March 13, 2007

MERGERS, METRICS, AND OTHER MUSINGS

Muses Recently I was musing about the frenetic merger and acquisition activity that has engulfed the business landscape, including the business of practicing law. In its MergerWatch press release for year-end 2006, Hildebrandt International, Inc. said 58 mergers and acquisitions involving U.S. law firms were completed in 2006, vs. 49 in 2005 and 48 in 2004.  The company said it expects “to see merger activity continue at an active pace” in 2007.

What are we to make of this law firm M&A activity?  In the “non-law business” business world, mergers often fail to accomplish their intended purpose.  In a 2004 article entitled “Where Mergers Go Wrong” McKinsey & Company noted, “[I]t is typically not the buyer but the seller who captures most of the shareholder value created.”   The article’s authors believe this result is due to the fact that “Most companies routinely overestimate the value of synergies they can capture from acquisitions.”  You remember “synergies” –the enhanced economic value expected from the merger, but often defined by “new” math as 2 + 2 = 5.  Synergies occur in the areas of revenues, expenses, and capital costs.

The McKinsey article asserts the area of greatest estimation error relates to revenue synergies – nearly 70% of the mergers in its database failed to achieve the estimated revenue synergies. The article points out practical steps executives can take to improve their odds of successfully capturing synergies:

For starters, they should probably cast a gimlet eye on estimates of top-line synergies, which we found to be rife with inflated estimates. They ought to also look hard at raising estimates of one-time costs and better anticipate common setbacks or dissynergies likely to befall them. They might also vet pricing and market share assumptions, make better use of benchmarks to deliver cost savings, and get a better fix on how long it will take to capture synergies.

What things can law firm M&A candidates do to avoid the “synergy trap”?  Right away one thing comes to mind – LawBall-type analysis, including a pro-forma of the post-closing firm, to facilitate the “due diligence” review.  Certainly, numbers aren’t the entire story to a successful M&A transaction; the transition and integration of the people, technology, and processes (including the typical law firm hot spots – culture and management) in the post-closing firm are critical.  But LawBall analysis, as with financial operating performance, can lead one to ask critical questions that facilitate a deeper understanding of the strengths and weakness of both the pre- and the post-merger businesses.

Let’s quickly look at 2 examples.  The first is the merger of Kirkpatrick & Lockhart Nicholson Graham and Preston Gates & Ellis, a merger announced in late 2006 and effective on January 1, 2007.  Using The American Lawyer’s 2006 (2005 operating results) AmLaw 200, here’s a look at both firms, as well as a “pro forma” for the consolidated firm with no changes in the number of lawyers, partners, gross revenue, or profit for either of the merger partners:

K_and_l_gates_analysis_1

Note the disparity in pre-merger return on equity (ROE or profit per partner).  Law.com reported that:

[K&L Chairman Peter] Kalis said the difference is not much of a concern for the firms. He said Preston Gates has a higher percentage of equity partners than his firm, and the firms believed that the synergies between them would overcome the difference in PPP. Kalis said no one is being de-equitized as a result of the merger.

Some of those synergies between the two firms, Kalis said, are Preston Gates' technology practice and Kirkpatrick & Lockhart's financial services and manufacturing practices.

It looks to me like Kalis’s expected “synergies” are revenue synergies, which based on the experience noted by McKinsey & Company will be difficult to realize.  Also, note the return on assets (ROA or profit per lawyer) both pre- and pro forma post-merger, which appear low by comparison to the ROAs we’ve looked at in prior postings.  That indicates an inefficient use of assets (lawyers).  Finally, pro forma post-merger changes in margin, asset turnover, financial leverage, ROE, and ROA all favor Preston Gates; only does pro forma post-merger cost per lawyer favor K&L.  Was this kind of analysis used?  If not, would it have changed anyone’s opinion?  I don’t know; but as a member of either firm I would’ve wanted to see this analysis long before I voted so I could ask financial questions and get comfortable with the answers.

