to borrow a penny.
Dechert’s fixed-asset expenses returned to normal levels in 2008. But the firm held on to its higher capital requirement, evidence of the lengths to which it still goes to avoid bank debt. Today, equity partners must maintain 44 percent of their current compensation level in their capital accounts, up from 30 percent in 2002. That capital cushion, combined with other cyclical cash management techniques, has allowed the firm to avoid even short-term borrowing during a period of high growth. "We were going to cancel our line of credit, but the bank convinced us to keep it," says Andrew Levander, chair of the firm’s policy committee.
If you think Dechert’s pay-as-you-go approach is unique, you’d be wrong. Attitudes have shifted remarkably since a decade ago, when borrowing by firms was on the rise, and banks found a willing audience for sales pitches. After 2008, in particular, many firm leaders began to question the whole idea of bank debt. "After all the firms started to fail, starting with Brobeck, then Heller, we stopped borrowing from the bank," says Perkins Coie managing partner Robert Giles.
Giles and others have long eschewed debt, relying instead on partner capital and other cash management techniques. "I sleep better knowing we are not borrowing money," says Barry Wolf, executive partner of Weil, Gotshal & Manges, where 5 percent of each partner’s pretax earnings each year goes into an interest-paying capital account. With the help of that capital, Wolf says, "we’ve always had enough to fund our hard assets, and we’ve always had a big cash cushion. We’ve never been caught short."
This past fall, The American Lawyer spoke with dozens of leaders of Am Law 200 firms about their partner paid-in capital programs. We asked how firms are financing their businesses and whether their debt-to-equity mix has changed. Of 20 firms for which details could be confirmed, six had bumped up or broadened capital requirements in the past few years. Several more said they were considering doing so in the near future. Seven, including Dechert; Weil; K&L Gates; Day Pitney; Perkins Coie; Morgan, Lewis & Bockius; and Gibson, Dunn & Crutcher, said they do not borrow at all, either for long-term expenses or for seasonal cash flow needs. Others have kept both kinds of borrowing at very low levels.
Our findings mirror data collected by Citi Private Bank’s Law Firm Group. Citi’s most recent survey of 171 firms, 122 of which are Am Law 200 firms, shows that, after an increase in 2008, debt levels fell steadily between 2009 and 2011.
Meanwhile, the privilege of partnership has become increasingly expensive, according to Citi’s data. Between 2007 and 2011, partner paid-in capital shot up by a third, from an average of $229,000 to $303,000 per equity partner; as a percent of net earnings, paid-in capital on the balance sheet went up from 21 percent to 26 percent. Equity partners at the 20 most profitable firms that participated in Citi’s survey were not exempt from the trend. They were asked to ante up more than $500,000, on average, in 2011, up from $423,000 in 2007.
Our findings indicate that partner capital on firm balance sheets ranged from single-digit percentages to 52 percent of firm earnings, with most firms in the middle. But individual partner obligations at one firm with a graduated capital contribution system, K&L Gates, topped out at 60 percent of a partner’s previous year’s compensation. Several had 40 percent or more of the previous year’s earnings tied up in the firm.
Surprisingly, the recession did not spark the upswing in capital contributions. In fact, partners began paying more capital into their firms in 2006 and 2007, when business was booming, profits were surging, and capital raisings were met with little resistance, according to Bradford Hildebrandt, chair of Hildebrandt Consulting. But the recession, and the resulting firm failures, intensified the trend. "With every firm dissolution, a few [other] firms will say, ‘We have too much debt,’ " Hildebrandt says. "It rattles the market, prompting them to up capital." Indeed, the biggest bump in paid-in capital was in 2009–10—a time when the recession was hitting firms’ earnings the hardest—and it coincided with the sharpest drop in debt. Firms "continued raising capital even when net income dropped in 2009," notes Citi’s Michael McKenney, who heads credit origination at the Law Firm Group.
