If you’re a leader at an Am Law 200 firm, you maybe didn’t love everything about last July’s starting associate salary increase from $160,000 to $180,000. Yes, the troops were overdue a raise but, wow, that’s a lot of cost. But after bemoaning the hit to 2016 profitability, you probably shrugged your shoulders and went back to work.
Not so fast. A one-step, across-the-board double-digit percent increase in its largest single cost component is a seismic event for any industry. The aftershocks can be severe.
This is certain to be the case for Big Law. Cost containment has been the biggest driver of the rebound in profitability since the start of the great recession in 2008. Last July’s salary increase has taken away this driver.
And things may well get worse: if the last two rounds of salary increases are a guide, salaries will increase again and then be followed by a recession.
However it plays out, there will be two effects: a general downward pressure on profits per partner (PPP) and a widening of the gap between the super-high and medium-high profit firms. This latter effect will have the more profound impact. It will accelerate the migration of the most commercially capable partners to higher-profit firms.
This migration has been ongoing for some time. The aftershocks from last July’s salary increase may simply nudge it along. Alternatively, they could take things to a tipping point after which the migration accelerates dramatically. It’s likely that the more partners see peers move up in the firm rankings, the greater license they’ll feel to break the social contract with their current firms, and the more prone they’ll become to moving themselves—a classic tipping point dynamic. If you’re the leader of a super-high profit firm, these dynamics play to your advantage. You could hasten them along by, say, pursuing laterals more aggressively or increasing compensation again. For medium-high profit firms, the imperative is to raise profitability to avoid falling on the wrong side of an increasingly bifurcated market. This requires that leaders focus their firms on only the service offerings that are truly differentiated. When clients don’t perceive a meaningful distinction in offerings, potential providers are forced to compete for business primarily on price; this results in dramatic erosion of firm profitability. There’s a simple way to assess an offering’s degree of differentiation: If it’s hard to make the annual billing rate increase stick, it’s undifferentiated.
A little appreciated facet of recent Big Law financial performance is the huge role played by cost containment. Figure 1 looks at how PPP (in real, i.e., inflation-adjusted, terms) regained and then exceeded its pre-recession 2007 level at the average of the 50 most profitable Am Law 100 firms. Comparing the left and middle panels shows that margin per lawyer was the major driver of PPP recovery. The right panel shows the two components of margin per lawyer—revenue and cost. Note that revenue per lawyer only regained 2007 levels in 2015; cost per lawyer contracted more than revenue per lawyer and had not regained 2007 levels in 2015. It is the sharp and sustained contraction in cost per lawyer that has enabled margin per lawyer (and hence PPP) to regain and the exceed 2007 levels.
Associate salaries are a law firm’s largest expense, comprising about half the total cost. The next biggest cost items are rent and staff salaries. While these last two have grown with inflation, associate salaries have been flat in nominal terms (and thus declined in real terms). Without flat associate salaries, PPP would not have recovered to and then exceeded 2007 levels. Now, in the wake of the recent salary increase, Big Law stands bereft of its most powerful profit driver of the last decade.
While past performance is not an indicator of future outcomes, history often rhymes. Figure 2 shows associate starting salary levels for the past 20 years. It’s notable that on both occasions in the past two decades when nominal salaries rose, they did so in multiple steps. Over the course of these multiple steps salaries went up 47 and 28 percent, considerably more than last year’s 12.5 percent. Thus, we shouldn’t be surprised if associate salaries go up again in 2017.
The historical data sound a second cautionary note: the timing of associate salary increases may contain information as to the current stage of the broader business cycle. As Figure 3 shows, the last two salary increases have been followed by Big Law recessions, i.e., declines in PPP. This could well happen again; Big Law is a highly cyclical business and we’ve been in boom times (i.e., profits growing) for eight consecutive years.
To most managers, costs going up is unambiguously a bad thing. To a strategist, though, it depends. If a cost increase hurts your competitors more than it hurts you, and you can turn this into an advantage in the market, then cost increases can be a good thing.
To explore how this might play out at elite law firms, the table titled “The Impact of Associate Raises” models the profit and loss statements of two hypothetical firms. ‘PPP 1-25′ is a super-high profit firm based on an average of the 25 most profitable Am Law 100 firms; ‘PPP 26-50′ is a medium-high profit firm based on an average of the second 25 most profitable firms. The models show that lawyer compensation is higher on a per-equity-partner basis at less profitable firms because they have a higher portion of nonequity partners whose remuneration is captured in the lawyer compensation line item.