The second example involves a merger that was announced but called off – the merger between Dewey Ballantine and Orrick Herrington & Sutcliffe.  Although one look at the 2005 individual and pro forma consolidated numbers indicates that a merger might make sense, another view signals that there could be problems.  Here’re the numbers, again from the 2006 AmLaw 200 and from the 1997 AmLaw 100:

Dewey_orrick_analysis

I'm surprised at how close the margin, asset turnover, financial leverage, ROE, ROA, and cost per lawyer for the pre-merger firms are in a relative since – both between the 2 firms and to the consolidated pro forma for the post-merger firm.  However, when I examine the 9-year compounded annual growth rates (CAGR) for both firms, one thing screams at me – Orrick’s growth rate in all areas vs. that of Dewey.  Such a disparity tells me that I’d likely find differences in management and culture that might be too severe to overcome for the merger to succeed.  When reporting the cancellation of the merger, Law.com said:

A source close to the deal said there were three major sticking points: Disagreements over management and governance at the new firm, concern over Dewey's unfunded retirement benefits, and concern over the number of defecting Dewey partners.

Oh, yeah – one other musing.  This same LawBall analysis will work – and be helpful – in lateral hiring decisions, whether a firm is hiring 1 lawyer or 50 lawyers.  When a law firm proposes acquiring assets (which lawyers are), it should understand the potential financial impact just like, say, an office REIT that seeks to acquire a portfolio of office buildings.

March 07, 2007

IS MAYER BROWN PLAYING LAWBALL? A POSTSCRIPT

According to the handy-dandy dictionary that is part of my Mac OS X Tiger software, “postscript” means:

[A]n additional remark at the end of a letter, after the signature and introduced by “P.S”; an additional statement or action that provides further information on or a sequel to something.

Why the postscript?  Well, for whatever reason, I couldn’t stop thinking about Mayer Brown’s decision to “de-equitize” 45 partners.  In yesterday’s posting, I rhetorically asked several questions about LawBall-type information that I’d like to see as part of analyzing Mayer Brown’s action.  The absence of that information bothered me, because I believe it holds the key to understanding Mayer Brown’s decision.  So I did a little digging last night and, by using the American Lawyer’s 2006 survey (2005 operating results), I created a thumbnail LawBall comparison of Mayer Brown to the top 15 (in terms of gross revenues) firms in AmLaw’s top 100 and, since Mayer Brown ranked number 8, also just to the other top 14 firms.  I also dug back to 1996 for Mayer Brown and looked at the changes in the firm in terms of compounded annual growth rates (CAGR) from then through 2005.  Here’s the information:

Mayer_brown_info_6

A quick look at this information shows that Mayer Brown’s offense (asset turnover) slightly lags behind that of the top 15 firms as a group ($749,809/lawyer to $761,156/lawyer) and the other 14 top firms without Mayer Brown ($749,809/lawyer to $761,915/lawer).  Mayer Brown’s defense (margin), though, is significantly better than that of the top 15 firms (41.53% to 37.00%) and that of the other 14 firms (41.53% to 36.70%).  As a result, Mayer Brown’s return on assets (ROA) is 10.56% higher ($311,400/lawyer to $281,647/lawyer) than that of the aggregate top 15 firms and 11.35% higher ($311,400/lawyer to $279,658/lawyer) than the other 14 firms in the top 15, indicating that it’s making more efficient use of its assets (lawyers).  And, its cost per lawyer is 8.57% lower ($438,409/lawyer to $479,509/lawyer) than that of the aggregate top 15 firms and 9.09% lower ($438,409/lawyer to $482,256/lawyer) than the other 14 firms in the top 15.  Finally, Mayer Brown’s leverage is 31.78% lower (3.0609 to 4.4867) than that of the top 15 firms as a group and 33.90% lower (3.0609 to 4.6308) than the other 14 firms in the top 15.  Finally, from a CAGR perspective, from 1996 to 2005, Mayer Brown experienced commendable growth:  revenues at 13.05%, profit at 15.88%, asset turnover at 4.48%, ROE (profit/partner) at 8.95%, and ROA at 7.10%.  The firm’s margin during the same period improved from 33.23% to 41.53%, while costs per lawyer increased at a rate of only 2.95%.  Its leverage increased during this period at a rate of 1.72%.

