This is a joint post by David Barnard & Mark Shapiro of Blaqwell and Jack Bostelman of KM/JD Consulting Blaqwell is a pre-eminent consultancy that advises top law firms on high-level issues, such as strategy, mergers & acquisitions, compensation systems, performance measurement and lateral hiring strategies. KM/JD Consulting advises leaders of Am Law 200 firms how to improve practice group productivity and achieve real follow-through from lawyers on internal initiatives.

Trends to watch for in the 2016 results

When the Am Law 100 results for 2016 are issued later this month, we believe they will confirm several key trends.

The big picture. A small group of approximately 20 firms is widening its lead over all other firms and concentrating its share of Am Law 100 profits. For now, there are a couple dozen firms in the mid-tier between the leaders and the lower tier. Each year, though, the mid-tier becomes emptier and a wider gap opens between leaders and the rest. Some mid-tier firms join the leaders and most fall into the lower tier.

Industry concentration. We believe this pattern reflects a predictable and inexorable evolution of the legal industry in the US, following the concentration path experienced in other service industries such as accounting and management consulting and for similar reasons. Concentration of the UK legal industry in the period through 2010 to five Magic Circle firms whose profit pools far exceeded other firms' is another example of this pattern at work.[1]

We will elaborate on this evolution, and its implications for law firm strategy, in future posts.

To understand the trends, recognize that growth in productivity and size are important

Growth in net income is a better measure of success than PPEP

Many commentators use profit per equity partner (PPEP) as the key law firm metric. We believe that growth of net income – what we call “profit pool” – is the better measure of success. It tracks both productivity growth – increasing profits with the same number of equity partners – and expansion of productive units (such as the number of equity partners). Both types of growth are important. Also, growth over the long term, not merely a one- or two-year spike, reflects a growing, sustainable business and is what matters.

PPEP growth is less useful for analyzing long-term performance because it doesn't reflect changes in a firm's productive capacity. In fact, many firms have steadily increased PPEP while shrinking. Eliminating less productive equity partners may be smart for many reasons, yet unless the firm replaces those equity partners, and ideally adds more, it will have a steadily less competitive platform as other firms grow larger. PPEP is important because potential laterals focus on it, not because it aids in strategic analysis.

Why size matters

Size is not a substitute for the disciplines of success but it certainly helps. Larger firms can

• exploit broader or deeper practice offerings,
• reduce dependency on individuals,
• pay more for highly productive talent,
• benefit from economies of scale in technology and other efficiency-enhancing infrastructure, and
• better withstand outside risk events such as last year's associate salary hike or an economic downturn.

A transformative merger can vault a firm from the lower tier to mid-tier, or even into the leading tier, but can the firm stay there? Such mergers are infrequent because they are challenging to consummate unless at least one of the merging firms is very weak. In order to continue to grow profit pool, the combining firms also need to improve productivity, an imperative that is often overlooked in the wake of a major merger.

Trends in the Am Law 100 since 2008

Results over the 7 years from the 2008 recession to 2015 have shown the following trends in the Am Law 100. The accompanying chart illustrates the effect of these. For illustration, the chart also includes projected results for 2020, to show the trajectory of firms using past growth rates. Click here for a larger version of the chart.

• Profits are concentrating in a few firms. Profits of the Am Law 100 are increasingly concentrating in a small number of leading firms having the largest profit pools, ranging from $555 million to $1.3 billion. The bands established for membership of the tiers of leading firms are arbitrary, but they reflect wide gaps between each tier of firms and the next that act as a ‘natural' dividing line.[2] In 2015, there were 18 firms[3] in this leading tier, representing 43% of the total profit pool of Am Law 100 firms, up from 36% in 2008. By 2020 profits are projected to be further concentrated in the leading tier at 53%.
  
• Once in the top, leading firms stay ahead. The composition of the leading tier has remained relatively stable. Only 4[4] of the 15 leading firms in 2008 had dropped out of the tier by 2015. Three of those 4 firms fell out notwithstanding that their profit pools grew during the period; that growth was too slow to keep up with faster growing peers. Seven[5] new firms joined the tier, several by growing through significant mergers.
• There are many routes to the top. Firms in the leading tier grew their profit pools through a variety of strategies to be distinctive. Some have pursued broad practice offerings; others focused on growing a deep bench in a handful of practice areas. In pursuing these strategies, growth can occur through productivity gains, adding equity partners (internal promotion, laterals, mergers), or both.
• The mid-tier is emptying, to become a sparsely populated band of firms whose profit pools in 2015 ranged from approximately $350 to $550 million. As the Am Law 100 stratifies, the mid-tier is emptying. In 2008 there were 25 firms in the mid-tier, but only 18 firms[6] by 2015. As a percentage of total profits, the mid-tier shrunk from 32% to 23%. It is projected to shrink further to 13% of profits and 11 firms by 2020.
• The lower tier is growing, as more firms drop from the mid-tier. As the mid-tier firms fall to the lower tier, it becomes larger. In 2015, the 64 firms with the smallest profit pools (up to $350 million) represented 34% of total Am Law 100 profits, up from 60 firms with 32% in 2005. These firms have no realistic prospect, absent a transformative merger, of reaching the leaders – a profit pool gulf of more than $200 million. These firms are generally not in financial trouble, but competitive pressure is steadily building because of their inability to catch up to the leaders.
• Individual success is possible in any tier. Being in a particular tier does not control a firm's results. Each of the three tiers included firms that had grown their profit pools extremely well for several years (7% or more annual growth). Record performance for firms in the mid-tier or lower tier may be satisfying, but without a change in competitive standing good performance is neither an indicator of long-term health nor of a winning trajectory.
• While many firms reduced equity partners, the leaders grew them. Net growth in equity partners for the Am Law 100 collectively approached zero from 2008 to 2015, but growth of non-equity partners continued. The number of equity partners in the Am Law 100 grew at a 20% annual rate in the 6 years before 2008, but only at 1% annually from 2008 to 2015. In contrast, the non-equity partners grew at 8% annually during the 6 years before 2008, and continued at 5% annually through 2015. The near halt in equity partner growth for the most part reflected firms' removing or de-equitizing less productive partners. In contrast, 9 of the 18 firms in the leading tier derived more than 20% of their 2015 profit pool increase by adding equity partners, including through laterals and mergers.
• Most mergers involved an obviously weaker firm, revealing the imperative for the stronger firm to grow. In most sizable law firm mergers in recent years, one of the merging parties had dramatically weaker performance. This is an early sign of how difficult it is for firms to grow and the pressure they feel to take action notwithstanding the potential dilution from merging with a weak firm seeking a white knight.

