Minding the Law's Business: BEAUTY IS IN THE EYE OF THE BEHOLDER

David Hume, in his Essays, Moral and Political, wrote:

Beauty in things exists merely in the mind which contemplates them.

So, I believe, is beauty in the eye of the beholder when evaluating a business – even a business involved in the practice of law – whether one is evaluating the business for investment or simply as an operating entity. Warren Buffett has offered that a stockholder and a business owner should look at ownership of the business in the same way and said, “I am a better investor because I am a businessman and a better businessman because I am an investor.”

The beholder’s view of beauty in business evaluation becomes relevant to today’s posting as the LawBall tour of Legalritaville has concluded and I’ve attached a *.pdf document that includes, among other things, an analytic table that shows the 2006 financial operating performance metrics for each of the firms in the 2007 AmLaw 200 and another table that shows the firms’ relative ranking (1 – 200) within each performance metric. The attachment also includes analytic tables that show the firms’ relative ranking based on both the simple summation of the firms’ rankings in each individual key LawBall metric category and the simple summation of the firms’ rankings in all individual LawBall metric categories. The *.pdf document is located in the right-hand margin under the category “Posting Attachments” as “AmLaw Top 200 Performance Statistics.”

Ever-mindful not only of the personal influence on business evaluation and how that might affect each individual reader’s view of the performance statistics, but also the oft-quoted bromide “There are 3 types of lies – lies, damn lies, and statistics,” I thought I’d include my own ranking of the Top 200 as an illustration of how each of us personally may place different levels of importance on separate performance metrics in evaluating a business. Buffett and Peter Lynch (What’s Good for the Goose Is Good for the Gander . . . And Maybe Even Better) have provided insights into their investment philosophies over the years that have pointed to the personal nature of investing and, by extension of Buffett’s comment, business ownership. These nuggets have included items whose actual application and implementation will differ from person to person such as: stay within your “circle of competence”; find companies with simple and understandable businesses (that have consistent operating histories and favorable long-term prospects); determine your tolerance for risk, your objectives, and your attitude; look for and focus on companies with high profit margins and high earnings rates on equity capital without undue leverage, accounting gimmickry, and the like; and, understand the nature of the companies you own and the specific reasons for holding the stock. From Buffett’s “An Owner’s Manual” also comes his personal view on the use of leverage:

We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”)

When evaluating a business for investment, purchase, or identifying operating performance issues – whether it’s engaged in the practice of law or some other business - I use the same metrics that I’ve incorporated into LawBall. However, ultimately I place the most importance on these 3 metrics, in order of their importance to me:

Return on assets (ROA or, in LawBall, profit per lawyer) (when financial capital is involved as opposed to intellectual capital, I’ll use return on invested capital). I believe ROA is a good measure of the efficiency with which a business allocates its resources and may be a better indicator of a firm’s financial health and performance than return on equity (ROE or, in LawBall, profit per partner) as it eliminates the potentially distorting effects of financial leverage on operating results. ROA is the product achieved from multiplying asset turnover times margin.

Asset turnover (revenue per lawyer in LawBall) – the measure of revenue being generated by the business’ asset base (“offense” in LawBall).

Margin – the measure of how much of the revenue generated is kept as profit (“defense” in LawBall).

I subscribe to Buffett’s view on the conservative use of leverage.

The biggest differences between the business evaluation I typically perform and the one that I share with you today of the Top 200 is that normally I:

Analyze a business over a 5-year operating period – not just a 1-year period.

Know more factually about the actual business in which the individual companies are engaged.

Include an estimated value of the business for investment/purchase purposes. Obviously, that’s not applicable here – and my view on the likelihood of U.S. law firms “going public” has been published previously (Public Ownership Ethics Issue a Red Herring).