From this down and dirty analysis, the inescapable conclusion is that Mayer Brown more than likely is underleveraged.  Why the hesitance represented by the qualifying “more than likely”?  Because we still don’t know anything about Mayer Brown’s base of business requirements – is it a more complex problem-solving business where more “specialized generalists” are required who can solve problems across multi-discipline lines in ever-changing circumstances or is it a more standardized/specialized one where specialists can easily recognize patterns and apply familiar tools so that they do not need to “reinvent the wheel.”  The former clearly should result in a lower leverage structure than the latter since complex problem-solving requires greater experience and generally is less efficient to execute, but it also should result in higher asset turnover and higher margins; while the latter involves pattern recognition that generally increases efficiency and should result in higher leverage, lower margins, and lower asset turnover.  Management of Mayer Brown’s business model requires that it support its strategy by, among other things, uniquely blending the firm’s competencies, assets, and processes.  If the existing blend is right, the firm’s problem may be that the margins and/or asset turnover aren’t high enough by comparison to its competitors, in which case the “de-equitization” of 45 partners may not be the right move.  If the existing blend is not right, then the de-equitization may be the right move.  Since Mayer Brown’s management is closest to the facts, I believe it’s entitled to the benefit of the doubt in saying, in effect, the firm has the wrong asset mix to service the demands of its base of business.

Mayer Brown still gets an “F” for public relations in my book, though.  Instead of substantively discussing the matter in the context of financial performance competitive comparisons, required changes to its business model necessary to service the demands of its business base, and the expected improvement in the long-term business outlook for the firm, it attempted to justify the move in a manner that screamed simple “denominator management” in order to line further the pockets of a bunch of greedy lawyers who’d eat their young and, to paraphrase Chuck Colson, would walk over their own grandmothers for more money.  Oblique, skeletal references to “competitive legal market”, the firm’s “strategic objectives”, “serving its clients’ needs most efficiently,” and “consolidating legal market” without some discussion that puts meat on the bones just isn’t good enough.  Yesterday, I closed with several competitive strategy questions from Gary Hammel and C.K. Prahalad in Competing for the Future that I think equally are appropriate to close today’s postscript and should be considered by all law firms, not just Mayer Brown:

•    Does senior management have a clear and broadly shared understanding of how the legal industry may be different 10 years in the future?  What is it?
•    Is this point of view about the future clearly reflected in the firm’s short-term priorities?  How?
•    Is the firm pursuing growth and new business development with as much passion as it is pursuing operational efficiency and downsizing?  How?

Andrew_shepherd To paraphrase President Andrew Shepherd in the movie The American President:

LawBall isn't easy. LawBall is advanced business. You've gotta want it bad, 'cause it's gonna put up a fight.

Although its still gets an “F” in public relations, Mayer Brown actually may be ready to put up a sign on the wall that says, “LawBall is played here.”  To paraphrase Dennis Miller, “That’s just my opinion.  I was partially wrong yesterday.”

March 05, 2007

IS MAYER BROWN PLAYING LAWBALL?

 Beesnest_2Well, it sure looks like Mayer, Brown, Rowe, & Maw LLP stirred up a bee’s nest last week when, according to various sources, it asked 45 partners to leave or to accept other positions with the firm as part of a restructuring.  According to an article in The Wall Street Journal on March 2, 2007,

James Holzhauer, who will assume chairmanship in June, said the cuts were made to increase the firm's "leverage" -- the ratio of partners to associates -- in an effort to boost profits per partner.

Does this mean that Mayer Brown is playing LawBall?  Honestly, based on what little we know about the decision, it’s hard to tell – although that alone may be telling.  According to the WSJ article, citing American Lawyer’s 2006 survey (2005 operating results), Mayer Brown was 8th in gross revenues but only 51st in profit per partner.  If we accept Holzhauer’s statement at face value, then in the language of “LawBall” it looks like Mayer Brown has decided that special teams (leverage) performance is the root of its financial performance evil, not its offense (asset turnover) or defense (margin), and needs fixing.