According to year-end balance sheets, partner investment now rivals undistributed income—earnings retained temporarily—as the leading source of balance-sheet capital available to firms. Partner paid-in capital represented 43.3 percent of total firm capitalization in 2011, on average, up from 37.8 percent in 2007. Meanwhile, undistributed income—which produces temporary funding for the firm during the withholding period—accounted for about half the capital available to firms over the five-year period.
As the use of partner capital rose, borrowing dropped. Only 7.4 percent of total capitalization in 2011 was borrowed, down from 10.3 percent in 2007. "Overall capitalization at firms is increasing, but the source of the capital is changing," says McKenney. "Firms are increasingly turning to their partners to make additional investments in the firm." Some firm heads say that the increase in capital-raising coincides with a move by banks to reduce the overall amount of credit to law firms generally, as well as stiffer lending requirements that followed the credit crisis and law firm failures. But Citi’s McKenney says that the bank’s survey reveals that the opposite was the case: Firms actually bumped up the amount of credit available to them until 2010, after the economic recovery was under way, even as they were using the lines less. (The average amount of credit available to firms only dropped by an average of $100,000 between 2010 and 2011, the first year Citi noted a decline.)
The stiffer lending requirements that firm leaders noted, McKenney adds, were likely the result of many firms moving from uncommitted bank lines of credit—where covenants are very light, but banks aren’t committed to lending—to committed lines. Committed lines have heavier covenants, but banks are locked into loaning firms money up to a set credit limit if the covenants are met.
• Click here for a detailed look at how 20 firms handle their capital programs.
In interviews for this article, we heard worries about the continuing weakness in the global economy expressed repeatedly. Richard Rosenbaum, Greenberg Traurig’s chief executive officer, says the firm’s decision to issue a capital call in 2012 was motivated by market uncertainties. "In looking at a changing world, which was becoming less predictable for the legal profession, we felt a modest move to create a greater equity cushion was in order," Rosenbaum says. (Greenberg does not hold back earnings past the end of the fiscal year and relies on bank credit for working capital in the first half of the year.)
With increased volatility comes increased risk that a short-term downturn in revenues can lead to a financial crisis. "My concern is that if there’s a market crisis of some sort, it doesn’t take long to burn through your cash. What do we rely on then?" says the head of one global firm that relies on borrowing, and who asked not to be identified. "That’s what haunts me as a leader."
Stanley Twardy Jr., Day Pitney’s managing partner, says that it’s not only firm managers who are focused on financial risk, but partners too. He says he expects to be grilled by partners the next time he proposes dipping into the firm’s line of credit. (Day Pitney, which currently retains 2 percent of earnings from all equity partners as capital in the final distribution each year, resets the percentage annually.)
Most firms have raised their capital quietly, but some have been quite public about it. DLA Piper, for instance, touts its 2008 expansion of capital requirements to nonequity partners as a way to heighten engagement and to distribute risk more broadly. "If you’re a partner making a half a million bucks a year, whether you’re an income partner or not, that’s a fairly significant sum of money, and it requires a level of infrastructure for you to practice," says Jay Rains, DLA Piper’s U.S. cochair. "Frankly, [income partners] should have skin in the game."
We asked officials at Citi Private Bank and several law firm consultants what level of overall capitalization should come from partner equity. They didn’t have a simple answer. The calculation, they said, depends on each firm’s growth strategy, practice mix, history, and culture. "Every firm has its own calculus of where that capital number ought to be," says Citi Private Bank’s McKenney. Firms with a lot of offices or heavy reliance on lateral hiring, for instance, need more funds to finance them, whether obtained via partner equity or bank debt.
McKenney advises that firms should use different sources of capital, whether equity- or debt-funded, for different purposes: Undistributed income, for example, provides short-term funding, often only in the first quarter of the year after it was generated, while paid-in partner capital is invested in longer-term investments, such as furniture, fixtures, equipment, and office relocations. On the debt side, term debt can be used for long-term investments, while revolving credit lines are for short-term, seasonal cash needs.
