In the face of the significant shifts in market dynamics that have impacted the legal industry since 2008, perhaps the most noticeable trend has been an apparent fixation on growth, as many firms appear to have adopted growth as their primary strategy. Law firm mergers and lateral acquisitions have
surged in recent years. Indeed, through December 3, 2015, Altman Weil reported there had been 84 mergers involving U.S. law firms, the largest number since the consultancy began tracking merger activity nine years ago.

As we have noted in previous reports and as other observers of the legal market have pointed out, growth as a strategic goal is not always a wise course for law firms to pursue. Above a certain size, there are no real economies of scale in the law firm business model, and law firms – unlike high tech enterprises for example – get no benefit from a “network effect” where having more users (or clients) inherently increases the value of the product or service being offered. Moreover, as repeated analyses have demonstrated, there is no correlation between firm size and profitability. Unfortunately, as law firms grow (particularly through mergers and large acquisitions) it all too often means that they face even greater challenges in offering fully integrated, quality services and become even less differentiated from their competitors. It is certainly arguable that most firms would be better served by strategies focused on responding more seriously to the expectations of their clients, tending to the
profitability of their organizations, and differentiating themselves on the basis of the quality and efficiency of their service. This is not to say that growth is necessarily bad but rather that a fixation on growing market share through mergers and large acquisitions can have downside risks, not the least of
which is diverting energy and attention away from making the difficult operational changes that are required for firms to remain competitive in the current legal market.

The problem, of course, is that making significant operational changes – e.g., implementing new staffing models, redesigning legal work processes, or adopting new pricing strategies – is hard and inevitably runs into stout resistance from partners or principals who see no reason to change methods
that have “always worked before” (the Kodak-like “danger of success” trap that we previously described). Such resistance is common in all organizations, but it can be especially strong in law firms for a variety of reasons, two of which loom particularly large.

First, most law firms remain locked in a “billable hour mentality” that makes it difficult for their partners or principals to think creatively about alternative approaches to legal service delivery, a problem that is not just (or perhaps even primarily) about alternative fee arrangements. Most firms of any size today
are accustomed to using fee structures that are not controlled by billable hours, but most still retain the billable hour as their key metric for other purposes. Lawyer evaluation and compensation systems usually incorporate a heavy billable hour component. Indeed, many firms still tie bonuses for associates and other lawyers to billable hour targets. Additionally, billable hours still remain the basic building block for matter or project budgets in most firms, and the “profitability” of matters is often assessed with primary reference to how close billings come to matching the “full value” of established hourly billing rates. The latter practice reflects the common – though often mistaken – assumption that work must be profitable for a firm if full hourly billing rates are being charged.

It seems doubtful that law firms will ever be able to respond fully to client expectations for more efficient and cost effective delivery of legal services unless and until the stranglehold of the billable hour mentality is finally broken. The most obvious alternative is, of course, to implement rigorous cost and profitability accounting systems, as used in most other businesses. And, in the law firm context, that requires the evaluation of costs and profitability at the matter level. In building project budgets, firms should calculate the actual hourly costs (not billing rates) for all lawyers and other staff required to deliver the anticipated services – factoring in both direct and indirect compensation costs – and should then add additional costs associated with the work including an appropriate allocation of firm overhead. Such an exercise would provide an opportunity to consider whether certain costs might be reduced by down-sourcing or outsourcing particular activities, by changing the assumed staffing mix, or by improving the work process in other ways. The hourly cost rates, as finally determined, would be the primary component of a project budget and would become the key metric for determining the firm’s ultimate success in managing the project and in achieving an acceptable level of profitability.

While matter-level profitability assessment has been adopted in some firms, it has been strongly resisted in many others by partners and principals long accustomed to thinking primarily in terms of the billable hour. Up to this point, firms have been able to tolerate this resistance primarily because of their continuing ability to raise rates on an annual basis. As previously noted, however, client resistance to rate increases has mounted steadily since 2008. This is reflected in growing demands for discounts, plummeting realization rates, and a noticeable slowing in the growth of collected rates. It is also reflected in clients “voting with their feet” (as described above) as the law firm share of the overall legal market has begun to contract.

A second reason that many law firms find it difficult to embrace significant operational changes relates to the amount of decision-making authority conferred on firm leadership to undertake such changes, whether in response to client expectations or in order to improve the firm’s overall economic performance. In its 2015 Law Firm in Transitions Survey, Altman Weil asked the 320 respondent firms to rank on a one-to-ten scale the extent to which their firms conferred on their leaders decision-making authority to drive change efforts. Among the respondents, 15 percent reported their delegation of such authority as “high” (i.e., ranked as a “9” or “10” on the scale), while 28 percent assessed their delegation as “low” (i.e., ranked from “0” to “5” on the scale). Comparing the financial performance of these firms from 2013 to 2014, the survey found that 76 percent of the firms rated “high” in delegation of authority saw their RPL improve, 14 percent more than the “low” delegation firms; 74 percent experienced growth in PPEP, 11 percent more than the “low” firms; and 74 percent had increases in gross revenue, 9 percent more than “low” delegation firms. 40 While not conclusive, these results certainly suggest a correlation between the degree of decision-making authority conferred on law firm leaders and better economic performance. Unfortunately, however, in many firms the idea of granting significant decision-making authority to firm leadership is viewed as inconsistent with the “democratic values” of the partnership structure.

For historic reasons, partnership (or its equivalent in professional corporations) is by far the most prevalent form of governance structure for law firms of all sizes. While this form made sense when firms were much smaller and less complex, it is questionable whether the broadly participatory decision-making style reflected in the traditional partnership model can work as effectively in today’s law firm environment. The National Law Journal’s list of the 350 largest U.S. law firms in 2015 showed an average size of 421 lawyers, with the smallest firm on the list having 116 lawyers. The American Lawyer’s 2015 Am Law 100 list disclosed 23 firms with over 1,000 lawyers, 22 firms with over $1 billion in gross revenues, and five firms with over $2 billion in gross revenues. Many of these firms reported scores of offices spread across dozens of countries. With such large and complex organizations, it is imperative that key strategic and operational decisions be entrusted to leadership teams empowered to act with broad authority on behalf of their firms.

This is not to suggest that firm leaders should be given a blank check, that they should be permitted to function without oversight, or that they should operate without transparency. Indeed, the sad story of Dewey & LeBoeuf is a powerful cautionary tale of what can happen if management is left unchecked. But it is to argue that law firm partners must understand that the exercise of their “ownership” rights can no longer entitle them to exercise a veto over every key management decision or to approve in advance changes in firm operating systems or models. Other professional service firms (including accounting firms and consulting firms) have made adjustments to their governance structures to make them more responsive to the demands of their market environments. Law firms need to do the same. This is important not only to enhance such responsiveness, but also to enhance the likelihood that decisions will be made with an eye on the long-term viability of the firm rather than the short-term interests of individual partners.

As the law firm management consultancy Fairfax Associates noted in a publication a year ago:

While the traditional partnership model has served law firms well historically, it may be time to rethink the structure and function of the partnership. Firms should be asking themselves what it means to be a partner and how to ensure that partners contribute as true owners of the business. They should also consider if their current partnership model is most appropriate in terms of governance, management and financing. While the current model may continue to work well for some firms, others may need to rethink how they apply the partnership structure more effectively and still others may want to consider alternative structures. Ultimately, in order to sustain growth and competitiveness for talent and clients over time, firms need to look ahead and think about new approaches to structuring the provision of legal services.

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