Are big law firms built on implicit leverage?

I found this blog post very interesting; there is much detail but here is the key excerpt:

Over the last few decades – concurrent with the growth of leverage in
the financial system – the business model of most large law firms has
developed into one built on leverage as well.  It is just a
leverage which utilizes people rather than borrowed money. 
Specifically, since law firms generally bill by the hour (a system
whose demise has been predicted for the near future and, in my opinion, always will be),
firms increase their profitability by increasing the amount billed in
respect of each equity partner. Since there is only so much time in the
day, firms have tended to increase the ratio of attorneys per equity
partner.  Without irony, this ratio is known as…"leverage,"

…Now, in times where there is an easy supply of credit work,
this system of leverage works very well for all involved.  But when the
flow dries up, the firms are left with high fixed costs to be serviced
– and the more leveraged the firm is, the harder it is to service those costs with reduced revenue.  Sound familiar? It should be no surprise that
large law firms have been laying off attorneys in far greater numbers
than in previous downturns, with some doomsayers (whom I hope are less
accurate than their counterparts with respect to the economy generally) predicting additional firm collapses and permanent changes to the firms' business models. (The one saving grace to the law firm model of leverage is that they can "deleverage" far more easily than banks, as banks can't merely fire their "troubled assets.")

As I've already written, "[A] central lesson of this depression will be how many different ways there are to leverage."

Comments

I don't see why this is "leverage" in the financial sense, instead of just growth. If the law firms borrowed money to pay these attorneys in advance, I would see the similarity. But the point that

they can "deleverage" far more easily than banks, as banks can't merely fire their "troubled assets"

seems to be exactly the critical difference. If you are leveraged, you have to shrink AND you are still in debt.

Of course, law firms' implicit leverage is built on explicit leverage as well. Law students take on $150k of student loans so that they get a chance to be a well-paid cog in the law firm machine. Most graduate from non-top schools with median grades and don't get that chance. And those that do are now going to find that they are at-will employees.

But hey, let's expand the student loan program some more in order to make education more "affordable" to everyone, as if the major schools are clueless idiots who don't capture the entire benefit of the subsidies by raising tuition concomitantly every time.

The relevant type of leverage here is operating leverage, which refers to the effect of a given percentage change in revenue on operating profit. Firms with a higher proportion of fixed costs relative to variable costs have more operating leverage. Professional partnerships like law firms have low operating leverage by this income statement definition because their primary cost is non-union labor, which is a variable cost. However, if you look at the opportunity cost of an equity partner's time as a fixed cost, then it makes sense to talk about the partner and the firm being highly levered. This is similar to a lot of distinguished professors with whose vitas include a couple of textbooks, several papers, several offices held, membership on 20 editorial boards, and much more in a year or two. How do they do it?

Using a lever is also called leverage, but that seems hardly relevant.

The "implicit leverage" concept seems to be useful if it leads to unexpected risks for the lender or others further downstream in the system. Situations such as this, where all the risk lies with the stock owners, are not examples of the systemic underestimation of risk that seems to have caused the current crisis.

Unless, of course, partners expanded too fast because credit was cheap, and are now not able to pay back loans.

Law firms also have other forms of leverage:

- real estate and real estate leases - probably the number 2 cost after people, and usually for a term of several years

- personal leverage by partners (not a problem for the firm)

- some firms do own real estate, against which they have borrowed

We saw a couple of Silicon Valley Law firms collapse in the tech crunch, and I would not be surprised to see the same in this cycle, in general corporate law.

It always sounded like the Amway business model to me.

@LZ, @valuethinker have it right -- a lot of the "leverage" is in the form of student loans or personal leverage by the partners.

So, law firms are basically getting somebody else to take on the financial leverage.

This doesn't seem unusual, though. My father was a unionized construction foreman -- but during slow periods in construction the firms would try to keep the formen working doing something, so they'd be available to supervise jobs when times got better. Of course, you'd get paid like a journeyman, but in construction there wasn't a large difference in pay.

This association only works if you don't understand the difference between a balance sheet and an income statement.

Maybe. I suppose it depends on what you're putting on your balance sheet.

I don't really see how this use of "leverage", meaning the associates/partners ratio, has anything to do with the hedge fund sort. (Without this claim, we may as well take a sudden interest in mechanical levers too.)

Compared to an individual practice or a pure partnership, a business with employees has bigger fixed costs. But most businesses have employees, and they're only "fixed" on timescales shorter than the hiring & firing. And moreover, the worst case scenario is that you get no work in a month, and have to pay all the salaries -- unlike shorting stock, you can't ever get leveraged "beyond 100%".

If the question is why did new lawyers become associates not start new firms as partners, in the good years, then probably the answer has something to do with rate of growth of the field (you need experience before striking out on your own) and perhaps with brand-recognition of the existing firms.

Yes, it's leverage, and it's made worse by the fact that firms compete on profits per partner, rather than profits per lawyer (or something closer to ROI).

We're getting ready to see a shift, I think, because it doesn't make sense to keep a skyscraper full of associates on call 24/7 -- but for the last 20-40 years, a big firm partner's income was a function of the profits on 5-6 associates per partner.

I would say this model for large law firms goes back at least 40 years, and has always been recognized as (and called) leverage. Everyone (well, everyone not a fool) could look around the office and realize that there was no earthly way all the associates, or even all the mid-level associates, could make partner.

But it has gotten worse over time. Sure, at one time, you would know that not everyone could make partner. But you could at least lie to yourself and convince yourself that you would be one of the fortunate ones. Not any more in many firms, with huge numbers of associates, et al. for each equity partner. If the ratio is 10/1, then you have a 10% chance.

It is not that easy though to just fire all the excess attorneys. Sure, it can be done, since for the most part, the firms have employment at will. But the end result is that these firms will likely lose access to the best talent over the long run. Why? There is more to life than money, and given the choice between a big firm that tries to keep as many as possible through a recession and one that dumps a lot of junior lawyers as soon as times get tough, many of the best and brightest will go with the firm that is a bit less leveraged but more paternalistic.

Well said Glen. Someone's tripped over the same word being used for two different things, and thinks he's seen a deep connection. This isn't high finance, it's salaried employment, and law firms employ lawyers, who knew?

So, the bottom line is that there was an "Attorney Bubble" which has now burst.

Yeah, the first guy who hired an employee or bought a slave instead of taking in a partner realized that back in .... Well, I couldn't find that blog post, probably because it's buried in the ruins a half a kilometer under under Catal Hayuk.

It's the same principle in any enterprise even to this day. You can take in partners and give them a fair share of the goodies, or you can take in employees and give them a fixed quantity of goodies and keep the surplus for yourself.

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