Most of the firm leaders we spoke to for this article agreed that paid-in partner capital should be reserved for capital expenses. "What permanent capital is for is long-term obligations, like office buildouts and equipment purchases," says K&L Gates chairman Peter Kalis. "Firms fuzzy the line between the two. It’s just a big pot of cash, so what the hell? But permanent capital should never be used for [short-term needs], because if it is, it really distorts the system."
Kalis’s view notwithstanding, Citi’s survey data suggests that firms are building up more partner capital than they need merely for long-term investment. Citi found that in 2007, firms in its survey averaged a little less paid-in capital on the balance sheet than the depreciated cost of net fixed assets. In 2011 the ratio was reversed, with paid-in capital substantially higher—120–130 percent more—than depreciated net fixed-asset costs. The result is a growing cash "cushion" at some firms. It’s unclear what that extra cash is being used for, and when.
At several firms we collected information on, partner capital far outweighed the average annual net fixed-asset expenses. For instance, Andrews Kurth’s total partner capital, which it funds via retained pretax earnings each year, was four times its fixed asset costs in 2011, up from three times the costs six years ago. Duane Morris’s paid-in capital was more than twice its capital spending last year and is growing. At that firm, capital contributions—4 percent of partner pretax earnings—have steadily, and intentionally, been raised over the past five years, even while fixed-asset costs remained flat, says Duane Morris chairman and CEO John Soroko. "We haven’t reached the point where we have decided that [partner] capital is sufficient," he says. "We are still in active accumulation mode."
K&L Gates has the highest required capital levels The American Lawyer was able to confirm—35–60 percent of annual earnings increasing with seniority. The firm’s management evaluates its capital program every five years to make sure it can satisfy planned buildouts and other long-term expenses over the next five years so that it can avoid sudden "capital calls" or dramatic annual increases in contribution. For short-term cash needs, meanwhile, the firm has an additional program where partners voluntarily invest additional funds for the firm to use at its discretion; in return, they are paid interest. Funds from that program are tapped for the firm’s cyclical operating expenses, but are available to partners on demand, much like a certificate of deposit.
On December 31 of last year, the firm had $166 million in permanent partner capital on the balance sheet, and $201 million more in discretionary partner capital, according to the firm. At its lowest, during April tax time, the discretionary partner capital on the balance sheet may drop to about $80 million. "When partners put their money where their mouth is, firm management should take that as a vote of confidence," Kalis says. "We have $75 million in lines of credit. We’ve never used a dollar of it."
For long-term spending, partner equity and bank debt each have advantages and disadvantages. Every firm has to assess its tolerance for risk versus the relative cost of either source of capital.
For one thing, it costs more to stockpile cash with partner money than via bank loans. The capital contribution is expensive for partners, who have to pay taxes on what is essentially phantom income. By contrast, interest rates on borrowed money currently are so low "that money’s almost free," notes one managing partner.
It’s also time-consuming to raise partner capital. Perkins Coie, for instance, spent five years between 2004 and 2009 recapitalizing its balance sheet, asking partners to contribute an additional $15,000 each year.
The speed and ease with which firms can access bank loans has helped many of them grow more rapidly. Firms that have stuck to a pay-as-you-go system "probably don’t open a lot of offices and probably don’t hire a lot of laterals. We do," says DLA Piper’s Rains, noting that his firm utilizes both paid-in capital and bank borrowing. "Most businesses have debt. Ideally you want it to be less rather than more, but I’m not sure it needs to be zero."
But some firms say it is possible and even desirable to fund long-term growth through paid-in capital alone. "So far, our practice of growing with partner capital rather than bank debt has not impeded our growth strategy," says Kenneth Doran, managing partner of Gibson, Dunn & Crutcher, which has no debt. "The firm has strong cash reserves, and we believe that we get a better return by reinvesting in the partnership than elsewhere."
And for older partners, there may be a question of fairness. In a major capital-raising like the one Dechert did before its office relocations, partners close to retirement took the same hit as younger partners, even though the new office space ultimately didn’t benefit them. "Why should a partner today be funding investments that will benefit the partner of tomorrow?" asks Gretta Rusanow, Citi Private Bank Law Firm Group’s director and senior client adviser. (The group is a major source of loans to firms and to individual partners.)
