Law firms - in search of "edge"

Corporate law firms had a bonanza in 2021. Latham & Watkins, for example, increased revenue by 26.7% to $5.5 billion and profit per equity partner (PEP) by 26.2% to $5.7 million.

Growth at this pace was surely unsustainable - and so it has proved. 2022 was a slower year. Not by any means a disaster, but slower. So, Latham’s revenue was down by 3% to $5.3 billion and PEP was down by 9.6% to $5.15 million.

There was quite a spread in the results on the top 100 US firms. Kirkland & Ellis drove revenue up by 7.8% to $6.5 billion (PEP up 1.7% to $7.5 million) whilst Davis Polk saw revenue decline by 6.1% to $1.85 billion (PEP down by 20% to $5.55 million). On average AMLaw 100 Revenue was up 2.7% whilst PEP was down by 3.7%.

The increase in Revenue was driven by increases in lawyer numbers as the AMLaw 100 average Revenue per Lawyer (RPL) was down by 2.6%. AMLaw average Profit per Lawyer (PPL) was down more, at 7.1%, reflecting increased remuneration and other expenses.

The big UK firms tend to run to a 30 April year end and so their results are not yet in. But it would be surprising if the trends were materially different.

Whilst the deal environment is stirring - Glencore/Teck, EQT/Dechra - it is not yet buzzing. And the world out there is in a fragile state, with persistent inflation, recent US bank failures and some major geopolitical uncertainties (not least the war in Ukraine). Ping An’s desire to split HSBC is but one symptom.

So, in a tougher and uncertain market, what should be front of mind for Managing Partners in the quest for edge?

Here are some themes.

1. Clarity in the pursuit of financial outcomes

The financial performance of corporate law firms has become a matter of intense interest. It drives client perception as, ironically, whilst clients want lower fees they also want to feel that their lawyers are astute business people and “winners”. It is also, of course, a key component in attracting and retaining talent - the law remains quintessentially a people business.

So how should smart law firm leaders prioritise differing financial outcomes when setting budgets and, as part of that, assessing recruitment and other expenses and promotions to equity?

Firms will want to balance long term considerations, such as promotions to equity and IT upgrades, against the short-term consideration of what this year’s numbers look like. But the market interest in year-on-year performance tends to make firms captive to their numbers.

Against that backdrop, and recognising that market conditions will of course be critical and only so many levers are available to management, I would make three points:

1. Revenue has become an increasingly important metric over the last few years. The fact, for example, that Kirkland increased Revenue in a tough market, even though its RPL was down, really caught the attention. The firm’s revenue would get it into the lower reaches of the Fortune 500 and that is, well, amazing. Top-line heft seems to matter more these days in bespeaking ambition, practice range and “edge”.
2. In a heady lateral partner recruitment market PEP is really important. This point finds resonant expression in the comparison between Macfarlanes and Travers Smith, two London firms long regarded as comparable. Macfarlanes reported a PEP of £2.5m last year and is holding its team together. Travers Smith reported PEP of £1.1m and, sadly, has lost 7 partners so far this year. Strong PEP, moreover, is a source of pride and confidence - important glue for the partnership. We should note here that the PEP figure has to be viewed with caution as it will be materially dependent on partnership structure. PEP at firms with a significant number of non-equity partners (like Kirkland, with some 800 non-equity partners and 500 equity partners) will not be directly comparable to the figure at all-equity firms (like Cravath). But such is the fascination with PEP that this point tends not to get much attention.
3. Although not as headline grabbing, RPL and PPL deserve particular analysis by Managing Partners focussed on productivity and a measure of profitability that is more “pure” than PEP. How much turnover and profit is attributable to each lawyer and how it is growing, or declining, is a real measure of the health of your business.

2. Mergers?

A tougher business climate will, of course, lead some law firm leaders to think about a merger in the search for heft, synergies, new markets and (maybe even) excitement.

According to Fairfax, a consultancy, interest in mergers is much greater than it was 10 years ago and the first months of 2023 have seen a couple of decent sized mergers in the States, including the merger of 1,400-lawyer Holland & Knight with 257-lawyer Waller Lansden Dortch & Davis.

The execution risk however is huge, as we are seeing with the fall-out from the attempted merger between Hogan Lovells and Sherman & Sterling. If the merger fails the franchise risk for at least one of the firms is highly material which suggests that bolt-on acquisitions will be more of a focus for large firms over the coming period than mega-mergers.

3. Alternative Legal Services Providers (ASLPs)

According to the Alternative Legal Service Providers Report 2023 published by the Thomson Reuters Institute, US law firms and corporates have “dramatically accelerated” their use of outside providers for work such as e-discovery and document review. The market was estimated to be worth $20.6 billion for fiscal 2021, a 45% increase from two years earlier. 23% of large law US firms are expected to increase their spending with ASLPs.