I think that’s a pretty weak explanation for the firm’s action.  In LawBall fashion, I’d want to see what’s going on with the firm’s return on assets (ROA or profit per lawyer), which is a good measure of the efficiency with which a business allocates its resources since it eliminates the effects of financial leverage on operating results, before I decided to increase leverage by “de-equitizing” 45 partners.  And, with respect to ROA, is the asset turnover (offense) better or worse? Is the margin (defense) better or worse?  Is the cost per lawyer better or worse?  What are the trends in ROA and its components?  How do the firm’s numbers compare to the competition?  If the firm is not using its assets efficiently, is the cause of that the 45 partners?  My best guess, based on the scant public information available, is that Mayer Brown is not really playing LawBall, although it would like the public to think it is by talking about leverage; instead, it is treating a symptom – what it’s labeling as low profits per partner or ROE – simply by engaging in “denominator management” and is not addressing the real cause of what ails it.

In any event, for a segment in the workforce (lawyers) that is seen as accomplished “spin-doctors,” Mayer Brown should get an “F” for public relations.  Despite admittedly record profits per partner, according to Holzhauer the firm decided to cut the number of partners to increase its profits per partner.  In its internal memo (posted via a comment to WSJ’sLaw Blog”), the firm said, “In an increasingly competitive and consolidating legal market, it is imperative that our firm be among the best managed in the industry.”  But, no explanation was given as to how this action would improve the long-term business outlook for Mayer Brown.   The memo made only oblique reference to the “competitive legal market”; the firm’s “strategic objectives”; “serving its clients’ needs most efficiently”; and “consolidating legal market.”   It was critically silent on how this action would facilitate best management:  no strategic objectives to be met by this action discussed; no competition identified; no financial performance comparison to the competition made along the lines of LawBall; and, no discussion of whether the firm’s business base or the demands of that base had changed, requiring a change in the “assets” (lawyers) necessary to service it.  With no explanation as Gordongecko_1 to what was going on with the offense or the defense or why the special teams needed fixing, one simply is left to ponder exactly how this move makes the firm among the best managed in the industry.  And to gargle to get rid of the dirty taste that it’s just about partners lining their pockets with even more green – and the image of Gordon Gecko addressing the firm.  One couldn’t have made a poorer case if he or she were Richard Nixon trying to explain that “third-rate burglary” known as Watergate.

About denominator management – it often can be the business equivalent to a cheap parlor trick and generally results in short-term improvement only.  Gary Hammel and C.K. Prahalad, in Competing for the Future, said about return on investment (ROI = profit ÷ investment):

Managers . . . know that raising net income is likely to be a harder slog than cutting assets and headcount.  To grow the numerator, top management must have a point of view about where the new opportunities lie, must be able to anticipate changing customer needs, must have invested preemptively in building new competencies, and so on.  So under intense pressure for a quick ROI improvement, executives reach for the lever that will bring the quickest, surest improvement in ROI – the denominator.  To cut the denominator, top management doesn’t need much more than a red pencil.  Thus the obsession with denominators.

. . . Denominator management is an accountant’s shortcut to asset productivity.

Hammel and Prahalad’s thoughts about competition also are in stark contrast to the tenor of Mayer Brown’s internal memo, which for whatever reason essentially seems to say that in order to meet its strategic objectives, serve its clients’ needs most efficiently, and compete successfully the firm must increase the amount that its partners make.  Hammel and Prahalad say:

We believe a sense of excitement and possibility can replace the fear and resignation that so often accompany downsizing and reengineering.  And we believe it is possible to regenerate purpose, meaning, and direction in the absence of crisis. . .

Rather than calculating the number of people to fire in order to become competitive, companies should be asking How can we create the sense of purpose, possibility, and mutual commitment that will inspire ordinary individuals to feats of collective heroism?

LawBall isn’t about denominator management.  It’s about having a business model that supports a strategy by, among other things, uniquely blending the firm’s competencies, assets, and processes.  And, when that model begins to decay, as it will, it means avoiding the temptation to pour human energy and capital into improving the efficiency of the operating model and, instead, inventing new business concepts or dramatically reinventing those that the business already has.  LawBall is about understanding that a firm’s financial operating performance is the result of efficiently allocating its resources and actively managing the relationship among its income statement and the left and right sides of its balance sheet – the firm’s asset turnover, margin, and leverage.   Its about understanding that financial performance is not just one year – it’s about trends based on past performance; and, it’s about competition or - again to quote Hammel and Prahalad -  about “creating a compelling view of tomorrow’s opportunities and moving preemptively to secure the future.”

