Add a little bit of revenue. Subtract partners. Control costs. That math helped a number of California law firms boost their profitability in 2012 despite shaky demand for legal services.

At Irell & Manella, a 5 percent increase in gross revenue and a 9 percent drop in partners contributed to a 19 percent surge in profits per partner. As Munger, Tolles & Olson’s partnership contracted, its profits per partner shot up 16 percent — more than triple the rise in revenue. At Orrick, Herrington & Sutcliffe, a 2 percent increase in revenue and a 5 percent drop in partners combined for a 10 percent jump in profits per partner.

Irell, Munger and Orrick are among 10 California firms whose statistics have been published as part of Recorder parent company ALM’s early coverage of 2012 financial results of The Am Law 100/200.

 

Struggling to raise the top line, firms like Orrick have found that one sure way to boost their numbers is to shrink, law firm consultant Peter Zeughauser said. "You don’t get a 10 percent jump in profits per partner with a 2 percent jump in revenue unless you shrink or restructure somehow," he said.

Law firm leaders are driven to take those steps by the mounting pressure they feel to keep their key financial statistics — gross revenue, revenue per lawyer and profits per partner — on the upswing, legal observers say.

But Silicon Valley stalwarts Cooley and Fenwick & West didn’t have to try hard to look good. Buoyed by the demand for their tech expertise, the firms posted healthy growth in revenue and expanded their ranks. Others got creative to post the gains they needed.

In fact, firm leaders were so determined to bring in revenue at the end of 2012 that they put on a historic collections push, legal consultant Ron Beard said. Some even offered discounts to entice clients to pay their bills by the end of the year, law firm consultant Kent Zimmermann said.

 

Those tactics may deplete inventory for the following year. But as the competition for work and talent intensifies, firm leaders are willing to borrow from one year to prop up another. Glowing financial statistics help them attract merger partners should they decide they need to combine forces to remain competitive, Zimmermann said. And in an age of partner-free agency, law firms need to show year-over-year gains in revenue per lawyer and profits per partner to lure prospective laterals and keep their own attorneys from defecting, legal recruiter Daren Wein said.

"How are you going to do that if you don’t project an image of profitability and confidence?" Wein asked.

Trimming expenses is one way for firms to become more profitable. But after several years of searching for savings, many firms’ operations are about as lean as they can be, Beard said.

Now, partners are often all that is left to cut. Having laid off associates in droves a few years ago and given de-equitization a try, firms are increasingly cutting to the chase and showing underperforming partners the door, Zimmermann said.

Those exits help firms put on a good face and position them for the future, too, Zeughauser said. With less demand for their services, firms must rightsize their ranks, he noted.

"It’s not pleasant, but it’s what the doctor called for," Zeughauser said. "The market is self-correcting for its excesses of the past."

Legal observers say California firms’ early numbers show the downsizing is paying off. By most measures, 2012 seems to have been a surprisingly strong year for the legal industry. All 10 California firms saw at least a slight uptick in gross revenue, with Fenwick posting the largest gains at 13 percent and Orrick on the other end of the spectrum with 2 percent growth. Morrison & Foerster crossed the $1 billion threshold for the first time with a 4 percent jump in gross revenue. Pillsbury Winthrop Shaw Pittman seemed to right the ship last year. After seeing flat revenue per lawyer and a 4 percent drop in profits per partner in 2011, it boosted revenue per lawyer 8 percent and profits per partner 10 percent on 8 percent revenue gains. California firms as a whole made healthy gains in revenue per lawyer, with Fenwick making the smallest increase at 1 percent percent and O’Melveny & Myers, Irell and Orrick all clocking gains of 9 percent or more.

Given firm leaders’ modest projections, legal recruiter Avery Ellis said he had expected to see a flatter year. "That’s one trick to successful business management," said Ellis, who is executive managing director of Mestel & Co. "Lower expectations and then exceed them."

The Widening Gap

This year’s Am Law race shows a small corps of firms pulling away from the pack, legal observers say.

