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July 06, 2007

THE WALL STREET JOURNAL FLUBS IT

No matter how hard I tried to keep my fingers from “tickling the plastic,” I couldn’t do it.  When I read the article “Partnership Is No Longer a Tenured Position” in today’s The Wall Street Journal, as well as its sister piece in the WSJ’s Law Blog entitled, “De-Equitization:  A Buzzword Sweeping Big Law Nation,” I tried to let it go – but I couldn’t.  I just did a slow burn.  What follows is one of my Dennis Miller-type rants.

The WSJ got it partially right – partnership no longer is a tenured position.  But, the WSJ completely flubbed it with the sub-title to the WSJ article, which read “More Law Firms Thin Ranks of Partners to Boost Profits, Attract, Keep High Earners,” and with the article’s quote:

Once rare, quiet and restricted to the most competitive firms, "de-equitization" has become one of the most popular buzzwords in law-firm management. As corporate firms across the country with ambitions to grow and boost profits have aggressively and publicly thinned their partner ranks, the word has stoked a new sense of vulnerability among lawyers.

Similar faux pas appeared in the remainder of the article and in the Law Blog piece, whether written as a quote from a lawyer or a consultant or as narrative written by the authors.  What irks me is that the WSJ missed a golden opportunity to expand the debate to what really matters in terms of addressing what may be wrong in a given firm’s business.  I’ve said it before, and I’ll repeat it again now:  Profit per partner is a metric only.  It does not determine the amount of profit (or “net operating income” as The American Lawyer prefers to call it) that the business generates.  It simply measures the amount of that profit made as if it were to be distributed on a per partner basis.  Profit per partner is a return on the “sweat equity” (or in some instances, actual financial equity) contributed to the firm by its partners.  As a metric used in human capital-intensive businesses, It is similar to the return on equity (ROE) metric as used in financial capital-intensive businesses:  ROE doesn’t generate the amount of the profit; it just tells one what the amount of profit made is as a return earned on the capital invested over the subject time period.

Whether the business is a law firm or is a maker of widgets, the amount of profit is determined by the amount of gross revenues that a firm generates from its assets and how much of those gross revenues it is able to keep and not spend on expenses.  It is a function of margin and asset turnover  - multiplying the two together gives you a product that is the firm’s return on assets (ROA).  Further multiplying ROA by the amount of financial leverage gives one the firm’s ROE.  ROA actually may be a better metric for determining the health of a firm since it eliminates the effect of leverage.  There lies the importance of margin, asset turnover (revenue per lawyer), and ROA (profit per lawyer) that LawBall emphasizes.  It is why, when one sees ROE or profit per partner cited as a metric, he or she must then de-compose the metric in order to see what caused the end result – changes in margin, asset turnover, or leverage?  And, what do those changes say about the firm’s business model?

I have no doubt that a number of the firms that have employed “de-equitization” have engaged in simple denominator management – and done so wrongly, thinking that it will “boost profits” instead of actually understanding that the answer to a firm’s performance lies in understanding what happened in the constituent components of margin, asset turnover, and leverage, all of which relate directly to the firm’s business model and which include the demands of its business base and the capabilities of its asset base.  By going along with the line of thought that equates the amount of profit with the number of partners and repeating it without question, as it did in its stories today, the WSJ just flat got it wrong, and it did the industry a disservice.  It kept the bright light of controversy on simple denominator management - which won’t fix a thing except make the metric look better - instead of trying to turn the focus toward understanding how to determine what’s really wrong with the underlying businesses.

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