New insights into equity profit shares in US BigLaw firms

“The topic of equity profit shares can bring more tears than working with an onion.” 

Ed’s views on a recent (February 27, 2017 ) American Lawyer article shed additional light on one of the first open commentaries by (BigLaw) firm leaders about the changing landscape of equity partner compensation. The topic is complex and nuanced in ways that are much deeper than any one article can cover. The real value is that finally it is being talked about in a more open and honest way than ever before, and that is a good thing. But a lot churns just below the surface, and isn’t discussed in the article by firm leaders, for understandable reasons.

Ed also cites some of his published articles on the subject, and links to them are sprinkled through the comments in contrasting colored text where they add some ‘drill down’ value.

As Ed always says, “Of course, these are just my opinion, I might be wrong”.

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Changing Compensation Strategies Put Partners Under Pressure

Partner compensation is increasingly in flux. Firms are more willing than ever to frequently adjust pay to hold on to their high performers. (We are talking adjustment of pay not only to increase the pay to high performers, but also to lower the pay of other partners to do it.  This is, or at least should be, a zero sum game out of a set pool of net income every year.  Dewey’s collapse showcased the problems associated with paying, or overpaying, currently with dollars to be earned next year.)

   Nell Gluckman, The American Lawyer, February 27, 2017     

Law firm partners have never been able to make as much money as they can now. The highest profits per partner on our Am Law 100 rankings in 2015 came in at $6.6 million at Wachtell, Lipton, Rosen & Katz, while the rainmakers and leaders (They are often, though not always, the same persons) at a select few firms can make at least twice that. But being paid more at the top can mean less for those below, stretching the definition of “partner.”

The legal profession has never been more cutthroat. As the race for revenue intensifies, firms are putting more pressure on their partners to perform on a number of criteria. If they don’t, it will be reflected in their compensation, title and possibly their place in the firm. For a profession that once provided a secure path to upward mobility, some partners are sliding back down in compensation, to the benefit of those still on the climb.  (Let us not forget the role of compensation guarantees in this mix: http://www.jdsupra.com/legalnews/the-question-of-partner-compensation-gua-70553/)

Law firm leaders say that with each decision they make about compensation, they’re sending a signal to the rest of the firm about what is and is not valued. While there are almost as many partner compensation systems as there are law firms, consultants say one thing many firms have in common is that they are growing increasingly scrupulous in how they make decisions about what to pay partners (What an interesting choice of words!  One meaning is careful/diligent/meticulous, but a second is honest/moral/ethical/principled.  While there should be little to question about the first meaning and its application to partner compensation, there is much to question when the second meaning is applied.). There are several ways law firms are putting the pressure on partners, from looking only at one year’s billings in setting compensation to more easily moving partners up and down the pay scale.

Firms are decreasing the numbers of years they consider in determining compensation, consultants say. Since the recession, firms have become less willing to give a partner leeway for a bad year. They also want to be able to reward a partner who does well to keep them from getting poached by another firm.

“Three years is history,” Jim Cotterman, a principal at the legal consultancy Altman Weil, says. “We’ve contracted that. The emphasis that’s placed on the current year has increased.”

That means the pressure is on for partners to constantly bring in business.

“The grace period for not performing is not very long anymore,” says Joe Altonji, another legal consultant. “A very well-run firm is lowering some people’s compensation every year.”

Dorsey & Whitney managing partner Ken Cutler says that while his firm looks at three years of data, plus other subjective measures when determining partner compensation, “there’s a bit of trend to place more emphasis on the previous year.”

Recently, partners’ performances have varied dramatically from year to year, because clients are less loyal, Cutler says. They’re willing to jump around between firms, making the stream of billable hours less consistent than it was in the past.  

“You’re competing for your clients’ business every project, every day,” Cutler adds. (The loyalty issue is a two way street.  When law firms fail to listen to what their clients are telling them loud and clear, and the client perceives that it is not delivering the value that they are asking for, they will move.  When the client perceives that the law firm is taking client loyalty for granted and preferring it interests over those of the client……on each of our matters every day, they are going to think about and may actually take action to protect themselves.  Are clients unilaterally less loyal, or did law firms through their own behaviors drive the clients this approach?).

One Am Law 100 firm leader who did not want to be identified agreed, saying partners “can move up and move down [the pay scale] more quickly. We aren’t a jump ball every year and we want longevity to be rewarded and loyalty to be rewarded, but I think at all firms, including ours, … there is less stickiness” among compensation tiers. (Firms are also deliberately adopting a quicker to go down than to go up bias.)