What to look for in 2016 results of the Am Law 100

Based on preliminary reporting of Am Law 100 results, we believe the trends outlined above did, in fact, continue in 2016. We predict:

• Concentration of profits in the leading tier will continue, and membership will remain stable. A few more firms will move into the leading tier, and the tier's percentage of total Am Law 100 profits will increase. The membership of the tier will continue to be stable.
• There are still many ways to achieve growth needed to reach the top. New firms reaching the leading tier will continue to employ a variety of strategies – growing a broad practice offering or growing deeply in a handful of practices. They will accomplish this growth through productivity improvement, equity partner growth through promotion, lateral hiring or merger, or both.
• The mid-tier will continue to empty. The number of firms in the mid-tier and their share of total profits will continue to shrink. Firms that take corrective action will move up to the leading tier; the others will fall to the lower tier. The net change will be shrinkage of the mid-tier.
• The lower tier will fall further behind. The profit pool gap between the lower-tier and the leading tier will increase. The number of firms in the lower tier will be stable, and may increase.
• Individual success in all three tiers will still occur. There will continue to be firms in the mid- and lower tiers that have grown their profit pools extremely well for several years (7% or more annual growth), yet have not transformed their competitive prospects and generated sufficient additional profit pool to move to the next tier.
• Merger activity will increase. We expect merger activity (including acquisitions of practice groups) to increase in 2017, because the firms that are falling behind are under increasing pressure to grow. The lateral market will also remain active. Firms will remain under pressure to improve productivity of their laterals.

Conclusion

The overall trend of concentration of Am Law 100 profits in a leading tier of firms appears to be following the pattern of other professional service industries.

The good news for many firms is that the trend is slow compared to other industries. There is opportunity for great performance by firms, and rich reward to their partners, in each of the three tiers. Firms in the mid-tier and lower tier – even those with very good performance – do need to be mindful, though, of the additional and growing risks they face from steadily losing competitiveness over time as they set their strategies. We will write more about this.

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[1]     The Magic Circle firms are Allen & Overy, Clifford Chance, Freshfields, Linklaters and Slaughter & May.

[2]     To observe trends, we used natural profit pool boundaries evident in 2015 to divide firms into three tiers – leading, mid-tier and lower tier. To isolate effect of the rising profit tide lifting all firms, we adjusted these boundaries by the average growth rate of total Am Law 100 profits so that the boundaries rise in line with that average growth. We analyzed only the firms comprising the 2015 Am Law 100, looking back to their 2008 performance, whether or not they were then in the Am Law 100 .

[3]     The 18 leading firms in 2015 – those with the largest profit pools – were (in descending order of profit pool): Latham & Watkins ($1.3 billion), Kirkland & Ellis, Skadden Arps, Gibson Dunn, Jones Day, Baker & McKenzie, Morgan Lewis, Sidley Austin, Quinn Emanuel, Hogan Lovells, Sullivan & Cromwell, Simpson Thacher, DLA Piper, Cleary Gottlieb, White & Case, Paul Weiss, Ropes & Gray, and Wachtell ($555 million).

[4]     The 4 firms that dropped out of the leading tier between 2008 and 2015 were Weil Gotshal, Paul Hastings, Greenberg Traurig and McDermott.

[5]     The 7 firms that had joined the leading tier by 2015 were Morgan Lewis, Quinn Emanuel, Hogan Lovells, DLA Piper, Paul Weiss, Ropes & Gray, and Wachtell.

[6]     The 18 firms in the mid-tier in 2015 were (in descending order of profit pool): Norton Rose Fulbright ($545 million), Davis Polk, Wilmer Hale, Weil Gotshal, Paul Hastings, King & Spalding, Greenberg Traurig, Milbank, Mayer Brown, Akin Gump, Goodwin Procter, Dechert, Cooley, Willkie Farr, Proskauer, Reed Smith, Morrison & Foerster, and Debevoise ($352 million).

[Photo credits: © Can Stock Photo Inc. / vasabii & Virgonira]