Some firms are, of course, choosing to create their own “captive” ASLPs - Eversheds Sutherland, for example, are selling hard their Konexo offering.

Whilst some law firm leaders will worry that closer working with an ASLP will cannibalise their premium offering, others will see opportunity. An ASLP can provide access to technology (see more on this below), non-permanent headcount and savings for clients - thus making more efficient the delivery of more mechanical tasks.

Clients will surely push their law firms harder in this area over the years to come. Time for more firms to take the initiative?

4. Generative AI

Generative AI is of course the subject du jour across many sectors. A fund manager friend of my daughter’s tells me that Chat-GPT has revolutionised her daily routine. It is open all the time and helps her with draft emails and a range of other tasks.

For oldies like me this is pretty mind-blowing. But then, as Sheryl Crow advises us us, https://youtu.be/GDwLPMOzHLY, “a change would do you good”.

Of course, the legal profession has long been seen as an area at risk to AI automation. Richard Susskind penned The End of Lawyers?, which raised lawyers’ blood pressure somewhat, in 1996. And e-discovery, data room analysis and automated drafting tools have proliferated over recent years. These tools, however, have not replaced lawyers - they have served more to help lawyers do their work and to save time.

Will Chat-GPT and similar products like Bard represent a threat to law firms on a different scale?

Given that, according to the American Lawyer, Chat-GPT outperforms about 90% of humans sitting US bar exams the answer must be Yes. There is a concern around the products’ ability to “hallucinate” and “make stuff up” but surely future iterations will iron out issues of this sort.

These tools, when used in conjunction with tailored software being developed by start-ups like Harvey, will be game changers particularly in less judgemental areas like commercial contracts, employment and routine litigation. Whilst Steve Lohr, writing in The New York Times , is surely right to caution that change will not be as rapid as some like to predict, there can be no doubt that firms keen to maintain their “edge” will need to be more focused on the AI challenge than they have been hitherto.

And they will need well-informed and credible answers for clients who will ask what they are doing in the space and how that will reduce fees.

5. The billable hour

The refrain is all too familiar. Law firms ought to be rewarded for value added rather than hours accumulated. The hourly rate is an incentive to inefficiency and hourly targets for associates and partners are stressful and unfair. If associate Joan Wasser is not given enough work how can she rack up enough hours to get a bonus?

The trouble is that hours are easier to measure than “value” and clients will often say that if they see the hours they can at least challenge evident time-wasting.

But in a world where fees will be under greater scrutiny, technology will increasingly do the more mundane tasks and the best talent will recoil from being a slave to billable targets, smartly led firms will surely find a better way.

How about a model which:

• focuses much more on agreeing “value-based fees”, perhaps building upon general principles of what value means for the client (complex problem solved, money or time saved, strategic objective achieved). These will depend upon a relationship of trust between client and law firm but that kind of relationship will often exist;
• uses fixed fees for particular jobs, for example (as often the case now) capital markets transactions, where there are market norms;
• works together with clients to identify where technology, or partnering with an ALSP, can save time and add to efficiency on particular matters;
• uses hourly rates on matters which are less obviously value add matters (maybe discovery and data room analysis); and
• does away with hourly targets for lawyers?

6. Purpose

I know that I bang on about this, but I do think that in 2023 and in a world which is worryingly uncertain corporate law firms should articulate a purpose beyond making profit.

Often, when you land on a firm’s website you will see an array of impressive statistics around global footprint, numbers of lawyers and deals done - but no “North Star” statement of “why we exist and what we are for”.

More and more corporates are embracing the value of clarity of purpose in underpinning strategy, motivating the team and driving the “equity story”. NatWest’s purpose of “championing the potential of people, families and businesses” ripples through its Annual Report and Rio Tinto has recently articulated its purpose as “finding better ways to deliver the materials the world needs”.

Sceptics will say that law firms are different as they have sufficient purpose in upholding the rule of law and advising clients well. But I think that that is to miss the point that partners and staff will want to feel that “they are part of a winning team on a worthwhile mission” and clients will increasingly empathise more with law firms which have explicit goals beyond enriching the partners.

Few leading law firms articulate a purpose. Freshfields do (“Empowering tomorrow”) and I would encourage other firms to push this topic up the agenda.

Christopher Saul

Christopher Saul provides independent trusted advice to senior executives and key stakeholders within publicly quoted and privately owned businesses and professional service firms. His areas of focus are governance, succession and the moderation of differences.

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