Despite being an industry that has been historically undercapitalized, a recent decision by one of the country’s largest law firms to increase its capital account has been met with questions about the firm’s fiscal health.
Those questions have some validity, according to several industry analysts who said midyear capital calls are rare and typically a sign a firm is in trouble.
Greenberg Traurig caused a stir last week when it confirmed that, for the first time in more than a decade, it was asking equity shareholders for a total of $24 million in additional capital contributions, according to a report from Florida-based Legal affiliate Daily Business Review .
Richard Rosenbaum, Greenberg Traurig’s chief executive officer, told the DBR the capital call was not required by its bank and was strictly a desire by the firm to “add to our equity cushion.”
“We have not raised capital in over 10 years and have long required more modest capital than most of our peers,” he said in a statement to the DBR . “In light of the current uncertainty in U.S. and global markets, we recently did announce a capital raise for our shareholders, each paying in a modest amount over several years in order to further add to our equity cushion.
“There was no current cash need or other requirement giving rise to this decision, one which is fully consistent with our conservative financial management and with what other well-managed businesses are doing in the current global economic climate.”
When asked whether Greenberg Traurig’s move may be a sign of things to come among other Am Law 200 firms faced with that same economic uncertainty, analysts agreed midyear capital calls were not likely to increase.
“One of the reasons law firms don’t tend to do it is what it looks like,” Edge International consultant Ed Wesemann said. “It looks like they really need capital or their bank lines of credit are tapped out or shut off.”
Most capital calls are planned out in advance or done in consistent increments, Wesemann said.
“It’s becoming increasingly rare for firms to do capital calls period,” he said.
Most firms will wait until they have a good year and just hold back a certain percentage of the profits from the partner draw as a capital contribution, he said.
New York-based recruiter Jerry Kowalski also noted that most firms will do capital calls at the beginning of a fiscal year as part of the typical compensation process. In those cases, if a partner’s pay increased, a firm would ask the partner for an increased capital contribution to meet the firm’s required percentage of a partner’s K-1 earnings that goes toward the firm’s capital account. Kowalski noted that may not happen every year with smaller increases in a partner’s take home, but perhaps will be readjusted every four to five years.
When referring to midyear capital calls, several sources used colorful phrases to point out they indicate a firm is in deep trouble.
While he pointed out that firms are still typically undercapitalized, Kowalski said capital contribution levels have increased over the last decade from an average of between 20 to 25 percent to close to 40 to 45 percent of a partner’s projected compensation.
And while he doesn’t predict midyear capital calls as the next hot trend, Kowalski said firms have been and will continue to increase capital contribution requirements on a per course basis in an effort to maintain profitability. With profitability becoming increasingly important in the lateral market and revenue increasingly difficult to come by, one way to increase profitability is through the use of technology. Kowalski said firms need to fund the purchase of new technology through capital as financing such expenditures is increasingly difficult.
The Dewey Effect
When it comes to financing constraints, downfalls of firms like Dewey & LeBoeuf make it all the more difficult on other firms. Banks — along with landlords and vendors — burned by large-scale firm dissolutions can put tighter restrictions on other law firm clients.
Wesemann said that is a natural, often temporary reaction in the wake of a high-profile business dissolution.
The joke used to be that banks would answer a law firm’s call with “yes” and then ask what the firm was calling about, Wesemann said, noting law firms are viewed as the safest investment. That joke isn’t heard quite as frequently, he said.
Relying on debt to run a law firm can lead to banks running a law firm, he said.
“There are very few firms that are well capitalized,” Wesemann said. “When you have situations like Howrey and Dewey, it raises why capitalization is important. With short-term operative debt comes covenants and those covenants, when breached, can effectively put the bank in control of your law firm.”
Bill Brennan, a law firm consultant with Altman Weil, told the DBR that Citibank, which issued loans to Dewey and Greenberg Traurig, could be tightening its restrictions on firms in light of the Dewey situation. Greenberg Traurig has denied its capital call had anything to do with the bank.
Brennan told the DBR that 30 percent of law firms have capital calls, and he recommends firms require capital contributions from partners.
“It increases the firm’s financial stability and reduces the risk so that if something unexpected happens, the firm has money in the till to address the problem and carry it through difficult times. Firms that rely heavily on debt are taking very significant financial risk.”
Increasing capital, while typically a bad sign when done midyear or unexpectedly, can be a good thing for the health of a firm.
“No business ever went under for being overcapitalized,” Wesemann said. “I think there’s a lot of value to having a significant capital account.”
Aside from the financial benefits, requiring capital contributions makes partners feel a sense of ownership rather than feeling like an employee, he said.
And when it can take upwards of five years for a partner to get her capital back from her old firm after making a lateral move, capital contributions can serve somewhat as golden handcuffs, Wesemann said.
A firm’s capital contribution level on its own is not enough to paint a full picture of a firm’s financial health. Wesemann said decisions regarding capital contribution are notable when they are out of the ordinary for that firm.
It’s hard to point to an industry standard for capital levels. Wesemann said some people would say capital accounts should be equal to six months of expenditures. The traditional standard has been 20 percent of K-1 income, but some say that isn’t enough anymore. Other firms require upwards of 60 percent of a partner’s compensation level as a capital requirement, Wesemann said. In Pennsylvania, K&L Gates has a 60 percent capital requirement.
For individual partners, the more money in a capital account, the more a partner is forced to save, the more he will get back upon his departure from the firm and the less his firm will have to rely on debt. On the other hand, if a firm faces the same situation as Dewey, the larger the capital account, the more a partner has to lose as partners go to the end of the creditors line in law firm bankruptcies.