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March 28, 2007

THE NEED FOR CHANGING BUSINESS MODELS

In one of my earlier postings, "What's All This Garbage About Business Models?" I wrote about the legal industry's business model "under distress" as described by Cisco General Counsel Mark Chandler in his remarks made at the Northwestern School of Law’s 34th Annual Securities Regulation Institute (a link to his remarks is in the margin under the heading “Articles of Interest”).  In that posting, I also pointed out some of the problem areas with the industry's business model as noted in the study of eLawForum (a link to which also is in the margin under "Articles of Interest") done by Harvard Business School Professor Clayton M. Christensen and Scott D. Anthony.

This morning, I read an excellent posting by Bill Gratsch at Blawg's Blog entitled "Changing Models:  Parallels Between Music and Legal Information."  I heartily recommend Bill's posting to anyone who wonders why the legal industry should worry about how it does business or why law firms should worry about their business models.

March 27, 2007

THE ART OF THE DEAL – LAWBALL STYLE

The serial disintegration of Dallas-based Jenkens & Gilchrist has created an “acquisition” opportunity for a number of firms.  That shouldn’t surprise anyone – the business world is full of examples where distressed situations give rise to tremendous buying opportunities.  For example, one of the biggest in my lifetime was the opportunity to acquire assets from the Resolution Trust Corporation after the concurrent failures of the real estate and financial institution (primarily savings and loan) industries in the late 1980s/early 1990s.

Based on published reports, Jenkens now has less than 200 lawyers after having reached 600 lawyers in 2001.  In the past several months, Jenkens has begun closing or has closed its Chicago and Los Angeles offices, as well as its Texas offices in Austin, Houston, and San Antonio.  It closed its Washington, D.C. and Pasadena, California offices late in 2006.  Jenkens’ Dallas office is rumored to be discussing a large-scale move of many of its Dallas lawyers to Hunton & Williams.

While there apparently have been moves by smaller numbers of Jenkens’ lawyers, the larger moves announced recently include 19 lawyers to Baker & Hostetler in Los Angeles, 10 lawyers to Jackson Walker in San Antonio, 15 lawyers to Nixon Peabody in Chicago, and 30 lawyers to Winstead in Austin, Dallas, and San Antonio.  Winstead apparently continues to discuss hiring as many as 10 more Jenkens’ lawyers from Dallas and Houston.  And, in February a Hunton & Williams partner in Dallas was quoted as saying that firm’s discussions with Jenkens involved the possible move of “more than 12 but less than 100” of Jenkens’ Dallas lawyers to Hunton & Williams’ Dallas office.

I imagine some form of due diligence was done by the “acquiring firms” with respect to each of these moves by Jenkens’ lawyers, as normally would be done with acquisitions in “non-law business” businesses.  Probably, there were discussions about gross revenues the acquiring firm expects to generate from the new lawyers, the compensation the acquiring firm expects to pay the new lawyers, and the cultural “fit.”  But, I’d bet unlike non-law business acquisitions, no pro-forma financial statements for the acquiring firm as reconstituted with the new lawyers was done by any of the firms, as it likely would fly in the face of a law business equivalent of what I noted in my last posting Warren Buffett calls the “institutional imperative”.  That would be a shame because each of these transactions is ripe for a “LawBall”- type analysis.  As I noted in “Mergers, Metrics, and Other Musings,” certainly numbers aren’t the entire story to a successful acquisition; 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-acquisition businesses.

A pro-forma financial statement similar to that done in a non-law business acquisition that shows how the reconstituted firm would have looked had the acquisition been in place for the prior operating year would not be difficult to create.  Set forth below is a table with a LawBall-type look at each of the 5 firms noted above that either have acquired or are expected to acquire Jenkens’ lawyers, as well as at Jenkens, from The American Lawyer’s 2006 AmLaw 200 survey.

Since the chart likely is difficult to read within the blog, click on it, and a larger version should open in another window.  I’ve also attached it as a *.pdf document in the right-hand margin under the category “Posting Attachments” as “Jenkens Moves.”

