Sometimes, asking the right question can be as important, if not more so, than the answer. This was illustrated again this morning by Bruce MacEwen’s excellent posting “Where Have All The Partners Gone?” at Adam Smith, Esq. Bruce’s posting, which reacts to an article in The American Lawyer that can be found at Law.com entitled “Is Shedding Partners the Right Way to Improve Profitability?”, uses the right question to direct properly the focus on the cause of equity partner changes to one of careful business analysis.
Obviously, in some instances improving profit per partner (the performance metric functional equivalent of return on equity as I’ve noted before) can be or is the result of “simple” denominator management. Gary Hamel and C.K. Prahalad noted as much in Competing for the Future when in discussing return on investment they said:
[R]aising 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.
But, if you understand LawBall, you also understand that denominator management is not the way to long-term financial health nor is profit per partner - which simply tells you what the equity in the firm is receiving as profit - a measure of that health. Rather, profit per lawyer (the functional equivalent of return on assets) is a better measure of a firm’s financial health since it measures the efficiency with which a business allocates its resources and eliminates the effect of leverage on operating results – and, as I’ve noted in prior postings, it not only mathematically is (profit ÷ lawyers), it also is (margin x asset turnover), which for those of you who might not have read the earlier postings about metrics is [(profit ÷ revenue) x (revenue ÷ lawyers)]. By understanding that return on assets is the mathematical product of margin times asset turnover, one can “drill down” into the components of this relationship to gain an understanding as to why his or her firm’s financial health has changed over time or that it may be one way while the financial health of a competitor may be another way.
Robert G. Hagstrom, who has written several books about Warren Buffett, notes that, “The driving force of Warren Buffett’s investment strategy is the rational allocation of capital.” Hagstrom further notes with respect to Buffett, when discussing a company’s earnings (which become part of a company’s capital), “Determining how to allocate a company’s earnings is the most important decision a manager will make . . . Rationality – displaying rational thinking when making that choice – is the quality that Buffett most admires.”
As businesses, law firms are knowledge businesses – they sell legal information and legal knowledge. As such, their biggest and most important assets are intellectual capital; and, in particular, human capital – their lawyers. In discussing business models, Gary Hamel has noted with respect to “configuration” – which is what he calls the intermediating between a company’s core strategy and its strategic resources – “The notion of configuration recognizes that great strategies (and great business models) rest on a unique blending of competencies, assets, and processes.” The strategic resources or assets must support the strategy – in Peter Drucker’s “theory of the business” that I’ve previously mentioned – the assets must “fit” with the other assumptions. In an intellectually capital intensive business like a law firm, that configuration requires aligning or matching the capabilities of the firm’s assets (its lawyers) with the demands of the firm’s business. That is nothing more and nothing less than the rational allocation of capital that Warren Buffett believes to be the most important decision a manager can make. Such critical managerial tasks and decision-making are hard work and take a great deal of time – and when done in this manner, partner changes are the natural result of intelligent and thoughtful business practices. Partner changes that occur from simple denominator management more likely are the result of “an accountant’s shortcut to asset productivity” practiced by a firm’s senior manager playing with a red pencil while he or she manages the firm in his or her “spare time.”
In my last posting, I included a matrix I developed that facilitates aligning the demands of a firm’s business with the capabilities of its assets. I suggested that as you look at the matrix, think about where some of the firms that I mentioned in my prior discussions about metrics might fall – like “Firm B”; Wachtell, Lipton, Rosen & Katz; and, Gordon & Rees. Sitting here “wasting away again in Margaritaville, searching for my lost shaker of salt,” it looks to me that, based on the operating performance levers chart that I introduced in “What’s Good for the Goose is Good for the Gander . . . And Maybe Even Better” and is included under “Posting Attachments” in the right-hand margin of this blog, Wachtell has aligned it’s assets with the demands of its business in the upper left-hand square of the matrix, while Gordon & Rees has aligned its assets with the demands of its business in the lower right-hand square of the matrix. Firm B? It looks misaligned, and I’m guessing it doesn’t have a clue – looks like it may have overestimated the demands of its business and aligned its assets accordingly, resulting in a loss of business and issues over pricing and costs per lawyer.
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