I’ll end with the thought that, if I were one of those affected by the Mayer Brown decision, either as one of those being asked to leave or to accept a different role in the firm or as one of those remaining lawyers (both partners and associates) in the firm, in addition to the LawBall questions I posed earlier I would want to be able to answer a few questions from Hammel and Prahalad before I decided that “de-equitizing” 45 partners would help make the firm “among the best managed in the industry”:

•    Does senior management have a clear and broadly shared understanding of how the legal industry may be different 10 years in the future?  What is it?

•    Is this point of view about the future clearly reflected in the firm’s short-term priorities?  How?

•    Is the firm pursuing growth and new business development with as much passion as it is pursuing operational efficiency and downsizing?  How?

Based on what’s publicly available about Mayer Brown’s action and its apparent reasons for taking such action, in my book that isn’t LawBall; and, Mayer Brown isn’t ready to put up a sign on the wall that says, “LawBall is played here.”  As Dennis Miller would say, “That’s just my opinion.  I could be wrong.”

March 04, 2007

LAWBALL

I never saw an ugly thing in my life: for let the form of an object be what it may - light, shade, and perspective will always make it beautiful.

- John Constable (1776 - 1837)

Much in life is a matter of perspective, not just beauty.  Two people can look at the same set of facts and reach different conclusions simply because they have different perspectives.  Stephen Covey described this phenomenon as:

We see the world, not as it is, but as we are – or, as we are conditioned to see it. . . [C]learheaded people see things differently, each looking through the unique lens of experience.

Sometimes it helps to bring a different perspective to something in order to understand it better and Moneyball to benefit from the mistakes of those who don’t.  In Moneyball, Michael Lewis wrote about a different perspective that has been brought to baseball.  Lewis said that he began his writing with a simple observation:  “Some baseball executives seemed to be much better than others at getting wins out of dollars.” When he finished the book (one about baseball and business that I highly recommend), he had captured how the Oakland A’s in a manner more akin to exploiting inefficiencies in financial markets had set about looking for inefficiencies in baseball and, by using a form of systematic scientific investigation to separate data from perception that was based on long-held individual images and beliefs, developed both a different way to value baseball talent and different metrics or key performance indicators for baseball.  These new metrics took advantage of what behavioral finance scholars have noted in the cognitive psychology part of their discipline – people make errors in the way they think and make decisions.  The A’s found that, just like financial investors, baseball talent investors generalized wildly from their own experience playing the game, were overly influenced by the most recent performance by a player, and were biased toward what they’d seen (or thought they’d seen) with their own eyes.

Recently (Metrics!  We Don’t Need No Stickin’ Metrics and Metrics! We Don’t Need No Stickin’ Metrics (Part II)) having bombarded the readers of this blog with a series of financial metrics for the business of practicing law, which I readily admit can be a powerful and sure-fire cure for insomnia, I thought it might be helpful to look at these legal industry metrics from a different perspective.  This different perspective is not one based on academic research or study – it’s just one based on an analogy that hopefully will make the metrics and their importance simpler to understand. 

Think of the business of practicing law as being the game of football – LawBall, if you will.  Like football, LawBall is competitive.  And, like football, there is a final result – in LawBall, it’s profit per partner (the functional equivalent to return on equity or ROE).  Just as a football team’s strategy must be in sync with its assets (its players) and what it does best in order to be successful – for example, be a running or a passing team on offense of play a 3-4 or a 4-3 on defense – LawBall requires that, in order for a “team” (or law firm) be able to achieve its best final result, its assets (lawyers) and what it knows and what it does must be configured in support of its strategy.   Finally, as football has 3 major team components that must be managed and executed well in order to win – offense, defense, and special teams – so does LawBall.  LawBall’s 3 major components are asset turnover (think offense), profit margin (think defense), and financial leverage (think special teams).

