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American Lawyer correlates growth in non-equity partners with declining profitability
A recent study by the American Lawyer reports what it describes as a surprising result from its analysis of the correlation of non-equity partners to profits per equity partner (PPEP) for Am Law 100 firms.
The study's results
Correlation of NEPs and PPEP. The greater the proportion of non-equity partners to equity partners, the lower are the firm's profits per equity partner, according to the study. For example, firms with a ratio of 0.5 non-equity partners to equity partners have average PPEP of just under $2 million; firms with a 2.0 ratio average just over $1 million in PPEP. The analysis was based on 2015 data, the most recent available.
PPEP Trends. The study also compared PPEP trends for 2007 to 2015 of the top quartile of firms by revenue (Am Law 1-25) and the bottom quartile (Am Law 76-100). The top quartile average PPEP shows consistent strong PPEP gains since the dip in 2008, exceeding its 2007 level by 20% in 2015. In contrast, the average PPEP of the bottom quartile is 10% below its 2007 level in 2015. The study concludes that non-equity partner engineering can soften but not overcome underlying profitability declines. The study does not address why the top and bottom 25 firms show such disparate results. We believe the financially outperforming firms are successfully pursuing strategies to differentiate themselves, as further discussed below, whereas the bottom firms are continuing their traditional approach, with declining results as they are forced to compete on price.
NEP Trends. The study also traces the growth of non-equity partners at Am Law 100 firms. The number of firms with non-equity tiers grew substantially from 1994 until the downturn of 2000-2001, from 45% of the Am Law 100 to 75%. During the next growth period, from 2001 until the downturn of 2007-2008, non-equity partners as a percentage of all partners grew from 30% to 40%, as the two-tier partnerships expanded their non-equity partner ranks. Starting in 2008, compensation of non-equity partners has flattened through 2015, on an inflation-adjusted basis. Meanwhile, compensation of equity partners has continued to grow significantly since 2008.
The study suggests that this is a natural market progression and that continued slow growth in the proportion of non-equity partners at flattened compensation should be expected.
The study does not discuss the possible correlation between size of firm and lower PPEP. It is possible that the underlying dynamic is not that growth in the percentage of non-equity partners signals a firm's unwillingness to address underlying profitability issues.
Instead, if larger firm size correlates with lower PPEP, it could be that larger firms are simply less profitable than smaller firms, having chosen to trade off profit potential for stability of their platform. In this hypothesis, the size of the non-equity partner tier is appropriate, is driven by the size of the firm and happens to boost PPEP from what it otherwise would be. In this case, the correlation of size of the non-equity tier and lower PPEP is a red herring because there is no causal link. It should be noted that despite their lower PPEP larger firms, because of their size, are still able to highly compensate their top-performing partners. Larger firms also have more flexibility to try different practice delivery models because of their greater flexibility in the range of compensation they can pay.
It is likely that larger firms are more advanced than smaller firms in establishing a robust non-equity partner tier at lower compensation than equity partners, because at large scale that category of lawyer is more essential to service delivery and acceptable profitability. In fact, the American Lawyer study cites the premier consulting firms as an example of appropriate development of a large non-equity tier. Developments in the large accounting and consulting firms have foreshadowed evolution of the law firm market. It is reasonable to expect that many law firms can benefit from a well-managed and designed non-equity tier, whatever it may be called.
The study's conclusions
In fact, both the study's conclusion and the above alternative hypothesis are likely true. As the study suggests, some firms do increase the size of their non-equity tier in an unsuccessful attempt to disguise declining underlying profitability. As the alternative hypothesis suggests, though, many larger firms are in fact focusing on business fundamentals but also understand that a significant non-equity tier at lower compensation is an important structural element of their service delivery model.
In any event, the study concludes with some very sound advice:
- Address financial pressures through a robust strategy that distinguishes the firm from competitors. The article suggests targeting specific client segments; differentiating from competitors the firm's offerings to these client segments; and changing partners' mindsets to make differentiated service offerings their consistent goal. Do not avoid that hard work by seeking to engineer higher PPEP through increasing the non-equity partner tier.
- Follow the lead of the elite consulting firms by addressing all partner career development in a professional way with formal training, counseling and expectations. Establishing and growing a non-equity tier should merely be an element of an overall soundly designed partner development program.
The American Lawyer study was authored by Hugh Simons, Ph.D., former chief operating officer at Ropes & Gray and a former senior partner, executive committee member and chief financial officer at The Boston Consulting Group.
Implications for law firm leaders
We agree with the study that law firms should first focus on developing a strategy – how to differentiate themselves from competitors in order to better avoid competing solely on price. For further discussion, see our blog entitled “What is a strategy? And why you need one (Pt. 1 of a series)”.
A firm needs to focus on a strategy that will allow it to grow its total profits, not merely PPEP. Generally speaking, a firm can distinguish itself either by broad practice offerings or deep specialization. The firm also needs to decide on a geographic focus and possibly a client industry focus. For further discussion, see our blog post entitled “How to choose a strategy – and why it must include growth (Pt. 2 of strategy series)”.
Our next post (Part 3 of the strategy series) will address how to select practice areas on which to base a strategy of deep specialization.