Firms that rake in more than $2 million in profits per partner — such as California players Latham & Watkins; Quinn Emanuel Urquhart & Sullivan; and Irell — are perched at the top of the market, Zeughauser said. Quinn Emanuel’s financial statistics are not yet available, but Latham’s revenue per lawyer and profits per partner climbed to $1.1 million and $2.4 million, respectively. And because those "super firms" are focused on the high-value practices that command premium rates, their competitors are falling farther and farther behind, Zeughauser added.

"It makes it harder for the vast majority of the market to compete for talent," he said. "It’s forcing them to do things that create strain in their partnerships."

To adjust to market dynamics, Orrick shed lawyers deliberately, chairman Ralph Baxter said. By bringing on smaller associate class sizes, hiring laterals conservatively and advising some lawyers to move on, the firm reduced its headcount by 7 percent in 2012, dipping below 1,000 lawyers for the first time in years. The firm now has the same number of lawyers it did in fiscal year 2008.

"We are managing the headcount of the firm so that we are ever more efficient in delivering services to our clients," Baxter said. "This is what our clients are doing — more with less."

And the leaders of the pack have thinning ranks, too. O’Melveny, which boosted profits per partner 19 percent to $2.1 million, lost 4 percent of its lawyers. Irell said goodbye to 4 percent of its lawyers as well, a drop that managing partner Andrei Iancu chalked up to natural attrition in an interview with Recorder sibling publication The American Lawyer.

Silicon Valley firms seem to be the happy exceptions to the shrinkage trend. Fenwick added a whopping 12 percent more lawyers to keep up with demand from clients, managing partner Kathryn Fritz said.

"When we have a good year, we also make sure that we do the right kinds of things to invest in the institution and make it stronger," she said.

Cooley went on a hiring spree of its own, recruiting 17 lateral partners that drove headcount up 3 percent. Four of those partners helped open the firm’s office in L.A., which is still building momentum, the firm’s CEO Joseph Conroy said.

"2012 was a year where we made significant investments in our future," he said. "The majority of the benefit of having recruited this big, strong lateral class will come in 2013 and beyond."

Natasha Innocenti, head of Major, Lindsey & Africa’s partner practice in Silicon Valley, said Cooley and Fenwick’s success illustrates the rewards of technology.

"This is more indication that the technology industry is robust and that it makes sense for firms to establish and grow local practices to capture that work," she said.

New Leverage

This year’s financial statistics reveal that lawyers who don’t bring in business are finding it harder to remain partners, legal observers say.

The term "service partner" is a bit of a misnomer — all firms need highly trained lawyers to solve problems for clients, Innocenti said. But the new market dynamics support fewer of them.

"It’s harder for firms to employ highly paid service partners when the work is spottier than it used to be," she said.

After the recession, many firms stripped partners of equity, paying them like "super associates," Zeughauser said. But firms found that tactic only gave their numbers a short-term boost — and the underlying problem remained. Non-equity partners are a costly source of leverage that many firms can no longer afford, Zeughauser said.

"They eat into the operating income. They are expensive overhead. And they don’t bring in business," he said.

Zimmermann says he often advises firms to bypass de-equitization and counsel chronically underperforming partners out the door. These days, firms are even reluctant to let senior lawyers who are underperforming remain equity partners as they wind down their careers, he noted.

Meanwhile, firms are being much more careful about who they make equity partners in the first place, often promoting associates to the non-equity ranks and forcing them to show they can bring in business before they gain a stake in the firm, said consultant Beard. Latham & Watkins’ non-equity partners rose 10 percent as its equity partners fell 1 percent, perhaps revealing the firm’s use of that tactic.

Weeding out underperformers is top of mind for many firm leaders, Zimmermann said. But he cautions them from trying to clean house all at once. A wave of exits could cause outside observers — and high-performing partners — to question the stability of the firm, even if the moves are meant to fortify it.

"You don’t want to cut too deeply too quickly," Zimmermann said. "You want to cut as much as you can without tearing the fabric of the firm."