When one looks at what it expects from a football team’s offense, it expects it to score as many points as possible (think the 2006 San Diego Chargers or the Indianapolis Colts almost any year with Peyton Manning).  With a law firm, the expectations should be the same – the highest asset turnover (revenues per lawyer) possible.  When one looks at what it expects from a football team’s defense, it expects it to hold the opponent to a few points as possible, thus preserving as many of the points its offense scored and creating as big a margin of victory as possible.  Law firms should expect the same from its “defense” – profit margin – the firm should seek to keep its costs per lawyer as low as possible, thus creating the highest profit margin possible.  Most times in football, when your offense and defense combined are better than the competition, you should win; and, if the teams are relatively equal in those 2 areas, special teams can make the difference (think the New England Patriots when they had kicker Adam Vinatieri).  The same holds true with LawBall – remember, profit margin x asset turnover = return on assets (or ROA), and ROA is a good measure of the efficiency with which a business allocates its resources – but if the competition in LawBall as measured by ROA is tight, financial leverage can be the winning difference for ROE (ROE = profit margin x asset turnover x financial leverage).

Vince_young Let’s take another look at what happened with Firm B by comparison to Firm A in the prior postings through the eyes of LawBall.  First, Firm A’s 2005 offense (asset turnover of $790,698) was much more explosive than Firm B’s ($518,116 asset turnover), despite the fact that the 9-year compounded annual growth rate (CAGR) of Firm B’s revenues was greater than Firm A’s (10.65% to 9.18%).  Over that same 9-year period, Firm B’s number of lawyers grew at nearly twice the rate of Firm A’s number of lawyers, resulting in Firm A’s asset turnover growing at a 9-year CAGR of 6.16% to Firm B’s 5.12%.  The effect of Firm B’s lawyer growth was like the effect of a high number of quarterback sacks or run attempts for losses on gross offensive yardage (revenues) – the negative plays result in a lower net offensive yardage output.  At the same time that Firm B’s offense was sputtering compared to Firm A’s, Firm B’s defense also was falling apart – it let much more of its net offensive output (asset turnover) be dissipated than that of Firm A’s:  Firm B’s 2005 profit margin had plunged to 34.84% from its 1996 level of 46.26%, while Firm A’s 47.84% profit margin for 2005 was slightly above its 47.10% level for 1996.   The combined effect of Firm A’s offensive and defensive dominance was a 2005 ROA (profit per lawyer) of $378,295 compared with Firm B’s 2005 ROA of $180,507.  Firm A’s 9-year ROA CAGR was 6.34%; Firm B’s was 1.86%.  Another way this offensive and defensive domination by Firm A is captured is to look at the asset turnover growth rate vs the growth rate of costs per lawyer (a major element of the “points given up” by the defense):  Firm A’s 9-year CAGR for its asset turnover was 6.16%, while its cost per lawyer CAGR was 5.99%; Firm B, on the other hand, had a 9-year asset turnover CAGR of 5.12%, while its costs per lawyer CAGR was 7.40%.  From 1996 to 2005, Firm B’s defense was giving up points at a faster rate than its offense was scoring.  A small bit of solace can be found for Firm B though – its special team play (financial leverage) improved from 1996 to 2005 to the point that the relative margin of its ROE defeat (Firm A’s ROE was 2.0192 times greater than Firm B’s) was slightly less than the relative margin of its ROA defeat (2.0957).

In LawBall, Firm A clearly outplayed Firm B.  Why?  Firm B’s performance probably was the result of a combination of actions and non-actions by it.  First, regardless of the type of “defense” Firm B played – the 3-4 or the 4-3 – it did a poor job of tackling its costs per lawyer.  Second, despite the rate at which it gained gross yardage (its 10.65% CAGR for gross revenues) on offense, it had too many “bad plays,” including growing the number of its lawyers too fast, resulting in a net yardage (asset turnover) growth rate below that of Firm A.  Firm B’s game plan – its strategy – likely wasn’t in sync with its assets (players/lawyers) and didn’t mesh with what those players did best.  Best guess:  the field of play for Firm B changed over the years, as the rate of specialization accelerated causing Firm B’s business to move from one that required a lot of complex problem solving to one that was more standardized or more “fungible.”  Instead of changing its pricing strategy to one that was more appropriate for its new fungible business base, it likely tried to move its rates up to the highest level it could, as if it still were doing complex problem solving, costing it business.  And, It probably kept the same mix of assets (type of players) that it had when it was doing a greater volume of complex problem solving.  Just like in football – in LawBall, a bad strategy and poor execution leads to poor performance relative to the competition.