On the other hand, a retired partner, upon joining a firm, enjoyed the windfall of all the capital and assets others invested in the firm on the day he or she joined; and partners generally receive their capital back fairly quickly, within a year of retiring, according to our reporting.
Still, bank borrowing comes with more strings attached than partner capital does. The most worrisome are bank covenants that limit the percent of the partnership that may depart in a given quarter. When covenants are breached, as they were with Howrey and Dewey, lenders can demand that the firms cease making distributions or even paying draws. "Guess what happens when partners don’t get paid? They hit the pavement," says Ed Wedemann, chairman at law firm consultancy Edge International Inc. It’s those strings that bother many firm leaders. Duane Morris’s Soroko says his firm has a great relationship with its bank, "but we do not want to be in partnership with our bank in running our law firm and making strategy."
Bank borrowing, whether short-term or long-term, says Weil’s Wolf, "hampers management’s ability to say, ‘This is just one bad year’ and to calm a crisis of confidence. Just the notion that the bank is involved can create havoc. Without debt, you can just go to your partners and say, ‘Hey, we had an off year, but this should not negatively impact next year.’ " (Wolf, who has led the firm since January 2010, notes that he hasn’t had to have this conversation.)
Many others say that equity in a firm also serves as a kind of institutional glue. Without capital, "a partner is effectively no longer an owner," says Wedemann. "It’s easier to leave." The high capital investment that partners had in Howrey—which management raised from 30 to 35 percent of current compensation in the year before default—kept many partners from leaving sooner, according to several former Howrey partners. Partners didn’t want to lose their capital, knowing that a partner exodus could trigger a default and a possible collapse.
Lastly, substantial paid-in capital can reduce the strings attached to other obligations, such as leases. Hogan Lovells’s strong paid-in capital program "has made it easier dealing with landlords and has led to more favorable lease terms for the firm," says managing partner J. Warren Gorrell.
In the end, partner equity capital can’t be viewed in isolation. It’s just one piece of a variety of techniques that firm leaders are using to free up capital on the balance sheet for various uses. Other techniques that firms say they are using in combination with partner equity include the maximum prepayment allowable of leases and other expenses and the depreciation of certain current-year fixed-asset expenses. To help meet short-term operating capital needs, many firms are back-loading distributions more heavily toward the end of the year or holding back final distributions several months into the next fiscal year, a sort of "soft capital call."
Andrews Kurth, which has been slowly recapitalizing its balance sheet since 1997, started prepaying fairly substantial expenses for the following year in 2008, notes Robert Jewell, the firm’s managing partner. That year, Andrews Kurth prepaid $10.6 million in expenses, up from $1.8 million. The firm has continued to do so each year. At the same time, total paid-in capital increased by nearly 20 percent, and long-term debt dropped by nearly a third. Cash available for operating expenses has nearly doubled, eliminating reliance on lines of credit.
Likewise, Perkins Coie raised capital between 2004 and 2009, but it is also relying on other cash-generating techniques, like a tax code provision that permitted it to accelerate write-offs of certain capital expenses and thereby increase cash on its balance sheet. Since 2008 the firm has held back the last 5 percent of year-end distributions until February, to defray expenses during months when collections are leanest.
For many firms, raising partner capital is just the first of several coordinated and long-term efforts to reduce debt. Squire Sanders has raised overall partner capital requirements and recently asked income partners to contribute for the first time. The partner capital is intended to cover long-term expenses. "We used to take on debt to finance new space," says James Maiwurm, Squire Sanders chair and global CEO. "In recent times, we haven’t done that." Concurrently, the firm has whittled its drawdown of lines of credit by 10 percent in the past five years via extending earnings holdbacks, Maiwurm says.
In the end, it falls to each firm to decide how much partner equity it needs. "The appropriate amount of capital," says Wedemann, the consultant, "is the amount that allows you not to worry about it."