If one of the firms were acquiring all of Jenkens, one simply would combine the gross revenues, profit, lawyers, and partners (equity partners) shown in the table for the 2 firms to create pro forma numbers for a single firm (the reconstituted acquiring firm).  Then one would calculate the “reconstituted” pro forma asset turnover (assets ÷ lawyers), pro forma margin (profit ÷ gross revenues), pro forma leverage (lawyers ÷ partners), and pro forma costs per lawyer ([gross revenues – profit] ÷ lawyers).  Finally, one then would calculate the pro forma return on assets (asset turnover x margin) or profit per lawyer and the pro forma return on equity (asset turnover x margin x leverage) or profit per partner.   The pro forma then would present a picture of how the 2 firms would have looked as one if the acquisition had been completed at the beginning of the previous year.  In the acquisitions at hand, the numbers to be used for Jenkens obviously would have to be modified to reflect the prior year’s performance by the actual lawyers being acquired.  And, if the 2006 operating numbers for both firms were available, those would be better to use.  A revised forecast for the current year of acquisition also could be created for the reconstituted firm in a similar manner.  The differing economic effect to the firms that acquire different parts of Jenkens could be significant.  For example, if the IP group joining Nixon Peabody performed better economically than did the Jenkens firm as a whole as reflected in the table and another group of Jenkens lawyers joining another firm performed worse than did the Jenkens firm as a whole, then the acquisition likely would be better for Nixon Peabody than the other firm.  As a quick observation, the fact that Jenkens’ return on assets lags behind 3 of the 5 firms should draw scrutiny at least from those 3 firms.

A caveat – if there are known operating changes that will occur with respect to the Jenkens lawyers once they join the acquiring firm, then adjustments should be made to the Jenkens financial operating numbers pre-pro forma consolidation.  For example, if the Jenkens lawyers will be vacating their current space and moving into space at the acquiring firm upon which the acquiring firm already is paying rent regardless of whether or not the Jenkens lawyers are there, then the occupancy expense for the Jenkens lawyers at the acquiring firm already is in the profit number at the acquiring firm and Jenkens’ actual occupancy expense at its old space should be removed from Jenkens’ prior year performance numbers for purpose of the reconstituted pro forma (in this case, the Jenkens’ profit to be consolidated with the acquiring firm’s for the pro forma would increase so as to avoid the double occupancy cost hit to the pro forma expenses).

I don’t know about you, but as a member of the acquiring firm I’d want to see this analysis before the transaction occurs so I could ask financial questions and get comfortable with the answers.  For any of you at one of the acquiring firms that would like to attempt such an analysis, I’ve included below a blank table for your use.  It’s also in the “Jenkens Moves” *.pdf file.

March 22, 2007

WHAT’S GOOD FOR THE GOOSE IS GOOD FOR THE GANDER . . . AND MAYBE EVEN BETTER

Warren Buffett, Chairman of the Board of Berkshire Hathaway Inc. and perhaps the pre-imminent investor of our time, says he “buys businesses, not stocks.”  He also believes a stockholder and a business owner should look at ownership of the business in the same way and says, “I am a better investor because I am a businessman and a better businessman because I am an investor.”  Interesting comments – but what do they have to do with the business of practicing law?  And why should lawyers care?  The answers can be found in Buffett’s approach to buying and owning businesses.

In The Warren Buffett Way, Robert Hagstrom outlines a set of basic principles, or what he calls “tenets,” that have guided Buffett’s decisions.  According to Hagstrom, Buffett makes investment decisions based only on how a business operates; and, as a result, Buffett concentrates on learning all he can about the business under consideration.  In what Hagstrom calls “Business Tenets” (the others are “Management Tenets,” “Financial Tenets,” and “Value Tenets”), Buffett focuses on whether the business (1) is simple and understandable, (2) has a consistent operating history, and (3) has favorable long-term prospects.  Hagstrom notes that Buffett understands the revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs of every one of Berkshire Hathaway’s holdings.  With respect to the Financial Tenets, Hagstrom says among other things Buffett also looks at return on equity, as he believes the test of economic performance is whether a company achieves a high earnings rate on equity capital (“without undue leverage, accounting gimmickry, etc.”), and looks for companies with high profit margins.  Buffett, in effect, learns the “story” of the businesses.

Peter Lynch, vice chairman of Fidelity Management & Research Company and another premier investor and money manager of our time, expresses similar sentiments.   Lynch also believes that before investing one should develop the story.  In his best selling book One Up on Wall Street, he says, “Investing without research is like playing stud poker and never looking at the cards.”  To make his point further, Lynch admonishes investors among other things to:

  • Understand the nature of the companies you own and the specific reasons for holding the stock.
  • Devote at least an hour a week to investment research.
  • Invest at least as much time and effort in choosing a new stock as you would in choosing  a new refrigerator.