February 21, 2007

METRICS! WE DON’T NEED NO STINKIN’ METRICS (PART II)

Jaws_3 Wow!  Just when I thought it was safe to go back into the water – I read an article this morning at Law.com in which a law firm consultant was quoted as saying:

The key determining factors in large law firm profitability are getting billing rates to the highest price the market will bear and getting the realization rate as high as possible.

Guess I better send a blast communiqué to every business school in the country – the schools obviously just don’t get it.  Their curriculum just got much shorter and much simpler:  no longer do businesses have to worry about such operating concerns as increasing the rate at which the business generates money through sales, lowering inventory, or lowering operation costs, much less worry about any strategic or marketing concerns such as delivering value to clients.  Just jack up those rates!

The above quote provides a great lead-in to today’s posting.  Two postings ago, I began looking at legal industry metrics and their significance.  I illustrated the metrics and the importance of examining them over time with public information from 2 real firms, which I called “Firm A” and “Firm B.”  Today, I’ve put a link to a *.pdf version of the illustration, with a few additions, in the upper right hand margin of this blog under the category heading “Posting Attachments.”  Return on assets (ROA) has been added to the illustration, as has “cost per lawyer.”  And, finally, to make the first “what if” example clearer where the key element being managed is the growth rate in lawyers, the heading above that example has been changed to “Lawyer Growth” from “Leverage.”

At the end of that earlier posting, I started focusing on the power of return on equity (ROE) metrics not only to answer “What happened?” but also both to address “Why did it happen?” and to show the way to manage for better performance.  To recap, the illustration shows Firm B narrowed the ROE (profit per partner) gap between Firm A and itself from 1991 to 1996, primarily on the strength of improving its margin.  But from 1996 to 2005 Firm A’s financial performance left Firm B in the figurative dust even though Firm B’s revenue grew at a higher compounded annual growth rate (CAGR) than, and its financial leverage grew to exceed, Firm A’s.  By “drilling down” into the ROE components, some of the reasons for this disparity in relative financial performance start to surface, including Firm B’s faster lawyer (or asset) growth rate (contributing to Firm B’s slower growth in asset turnover) and deteriorating margin.  The illustration’s “what if” examples show that if Firm B had managed its growth in lawyers to be at the same CAGR as Firm A, while still achieving the financial leverage that it actually did, the improvement in its asset turnover would’ve led to an ROE that was $122,825 better than it achieved; or that if Firm B had managed its margin so that its actual decline had been only to the average margin it experienced from 1991 to 1996, it would’ve led to an ROE that was $104,527 better than achieved.  I want to continue drilling down into the illustration’s metrics in today’s posting.

ROA is a simple equation:  ROA = net income ÷ assets.  To put it in the context of its principal components, it’s:  ROA = profit margin x asset turnover.  Remember the algebra:  ROA = (net income ÷ sales) x (sales ÷ assets).  For the legal industry, with terminology changes ROA = profit ÷ lawyers; or, ROA = margin x asset turnover, with the algebra being:  ROA = (profit ÷ revenues) x (revenues ÷ lawyers).  ROA is a good measure of the efficiency with which a business allocates its resources, as it eliminates the effects of financial leverage on operating results.  Just as with ROE, Firm B narrowed the ROA gap between Firm A and it from 1991 to 1996, as its ROA, fueled by its margin improvement, grew at a CAGR of 7.64% to Firm A’s 5.77%.  But by 2005 Firm A’s ROA again had left Firm B in the figurative dust.  Firm A’s profit growth and its asset turnover growth both exceeded Firm B’s CAGR.  As a result, Firm A’s ROA grew at a 6.34% CAGR from 1996 to 2005, while Firm B’s ROA grew at an anemic 1.86% CAGR for the same period.  Firm A’s ROA grew from 1.4232 times that of Firm B in 1996 to 2.0957 times in 2005.  The relative disparity between the firms’ 2005 ROE (2.0192) was slightly less than that of the firms’ 2005 ROA due to Firm B’s relative financial leverage improvement.