But some firms say they’ve resisted this trend. At Weil, Gotshal & Manges, for example, the management committee still looks at several years when determining a partner’s compensation.

“We think that’s the right measure of someone’s performance,” Weil executive partner Barry Wolf says. “Someone could have an off year for personal reasons, or the market went down.” (Or a client merged out of existence, or went out of business, or the business cycle impacted an over-weighted practice concentration in the firm.)

Laterals continue to contribute to stratification within the partner ranks. Last year, the lateral market hit an all-time high since the recession, according to our previous reports [“No Book? No Problem!” February], with more partners defecting for rival firms. That reality has had an impact on some firms’ compensation systems. Firms must promise rainmakers huge sums if they want to attract them as laterals, while paying their own top producers equally well to prevent them from being poached.

(This element of equal pay for equal performance is a natural consequence of having a policy of growth through lateral hiring.  It also kicks open the door of measuring profitability not only of the newcomer, but then every other partner in the firm.  Something that has been a source of push-back from entrenched long-term partners with big revenues, but modest profit margins on their work. THAT has been one of the bigger sticks in the bicycle spokes to “fair” compensation reforms.)

The hope is that the revenue generators who are brought in will pay for themselves and then some, but it sometimes doesn’t work out that way, at least not immediately. Firms have to get those shares or points from somewhere, and typically it will come from the mid- and low-level producers, increasing the spread between the highest and lowest earners.  (Here is a five part series on pricing the different levels of lateral partner talent written a few years ago: http://www.jdsupra.com/legalnews/pricing-lateral-hires-48156/.)

“As a firm leader, I have to make sure that my best producers of business stay,” says another Am Law 100 chairman, who asked not to be identified so he could speak candidly about compensation. “They may be willing to take a discount as compared to what they could get [at another firm] because they love the firm and they love the culture, but there are limits.”

Data collected by ALM Intelligence (ALI) shows that the spread between the highest- and lowest-paid partners has widened industry-wide. In 2013, the first year ALI began collecting this information, the average ratio of highest- to lowest-paid partners was 10.6-1, while the median was 9.8-1, based on a survey of just over 100 firms on the Am Law 200 list. Last year, the average compensation ratio had risen to 11.7-1 and the median had risen to 10.4-1. (There can be serious danger with wide compensation spreads. Patrick McKenna and I wrote directly to this issue several years ago:  http://www.jdsupra.com/legalnews/sliced-too-thin-the-danger-of-wide-partn-80718/).

This data comes from firms that self-reported, with many of the most profitable firms choosing not to disclose their compensation spreads. The figures reported include non-equity and equity partners.  (Two additional measures need to be kept, one for equity partners only, and one for non-equity partners only, in addition to the combined figure.  One reason is that only profit is in the equity partner component, but non-equity partners are typically not participating in profit…they are salaried and thus an expense.  To include them in the numbers requires a restatement of their comp as income, increases the spread and the stated profit pool.  It also makes it difficult if not impossible to do the one calculation that chills the blood of managing partners and leaders…the calculation of an accurate PPEP against which the equity partners can compare what they took home and what is reported as PPEP.  About two-thirds to as much as three-fourths of equity partners won’t make as much as the reported PPEP.  Which means…….many of those partners in the equity rank are in fact leveraged contributors to the pool, shifting income upstream.)

Compensation spreads don’t tell the full story, given the ratios could differ when comparing single-tier to two-tier partnerships, and outliers could easily skew the spreads. But the rise in the average and median over time support anecdotal evidence that the gaps are generally widening.  (The key is ‘where is the money coming from’?  The top is getting more, that is clear. The bottom is getting less.  But one has to take a lot from the bottom to have an impact at the top, and by definition, they have a lot less to give.  By dropping folks into a non-equity salaried class and thus out of the profit pool, the reported PPEP goes up, and the profit pool goes down. Add to that mix a reduction in compensation to the partners dropped from the pool, and PPEP goes up.)

The firms that reported the widest spreads for 2015 were Squire Patton Boggs, with 30-1; Barnes & Thornburg at 29-1; Nelson Mullins at 27.3-1; and Reed Smith and Goodwin Procter, each with ratios of 27-1. Perkins Coie’s spread was 26.7-1.  (These structures put a lot of ownership and compensation in very few hands.  What happens when they are the center of a death, disability, retire, withdraw event? The impact on sustainability of the enterprise can be an even more serious issue than it is in firms already, and the impact on culture currently is also a consideration.  

http://www.jdsupra.com/legalnews/is-your-law-firm-creating-a-star-culture-72503/).