Most business lawyers probably recognize that their clients do the same thing in conjunction with buying a company, business, or asset – except they often call it “due diligence.”  Every acquisition or investment has a story; and that’s what due diligence is about – it’s a method and/or process for getting the story.

I believe the single biggest investment lawyers make is the investment they make in their law firm.  This especially holds true for the partners (or whatever the nom du jour for “equity stakeholders” in a firm may be).  The investment isn’t necessarily cash; in fact for most lawyers significantly all of the “investment” is the blood, sweat, and tears they “spend” that is converted to intellectual capital in the business.  But the form of the investment doesn’t diminish the nature of its impact or significance to the “investor.”  For that reason, I simply don’t understand why most lawyers, particularly the partners who both are managers and owners of the business, “play stud poker and never look at the cards.”  One would think that what’s good for Buffett and Lynch would be good for lawyers – and maybe even better.  Butlawyers apparently don’t seem to think so; maybe it’s because enough firms are playing without looking at the cards that the others can’t resist what Buffett calls the “institutional imperative” - the lemming-like tendency of corporate management to imitate the behavior of other managers, no matter how silly or irrational that behavior might be.  Or, as Buffett said in his 1989 Chairman’s Letter to Berkshire Hathaway’s stockholders, “[R]ationality frequently wilts when the institutional imperative comes into play.”  But whatever the reason, when it comes to their own firm’s business of practicing law most lawyers don’t do what Buffett, Lynch, and clients do when they make investments – that is, learn the “story” and then keep current on the story.  That means understanding the firm’s business model, operating history, and long-term prospects.  It means understanding the competition.  It means playing “LawBall.”  That’s the real benefit and value of “playing LawBall” – it’s about learning, and staying current with, the story of the firm’s business of practicing law.  It’s about looking at the business with a panoramic view that spans multiple years, not just an annual snapshot.  It’s about actively managing the business to improve financial operating performance.

As I’ve said in prior posts, using LawBall and looking at the return on equity (ROE) components it encompasses simply at a given point in time is interesting but not very helpful alone. One can see what happened at that point in time, but not why things happened.  Its greatest value is looking at the information over a period of years.  How and why did ROE change over time?  What happened in the 3 ROE components (margin, asset turnover, and leverage) that contributed to the change?  What happened to your competition over that same period of time?  At the same time, you also can drill down into each of the components to find what led to their changes; e.g., was a revenue increase the result of increased volume, increased pricing, or both? 

I’m going to leave you with some interesting information from the 2005 operating year to contemplate.  Set forth below is a LawBall-type look at 5 firms from The American Lawyer’s 2006 AmLaw 200 survey.  Each firm was chosen because it ranked number 1 in at least 1 of the LawBall operating measurements.  Some firms, e.g., Wachtell Lipton, ranked 1st in several categories.  For each firm, all of the LawBall financial operating measurements are included in the top portion of the chart.  The firm’s ranking in each category is included in the bottom portion of the chart.  As a result, for a firm that finished 1st in one category you can compare it’s overall performance with that of another firm that finished 1st in a different category.  For example, Skadden Arps had gross revenue of $1,610,000 and ranked 1st in that category, while Gordon & Rees is included because it ranked 1st in leverage (at 11.0455!).  In addition, in the middle of the chart are the financial operating performance numbers for the aggregate top 200 so that you can compare the firms in the select group below to the performance of the entire 200 as a whole.  Since the chart likely is difficult to read within the blog, click on it, and a larger version should open in another window.  I’ve also attached it as a *.pdf document in the right-hand margin under the category “Posting Attachments” as “Top 200 Operating Lever Leaders.”  Take some time to think about the data – and particularly what it could show you if you had 5 years of data to compare for each of the firms.  What would it tell you about the firms’ business models?  What would it tell you about their trends?  How would your firm compare?  Which firm’s performance more closely mirrors that of your firm?  What changes to your business model would you make based on seeing what the competition is doing?  How surprised are you that Wachtell Lipton was 49th in gross revenue, 18th in profit, 170th in leverage, and 199th in costs per lawyer – and still finished 1st in ROE on the strength of its margin (2nd) and asset turnover (1st), which gave it 1st in return on assets (ROA)?  What do you take away from Wachtell Lipton’s performance or, say, from Gordon & Rees’ performance - 9.87% margin (200th), profit (200th), ROA (200th), leverage (1st), and ROE (151st)?