What happened with Firm B?  Let’s look at revenues, cost per lawyer, and business base requirements.  Revenues generally grow from price increases, volume increases, or a combination of both.  They are a product of the rate achieved (price) and the units produced and sold (volume).  For a law firm, this concept is:  total revenues equal a firm’s realized billing rate times the hours billed.  Drilling down into asset turnover can help us understand revenue changes.  Asset turnover = revenues ÷ lawyers (or revenue per lawyer).  Another way to look at asset turnover is:  asset turnover = price (sales ÷ billable hours) x volume (billable hours ÷ lawyers).  We don’t have any information about Firm B’s billing rate or its billable hours, so let’s use an example.  Assume that in 1996 Firm B’s lawyers billed an average of 2,160 hours per year.  As a firm, the aggregate hours billed would have been 375,840.  Using Firm B’s 1996 revenues, its realized billing rate would have been $152.9906 per hour.  (Just for grins, multiply 2,160 hours/year x $152.9906/hour.  The answer is $330,460 – just what the illustration shows for Firm B’s 1996 asset turnover – the asset drill-down math works!)  Now, let’s assume that all of Firm B’s revenue growth from 1996 to 2005 was the result of rate increases (let’s get the highest rate possible!) – although in the real world that’s not likely to happen.  At Firm B’s actual 10.65% CAGR for its revenues from 1996 to 2005, it’s realized billing rate in 2005 would’ve been $380.4811 (a price increase).  If that’s the case, its 2005 aggregate billable hours would’ve remained constant (no volume increase) but the billable hours per lawyer would’ve decreased to 1,361.7391 as the firm’s number of lawyers grew at a CAGR of 5.26%.  Or, if the billable hours remained at 2,160 per lawyer in 2005, then the total billable hours would’ve had to increase by a 5.26% CAGR (volume increase) due to the increase in the number of lawyers and the realized billable rate would’ve increased by a 5.12% CAGR (price increase) in order for Firm B to achieve its actual 2005 revenues.

The actual line item costs for Firm B aren’t public, so we have to do some simple extrapolation to get to cost per lawyer.  In 1996, Firm B’s revenues were $57,500,000 and its profits were $26,600,000.  That leaves $30,900,000 as costs for 174 lawyers or $177,586 per lawyer.  In 2005, Firm B’s costs per lawyer were $337,609 – a 7.40% CAGR.  Think about that - Firm B’s revenues from 1996 to 2005 grew Robin_3 at a 10.65% CAGR; but its asset turnover (revenue per lawyer) grew only at a 5.12% CAGR. Its costs per lawyer grew at a 7.40% CAGR.  The business result was an anemic 1.86% ROA CAGR.  By comparison, Firm A’s revenues grew at a 9.18% CAGR and its asset turnover grew at a 6.16% CAGR, while its cost per lawyer had a 5.99% CAGR.  The business result was its 6.34% ROA CAGR. Holy Cow, Batman!  I think that if your costs per lawyer grow at a faster rate than your revenue per lawyer, you’re not efficient in the way you allocate and manage your resources and your returns aren’t going to be very good.

We don’t know the requirements necessary to adequately service Firm B’s business base.  But, law firms must match their assets (lawyers) with the requirements of their business.  As lawyer-tasks become more standardized and require less complex problem-solving, the experience level and pricing for the lawyers in the firm must be managed to match these changing business requirements.  If you have a real estate project that can be handled by a $300/hour lawyer but you only have $500/hour lawyers to do the project, today’s client is more apt to push back – either bill it at $300/hour or lose the business.  My best guess – what it took to service Firm B’s business did become much more standardized and did take less complex problem solving.  But, instead of managing its mix of assets and pricing to reflect that change, Firm B focused on raising its rates as high as it could.  It probably lost business as a result, while at the same time growing its number of lawyers.  It likely got lulled into a false sense of security because its revenue and profit both grew; it didn’t actively manage its business through the ROE component operating levers; and it didn’t realize that its costs per lawyer were growing at a faster rate than its revenue per lawyer or that its ROA was anemic. It didn’t, and probably doesn’t still, understand that business is competition – and by comparison to at least one competitor, Firm A, it’s not even in the game.