Perkins Coie managing partner John Devaney says his firm has a wide compensation ratio in part because of its merit-based pay system.

“We have long been a very merit-based compensation system where if you have a good year you get handsomely rewarded for it,” he says. “There can be meaningful variation from one year to the next.”

Devaney adds that the firm has a large bonus pool, so a typical partner’s bonus is one-third of their income. The partners, many of whom work for newer companies with startup cultures, tend to like the opportunity to knock it out of the park and are comfortable with the risk, he says.

The wide compensation spread is also due to the fact that the firm has offices in cities like Boise, Idaho and Anchorage, Alaska, where lawyers charge very different rates and have very different expenses than their partners in New York and San Francisco. Finally, the firm promotes a relatively large share of associates and counsels to partner, which Devaney says adds to the discrepancy.  (The average may be one-third, but the reality is that for a few it is a big opportunity to “hit it out of the park” and for many it is not reached.  It is just a measurement system, and let’s face it, most bonus systems are drafted and/or ratified by those who benefit from them.  So this is an allocation tool as much as it is a comment about spreads.)

“Goodwin’s 27-1 compensation ratio includes both equity and non-equity partners since ours is a two-tier partnership,” Goodwin CFO Jon Kanter said in a statement. “Our equity partner compensation ratio is 8:1 and it has not changed since The American Lawyer started collecting this data in 2013. For all partners, if we remove from our calculation a few partners who have retired as of the end of 2016, our compensation ratio becomes 19:1, which we believe is a more accurate, true ratio to use for Goodwin in 2016.”

Some firms say their partner compensation spreads shrunk in 2016 because of the associate pay raises prompted by Cravath, Swaine & Moore last June and matched by many other Am Law 100 firms. One Am Law 100 firm leader said his shop also raised the pay of new partners in order to ensure that becoming a partner is financially worth it, but the highest compensated partners did not get a commensurate raise, meaning the firm’s compensation spread shrunk.

So far, some lockstep firms have kept their compensation systems intact, but they have seen some big producers walk out the door. An example of that was when M&A heavyweight Scott Barshay left Cravath for Paul Weiss, which is not lockstep, last year. And the British firms, which were traditionally lockstep, have largely had to modify their systems in order to keep high earners, according to several consultants and law firm leaders.

Most law firms will say their compensation systems incentivize collaboration, but in reality, this is hard to achieve. Partners are likely to push back when origination credits are de-emphasized in favor of a system that awards points to lawyers who do work for someone else’s client, but legal consultants say this is important.

“It’s always a key question: Am I better as a partner at the firm helping a fellow partner on a $2 million relationship or am I better off going out and chasing small clients on my own?” says Cara Rhodes, a legal consultant with the firm Hoffman Alvary. “The better thing for the institution is to grow the largest client.”

It’s easier to know who helps whom and who only works on his or her own clients at a smaller law firm, where all the partners know each other, than at a large firm with offices scattered across the globe.  (The lawyer comparison to the sports free agent opens some eyes about the ‘take all you get as fast as you can get it’ energy that is also at work in this dynamic of increased compensation for a few at the cost many: 

http://www.jdsupra.com/legalnews/free-agency-and-lateral-partner-moves-66003/).

“The bigger the firm, the more you have to rely on the numbers,” says Altonji. “It’s difficult for a managing partner to have intimate knowledge of everyone’s work.”

One way to go about this is through questionnaires, which several top Am Law 100 firms use. The firms ask not only who did you help, but also who helped you.

But firms are trying to work collaboration incentives into their systems in a more structured way. A couple of years ago Mintz, Levin, Cohn, Ferris, Glovsky and Popeo tweaked its compensation system so that no one partner can get 100 percent of a client’s origination credits.  (It may be helpful, but too many structured approaches can invite ways to play the game and circumvent the purpose of the rules to obtain personal advantage.  This is something that lawyers are brilliant at doing.  Great care is warranted that this does not undermine rather than advance a laudable objective.) 

“That’s to reinforce the collaborative nature of what we’re doing,” says Mintz Levin managing partner Robert Bodian. “In some instances, it means you have less incentive to try to originate a client by yourself.”