March 16, 2007

SOMETIMES LAWYERS ARE GREAT MIMICS . . . BUT WOULD BE EVEN BETTER MIMES

Let me apologize now for the Dennis Miller-type rant that follows.  If you have a weak stomach, over-inflated self-image, or very large ego (as for me in that regard, I’ll just quote Tex Schramm, the late general manager of the Dallas Cowboys, who when called “sick, demented, and totally dishonest” by Duane Thomas said:  “Well, he got two out of three”), you may not want to read further.  Why the rant?  One of my pet peeves - the incorrect use of business terms by lawyers, particularly when they’re talking about the business of practicing law.  For a group that normally is incredibly precise when it comes to words – and makes a lot of money when the rest of the world is not so precise – lawyers are very imprecise when it comes to using business terms.  Unlike Justice Potter Stewart who in effect said that although he couldn’t define “hard-core pornography” he knew it when he saw it, most lawyers not only can’t define the business terms they throw around like so much cocktail party conversation, they often don’t know the things represented by the terms when they see them.

Bill Gratsch at Blawg’s Blog wrote a nice piece this morning about how the “legal vertical” finally may be catching up with the rest of the world with respect to “new (and not so new) technologies.”  I hope he’s right!  But, as it relates to understanding business terms lawyers frequently use, they still lag far behind.   When it comes to their use of business terms in talking about the business of practicing law, lawyers are great mimics . . . but would be even better mimes.  Why?  Because lawyers “talk the talk” but don’t “walk the walk.”  Despite, or perhaps as a result of, the fact that many lawyers frequently are around business transactions and/or interact daily with business people they pick up the context within which certain business terms are used.  But knowing the context doesn’t convey the term’s actual meaning as well.  When lawyers spot a context involving the business of practicing law that is analogous to one for “non-law business” businesses they’ve experienced, they “mimic” the non-law business context and use the term in the law business context.  The end result often is the speaker has communicated that he or she doesn’t know what he or she is talking about, particularly when the law business context in which the term has been used is devoid of fundamental business performance analysis.  In that situation, the lawyer would be better served if he or she would be a mime and not say a word rather than by being a mimic.

Let me give you a few examples.  “Synergy” is a word used so often that I cringe when I hear it.  Mark Sirower, in his book The Synergy Trap, defines synergy as “increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently.”   Merriam-Webster defines “synergism” as the “interaction of discrete agencies (as industrial firms), agents (as drugs), or conditions such that the total effect is greater than the sum of the individual effects.”  In Mergers, Metrics, and Other Musings, I noted synergy is “the enhanced economic value expected from the merger, but often defined by ‘new’ math as 2 + 2 = 5.”  Whichever you choose, I think it’s safe to say that synergy means the value of the parts together is greater than the value of the parts standing independently – it’s not just the feeling that the parts will complement each other.  So, if two law firms are going to merge and it’s reasonable to forecast based on available information that the consolidated margin, asset turnover, leverage, profit per lawyer (return on assets), and profit per partner (return on equity) post-merger all will be lower for one firm than it was pre-merger while for the other firm it will be higher, then one would think that it’s not wise to talk about the expected “synergy” from the merger, especially if more mergers than not fail to achieve their expected purpose because (as noted by McKinsey & Company in its report cited in my preceding posting) most companies routinely overestimate the value of synergies they can capture from acquisitions.  Nonetheless, as I pointed out in Mergers, Metrics, and Other Musings that looks to be what the Chairman of then Kirkpatrick & Lockhart Nicholson Graham did when discussing it’s announced merger with Preston Gates & Ellis.