Here in order are my LawBall top 10 financial operating performance firms for 2006 from the 2007 AmLaw 200: Wachtell, Lipton, Rosen & Katz; Wiley Rein; Sullivan & Cromwell; Cahill Gordon & Reindel; Irell & Manella; Cravath, Swaine & Moore; Simpson Thacher & Bartlett; Munger, Tolles & Olson; Gibson, Dunn & Crutcher; and, Quinn Emanuel Urquhrt Oliver & Hedges. Below are 2 tables for my top 10 - one contains the 2006 financial operating performance metrics for each of the firms, with my personal key metrics highlighted in blue, and the other contains the firms’ relative ranking among the AmLaw 200 (1 – 200) within each performance metric, again with my personal key metrics highlighted in blue. By clicking on the tables you can open a larger version. The *pdf attachment also includes a complete list of the firms ranked (1 - 200) according to my 3 personal key metrics.

Several brief observations:

When compared to the aggregate performance of the AmLaw 200, the aggregate relative financial operating performance of the LawBall Top 10 picks significantly exceeded that of the aggregate AmLaw 200 in every individual key metric category (margin, asset turnover, ROA, leverage, and ROE) except for leverage. In other words, these 10 firms achieved superior performance with slightly less risk (more conservative leverage) than that of the aggregate AmLaw 200. What does that say about these 10 firms’ business models, particularly the firms’ strategy and the mix of the firms’ business demands and their assets (lawyers) to meet that demand as contemplated by the professional asset capability matrix?

On average, the LawBall Top 10 pick firms were moderately sized. The average gross revenues and profit achieved by the 10 firms was $489,200,000 and $272,450,000, respectively. Also on average, the LawBall Top 10 pick firms had 379 lawyers, 111 of whom were partners.

By comparison to the LawBall Top 10 picks, when summing up the AmLaw 200 rankings in each individual key metric category the top 10-ranked firms in order were: Wiley Rein; Cravath, Swaine & Moore; Paul, Weiss, Rifkind, Wharton & Garrison; Simpson Thacher & Bartlett; Quinn Emanuel Urquhart Oliver & Hedges; Cahill Gordon & Reindel; Cleary Gottlieb & Hamilton; Millbank, Tweed, Hadley & McCloy; Sullivan & Cromwell; and, Schulte Roth & Zabel.

By comparison to the LawBall Top 10 picks, when summing up the AmLaw 200 rankings in all of the metric categories the top 10-ranked firms in order were: Dechert; Latham & Watkins; Wiley Rein; Cleary Gottlieb Steen & Hamilton; Simpson Thacher & Bartlett; Kirkland & Ellis; Paul, Weiss, Rifkind, Wharton & Garrison; Skadden, Arps, Slate, Meagher & Flom; Sullivan & Cromwell; and, Gibson, Dunn & Crutcher.

The *.pdf attachment also has easy to view individual tables that reflect the firms’ individual rankings (1-200) in all of the key metric categories of margin, asset turnover, ROA, financial leverage, and ROE versus the AmLaw 200 in the aggregate. I encourage you to go through the attachment, to see where your firm falls within the data, to see where other firms that interest you fall with in the data, to look at what you consider to be the “best” or “top” firms, to compare relative performances, and to add several more years of your firm’s data to the mix and analyze it in terms of trends. Most of all, I encourage you to question what insight this data gives you as to business models employed in the legal industry.

In an effort to make it easier for you to navigate through the *.pdf attachment, here’s a listing (in order) of the tables in the document:

2006 Financial Operations Performance – Listed in Order of the LawBall Picks (Just the Top 10).
2006 Financial Operations Performance – Listed in Order of the LawBall Picks (1-200).
2006 Financial Operations Ranking – Listed in Order of the LawBall Picks (1-200).
2006 Financial Operations Performance – Listed in Order of Gross Revenues (the order of ranking chosen by The American Lawyer for its top 200).
2006 Financial Operations Performance – Listed Alphabetically.
2006 Financial Operations Ranking – Listed in Order of Gross Revenues.
2006 Financial Operations Ranking – Listed in Order of Key Metrics Ranking.
2006 Financial Operations Ranking – Listed in Order of All Metrics Ranking.
2006 Financial Operations Ranking – Listed Alphabetically.
Margin Ranking.
Asset Turnover Ranking.
Return on Assets Ranking.
Financial Leverage Ranking.
Return on Equity Ranking.