The firm also began awarding origination credits by matter, rather than client so younger partners will be compensated for opening a new matter with an existing client.

Dorsey & Whitney’s compensation system distinguishes between a “billing attorney,” who originates a matter, and a “responsible attorney,” who does the work on it. A partner could be a billing attorney on some matters and a responsible attorney on others, but the firm doesn’t give credit for being both on the same matter.

Partners who might otherwise have been both the billing attorney and the responsible attorney are encouraged to bring another partner on to the matter and designate him or her as the responsible attorney, Cutler says.  (This can devolve into some interesting game playing with how those designations relationships can be brokered and over time result in distortions.  You can wind up with the functional equivalent of a financial appendix that basically means/does nothing, but weighs thirty pounds.  When it comes time….how do you remove that from the patient without damaging or even killing it?)

The size of bonus pools are growing. Many firms set aside a percentage of their profits to distribute to a select group of partners who had a particularly good year. Consultants and firm leaders say they’re seeing bonus pools grow and, as with shorter-term decisions on how to distribute profits, it’s in part to keep rainmakers from leaving for rivals.

A typical bonus pool is between 5 and 15 percent of a firm’s profits, says Lisa Smith, a consultant with Fairfax Associates. Some firms can go up to 20 percent, however.

Rewarding partners with a bonus, rather than moving partners to a higher tier on the pay scale, is easier for long-term planning purposes, says Jacqueline Knight, a recruiter at Major, Lindsey & Africa. If the partner is not as productive the following year, it’s easier to simply not give them another bonus, than it is to demote them. “I have seen an increase at many firms in the bonus structure,” Knight says.  (There is another reason.  Because it is a “bonus” it can have a claw back attached to it if a partner receives it and then leaves within a prescribed time!)

Firms are paying attention to the profitability of partners’ practices, not just their books of business. Since the recession, consultants say, firms have been forced to operate more like businesses in which every line item on their budget matters. That means simply making money isn’t enough. Practices must be efficient and realization rates matter—a scenario only intensified in a low-growth market.

“Historically, most firms were, and still are, top-line oriented,” says Altonji. “They look at your book of business [when determining compensation.] I have to tell you, not all dollars were created equal.”  

(Bingo!  A partner with a $20 million book at 40% profit margin versus a partner with a $20 million book at 20% profit margin.  Which should be paid more?  There are firms out there paying such partners equally or close to it, and that used to be very common.  Today it has the survival trajectory of the last triceratops.  Some are in fact are subsidizing a few of these massive practice books, because the equity partners on the practice team in the aggregate are taking out more compensation than the profit they generate.)

Profitability, in particular, has become a focus of compensation committees. Some firm leaders say they are generally taking more data into account when measuring a partner’s performance.

“We are looking at using more analytics rather than anecdotal evidence,” says McDermott Will & Emery chairman Ira Coleman. When determining compensation, the firm “look[s] at all the clients this person touched or all the lawyers and professionals this person brought in to help the clients.”

Having an open compensation system makes the firm’s decisions about who makes what much more consequential.

“Because it’s transparent, in addition to just deciding what each partner’s compensation is, we’re sending messages to all the partners as to what is being rewarded,” Weil’s Wolf says.

But a chair whose firm has a closed system makes the case that if partners don’t know their colleagues’ compensation, they spend less time worrying about who makes what. A closed system is beneficial to culture because resentments are less likely to build, he says.  (I have seen and worked with firms that have both, and a lot in between, and they can all work as long as the partners have buy-in and believe that the system is fair to them.  The potential for abuse in both is obvious.  In the closed system, nobody knows and everybody agrees that is OK. You get what you deserve if you do that.  In the open system everybody thinks they know, but then one may discover that “transparency” was closer to “opacity with patches of clarity”.)

Decisions about every aspect of partner compensation from how to award points to who gets to see the final breakdown have an impact on another, more nebulous concept that law firm leaders love to talk about: culture.

“Compensation drives culture by far more than any other attribute,” says the chairman of a top Am Law 100 firm.

Culture and that historical understanding of the definition of partnership are often what have kept law firms from radically altering compensation or partnership structures. But they have also contributed to overcapacity at many firms.

If an Am Law 200 firm started anew today, would it be structured like the rest? The shifting partner compensation models are testing the bounds of a law firm’s culture in the face of the business realities of running a partnership akin to a Fortune 1000 enterprise.

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