I’ve spent more than enough time already blogging about Mayer, Brown, Rowe & Maw’s recent decision to “de-equitize” 45 partners (Is Mayer Brown Playing LawBall? | Is Mayer Brown Playing LawBall?  A Postscript), so I’m not going to spend any more time analyzing that decision here.  I’ve also commented on how poorly I think the PR surrounding that decision was handled – I’ve noted the sterile use without substantive reference of the terms “competitive legal market”; the firm’s “strategic objectives”; “serving its clients’ needs most efficiently”; and “consolidating legal market” in the firm’s internal memo and reported comments.  In fact, the mental image I got from reading those words was that of a PR firm in the persona of Soap’s Chuck Campbell having written the comments to be spoken through an internal firm spokesperson in the persona of Bob sitting on Chuck’s knee.  But for today’s posting, I must admit that I was amused to hear that law firms apparently have a “stock price.”  When discussing the firm’s de-equitization decision, Mayer Brown’s incoming chairperson reportedly said, “We want to drive our stock price up.”  Hmmm.  Stock price is about value – what a willing buyer will pay and what a willing seller will accept for an interest in a company.  And, value of a business enterprise generally is about the present value of the future cash flow from the enterprise.  Putting aside whether or not there actually is a market (private or otherwise) where one could buy or sell “stock” in a law firm (other than perhaps to another firm or an individual lawyer) so that there would be a “stock price,” value was not the focus of the chairperson’s other reported comments – those were all about improving the firm’s leverage.  “Leverage” is a financial operating measurement that affects profit per partner – the functional equivalent in a law firm of return on equity (ROE) in a non-human capital-intensive business.  ROE is a measure of “return” on capital invested by the owners, not a “value”; and, as such, leverage is not about value, it’s about return.  The chairperson’s analogy rang hollow.  Profit per partner is a distribution to the owners of the return earned on their capital– if one felt compelled to say anything at all as justification and to analogize to a non-law business context, “We want to increase our annual dividend” might have been more accurate.

Now the one that really irks me – “competitive advantage.”  If one more lawyer says the acquisition of a certain group of lawyers gives his or her firm a “competitive advantage,” I’m going to toss my cookies.  It’s the same with some firms’ promotional material.  One I read says, “With the guidance of its Chief Information Officer and professional support staff, [the firm] invests in the use of technology to maintain a competitive advantage in the marketplace for legal services and to support the practice and business of law.”  That’s nice – but to paraphrase the young fan seeing Shoeless Joe Jackson emerge from the courthouse, “It ain’t so, Joe.”  Because you benefit from new technology, cheaper labor, new or additional lawyers, or some other temporary competitive “edge” simply means you are able to compete better; but you don’t have a competitive advantage since those things can be replicated by your competition and often times quicker and cheaper.  Basic economic theory says in a perfectly competitive market rivals eventually will eat up any excess profits earned by a successful business.  In their books Competition Demystified and Value Investing, Bruce Greenwald and Judd Kahn describe this environment as one where there will be no “economic profit” – no returns greater than the cost of invested capital.  If market demand conditions enable any firm to earn unusually high returns, others will notice those returns and, absent real barriers to entry, jump into the market.  The resulting fragmented demand will drive profit down.  In those markets, Greenwald and Kahn postulate that that the only chance a company has is to run itself as efficiently and as effectively as possible.  “Competitive advantage,” on the other hand, means being able to do something that your competitors cannot – and doing it over a long period of time.  It’s what Warren Buffett calls a “wide moat” – a sustainable, durable advantage that allows the business to earn profits greater than its cost of capital for long periods of time.  I’ve yet to hear of or to see a law firm that can do something that no other, or very few others, can do that can’t be replicated in very short order.  Until that happens, there are no law business competitive advantages – only temporary “competitive edges.”

I hope you’ve gotten as much enjoyment from reading this rant as I did in its writing.  But I also hope the fact that it’s a rant hasn’t hidden my real message.  Don’t kid yourself - lawyers are intelligent people.  But their intelligence notwithstanding, neither their education nor their on-the-job training through exposure to the business world has prepared them to own, operate, and manage multi-million dollar, and in some instances multi-billion dollar, businesses.

As Dennis would say, “That’s just my opinion.  I could be wrong.”  And, since I’m going to see him “live” next week, maybe I’ll just ask him!

March 13, 2007

MERGERS, METRICS, AND OTHER MUSINGS

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:

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:

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:

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?

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?

Well, 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 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 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).

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.

  • Robert C. Higgins: Analysis for Financial Management (Irwin Series in Finance)

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  • Thomas A. Stewart: Intellectual Capital

    Thomas A. Stewart: Intellectual Capital

  • Gary Hamel: Leading the Revolution

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  • Michael Lewis: Moneyball: The Art of Winning an Unfair Game

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