In connection with the American Lawyer’s announcement of the 2010 Am Law 100, Amy Kolz, a reporter there, wrote an article about profit margins of those firms over the last five years, to which I contributed. To summarize the article’s main points:

  • Not only for the past 3 recession years but also for the final two years of the boom (and we would argue even before that), associates in highly-leveraged firms were "underutilized assets with high fixed costs."  Thus, the majority of firms with profit margins higher than the average (38%) reported leverage ratios lower than the average (3.45), with firms in the bottom profitability quartile (32% and below) showing leverage 22% higher than the average. 
  • In spite of significant growth in nonequity partners over the last 5 years, single tier firms and those with the fewest nonequities consistently reported higher profit margins–averaging @45%– than that of firms with a majority of non-equity partners–27%. Part of the answer lies in the fact that since at least 2007 average hours billed by nonequities are lower than those of both equity partners and associates (a distinction which might become less relevant in the fixed fee marketplace).
  • Firms within the highest quartile of profitability hired the fewest laterals–comprising less than 4% of their equity partners, compared with firms in the bottom quartile who hired in an average of 18% of their partners. Part of the explanation continues to be in rich up-front compensation packages for laterals, 60% or more of whom don’t work out. 
  • Real estate also took a bite out of profits: firms with more than 20 offices had an average margin of 34% compared to 46% for those firms with less than 7 offices. Nonetheless, truly international firms enjoyed slightly higher profit margins than their more domestic peers.

There were a number of issues we discussed that didn’t make this and related articles (see also "Living on the Margins"). For example, an additional and ongoing drag on profitability is the steadily declining rate of realization, in both billing and collecting, over the last ten years or so, which may abate as the economy picks up but has hit some firms hard. Better intake procedures, client relationship management and billing follow-up can help improve realization.

The practices within a firm–whether it’s bond work at Weil Gotshal or Cravath-style deals–also impact profitability, so much so that it makes the firm-wide information less valuable than the practice group information, according to Steve Roster, formerly managing partner at Morrison & Foerster.  

On the real estate side, when a firm negotiated its lease, how prime the space is and how much was spent on building-out and furnishing can have a long-term impact on firms profits.

Many firms have tried to improve profitability by radically reducing expenses–renegotiating big-ticket costs, firing staffers and associates and under-performing partners, with a resultant up-tick in profitability.  The problem is that many firms are running out of expense reductions and those they have made have not been focused on long-term benefit.

As to the oft-asked question as to whether profit margins will recover or continue to be erratic/decline, my guess is that there will be a fake toward returned profitability as revenues general pick up, which will be most deleterious to those firms who have not done some serious thinking about retooling their delivery model and internally aligning with that—they will assume all is back to “normal.”  For those firms, that comfort will get them through a few years of bumpy but fairly steady profitability that will eventually decline as more forward-thinking firms with more sophisticated internal processes and management make inroads into the revenue pie.  And it will be hard for them to catch up.