The “before” scenarios show the P&Ls before any salary increases. The “after” scenarios show what would happen if last year’s 12.5 percent salary increase were followed by a similar increase in 2017. The model applies the increases on a full-year basis to all lawyers who are not equity partners. The bottom line effect is that PPP of the super-high profit firms falls 10 percent while that of the medium-high profit firms falls more than 20 percent. This differential would be even greater if a Big Law recession hit.
The modeled 10 percent reduction in PPP at the super-high profit firms would not go unnoticed. It would augment the ability of super-high profit firms with relatively high ratios of highest to lowest partner compensation to lure highly productive partners away from their super-high profit peers. However, the discomfiture at the super-high profit firms would be minor compared to the havoc a 20+ percent drop in PPP would create at the medium-high profit firms. There is nothing like a major contraction in the profit pool to bring to the surface the sleights perceived by high-performing, mid-career partners and incline them toward returning the calls of headhunters representing more profitable firms.
While this increase is an immediate blow to the profitability of super-high profit firms, it can benefit them over the longer term. It bolsters their capacity to use their wallets to lure talent from less-profitable platforms and thus to distance themselves further from these competitors. To a strategist, such distancing is the most potent source of long-term superior profitability.
The forgoing dynamics provide super-high profit firms with an advantage. They could press it further. For example, they could dramatically increase the bonuses paid to senior associates or, say, move to $1 million compensation for newly minted partners. Firms with aspirations to be in the top tier but with weaker profitability would have to follow. Such moves could provide a greater competitive impact to the super-high profit firms for about the same cost as another increase in starting salaries. They would certainly wreak havoc at firms in the middle echelons of profitability.
Individual super-high profit firms could also look to create an advantage over their comparably profitable brethren. The mechanism would be to broaden the range between highest and lowest comped partners. Today many firms are at a 3-1 ratio; this is inconsistent with the range of inherent profitability of individual partners’ practices. Firms who move to, say, a 9-1 ratio would give themselves flexibility to attract partners from within the super-high profit ranks.
If you’re a leader at a medium-high profit firm, the forgoing could be dispiriting. However, such firms could have one huge advantage over their super-high profit brethren: a sense of urgency. While many of the super-high firms may be complacent about their competitive position, and thus slow to push their advantage, their medium-high profit counterparts have (or at least should have) no such propensity to inertia and a keen awareness that falling down a tier in PPP would drastically transform their firms.
Such firms should look to act in two areas: moving revenue per lawyer to a sustainably higher level and tightening the bonds with the highest-performing partners. On the revenue side, there are only two ways to increase revenue per lawyer sustainably. One is to have differentiated offerings—i.e., offerings for which few, if any, other firms are considered by clients to be capable providers. Few alternative providers enables strong price realization and profit. The other way is to have offerings that others can match but for which the aggregate demand meets or exceeds the aggregate supply—the supply-demand imbalance allows firms realize strong pricing and profitability. This latter dynamic occurs only at the top of the demand cycle for a particular offering and hence is short lived. Differentiated offerings are thus a prerequisite for sustained strong revenue per lawyer and profitability.
Medium-high profit firms should focus their strategy more tightly on differentiated offerings. This includes paring back service lines that struggle to achieve pricing commensurate with the firm’s economic aspirations; scaling back expansions that don’t serve core firm clients; fostering integration of services across different legal specialties to create offerings that are unique; lionizing those who develop innovative offerings; finding ways for partners to help each other to develop as business people; slowly but steadily transitioning out of the firm partners whose practices no longer fit with firm strategy; and continuously raising rates and leverage. Pursuing a major merger is unlikely to help. Combinations typically add more to scale, complexity and partner anxiety than to differentiation.
On tightening bonds with partners, compensation obviously plays a central role. One way for medium-high profit firms not to be outmaneuvered by their super-high profit competitors is to de-average partner compensation more. A medium-high profit firm with a 9-1 ratio of highest to lowest compensation should not be at a disadvantage in protecting its most commercially-capable partners from the attentions of super-high profit firms with a 3-1 ratio. A related imperative is to ensure that rewarding more senior partners for longevity is not constraining the ability to match younger partner’s compensation with their economic contributions. On the noncompensation side, many firms could leverage more their soft power retention incentives, such as public recognition, titles and sincere mentorship.
In sum, the reverberations of the recent salary increase are broad reaching and profound; they raise important questions for law firm leaders. Careful consideration of these, followed by steadfast action, will redound to the benefit of those firms whose leaders have the courage to engage in earnest now.
Hugh A. Simons is a strategist and veteran professional services firm leader. He is a former senior partner, executive committee member, chief financial officer and chief administrative officer at The Boston Consulting Group and the former chief operating officer at Ropes & Gray. He is currently conducting research for a book on the fundamentals of elite law firm strategy. Email: email@example.com.
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