Seesaw staffing: The optimal leverage ratio in law firms

One of the most pervasive features of the modern law firm is its size, reflecting past growth. Take Baker & McKenzie and DLA Piper, the largest law firms in the world by revenues. Formed in 2005 by a merger, DLA joined the billion-dollar club in 2006 and boasted US$2.48bn in revenues in 2013. Baker's growth took place over a longer period of time, but is impressive nonetheless: today it is even larger than DLA Piper, having recorded revenues of US$2.54bn in the past financial year. Both firms have invested heavily in international expansion, with offices in growth markets such as China, South Africa and United Arab Emirates.

Modern law firms are not alone in this respect. In fact, firms in some other professional service sectors have grown much faster. Even the largest law firms in the world pale in comparison to some of the integrated accounting and auditing organisations. As an illustration, the combined global revenues of the ten biggest law firms only make up two-thirds of the annual sales of PwC, the world's largest accounting and auditing firm. While diversified firms are common in
the accounting sector, this is becoming an increasing trend in the legal sector
as well.

Law firms are going through the same underlying mechanisms as firms in other professional service sectors. They have extended their service portfolios beyond their original areas of expertise and diversified across different service lines. A good example is the UK-headquartered law firm Bird & Bird: initially focused on intellectual property law, it now offers legal advice across a broad range of commercial law areas, including M&A and employment law. This diversified portfolio has been accompanied by rapid geographical growth, from only three offices in London, Brussels and Hong Kong in the 1990s to 26 offices worldwide today.

The main motives for diversification in professional service firms are twofold: client demand and internal resource utilisation. On the one hand, partners may use their existing client contacts for new business opportunities. On the other hand, diversification allows the present infrastructure to be better utilised and for synergies between adjacent legal practice areas to arise. Moreover, diversification has been found to reduce firm risk because losses in one service line can be offset by gains in another one.

At the same time, diversification strategies require law firms to manage their internal organisational structures differently. Structure and strategy must fit - adapting one without the other is the road to perdition.

In an earlier Managing Partner article, Ansgar Richter explains the complementarity phenomenon, especially how strategic and structural elements within organisations with good fit reinforce each other.¹

Changes in strategy (such as diversification) should be accompanied by changes in structure (such as organisational resources) to prevent performance declines. Many a law firm has failed because it jumped into new service line opportunities without considering the organisational implications of doing so.

Balancing leverage

A central variable defining the internal organisational structure of professional service firms is the leverage ratio. This ratio describes the average number of junior professionals (associates) to senior professionals (partners) within a firm. The notion of the leverage ratio has been long known in organisation theory as 'span of control'. Discussions around the optimal span of control date back to the early part of the 20th century.

The leverage ratio in this context is related to the eponymous variable in financial accounting. In the latter, 'leverage' denotes the ratio between debt and equity capital. Just as taking on debt can enhance the returns on equity, in the context of professional services, the knowledge and client relationships of senior professionals play a similar role as financial equity in more capital-intensive industries. By employing more junior professionals, seniors leverage their valuable resources in terms of intellectual capital and client relationships.

The basic logic of leverage is that greater leverage is good, as long as it can be managed. High leverage comes with many advantages: partners can concentrate on building client relationships and giving strategic, high-level advice to clients, rather than getting into the details of contracts and paperwork. Therefore, the use of a larger number of associates enables partners to utilise their own resources and serve their clients in better ways. This generates greater fee income with the same number of partners.

Since good partners are arguably harder to find on the job market or to develop in-house than good associates are, it makes sense for the firm to leverage partner resources as much as possible, even if it means introducing some slack in the number of associates. For equity partners, a pleasant side effect of this business rationale is that they accrue higher profits the more they leverage, as long as they are able to sell sufficient mandates to use associate capacity. Higher leverage also leads to greater competition among associates for scarce partner positions, and thus to higher average associate performance.

However, leverage is easily overstretched. If you allow that to happen, then all sorts of problems arise. In a firm with a large leverage ratio, young professionals don't get the exposure to partners (and to clients) that they deserve and desire. They become mere cogs in a machine, or at least feel like that. The knowledge flow between partners and associates dries up. This defies the implicit contract between associates and partners: an exchange of hard work for attention, knowledge and career opportunities. Associates are often left on their own. Quality management within the firm, traditionally ensured by partners, takes
a hit. Associates see their statistical chances of making it to partner-level decline. Consequently, they begin to
fly under the radar, rather than working hard for a distant goal.

Of course, this does not go unnoticed by clients. At the same time, organisational culture is sacrificed for the opportunity of running large-scale projects to maximise capacity utilisation. As a result, performance begins to decline: clients defect, liabilities arise and employees begin to leave. The firm's reputation suffers in both the client and the recruitment marketplaces, often with long-term repercussions.

In economic terms, leverage has an inverted U-shaped relationship with organisational performance. It is positively associated with performance up to a point, but increasing leverage beyond that point leads to a decline in organisational performance.

Optimising leverage

In the literature on the organisation of professional service firms, the search for the optimum leverage ratio has become akin to that for the Holy Grail. Our own research on a sample of the 50 largest law firms active in Germany suggests that, holding everything else constant, the optimum leverage ratio is between three and four, well above the observed mean leverage of two in our sample.

We derive the optimum value by fitting a regression curve through more than
400 data points of actual leverage-performance relationships observed in our sample, and calculating the maximum performance along this curve (see box: 'About our research').

 

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About our research

In a current working paper, we examine the joint effects of diversification and leverage on the performance of professional service firms (see Figure 1).

Based on a sample of the 50 largest law firms active in Germany over 10 years, the quantitative research finds an inverted U-shaped relationship between leverage and law firm performance, and between diversification and law firm performance. The returns to increasing leverage and diversification are initially positive, but turn negative at an inflection point representing optimum leverage and diversification.

The performance peak, measured as average fee earnings per professional, is located at a leverage ratio of around three to four associates per partner, and at diversification of between two and four equally-sized service lines.

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Despite the importance of leverage, an exclusive focus on the performance-optimal leverage ratio can be deeply misleading. In his seminal work, Maister taught us that whether a firm should choose a greater or a smaller leverage ratio depends on the nature of the service it is providing.²

Maister considered three broader categories of work: 'brain', 'grey hair' and 'procedure' projects. Brain projects deal with new solutions to new problems. Because these solutions are highly customised, they offer little potential for task standardisation. Moreover, brain projects are hard to sketch out in advance and initial solutions may change significantly along the way. Senior professionals need to be involved at every step of the project and look over youngsters' shoulders frequently. Therefore, the leverage ratio in brain projects will be small.

By contrast, senior professionals in gray hair projects (the second type) are usually familiar with the problem at hand and can draw from their experience in crafting similar types of solutions. These projects may be pre-structured more accurately and require less supervision
by partners, leading to a medium
leverage ratio.

The third type, procedure projects, involves little customisation and high standardisation. Both the problem and the solution are largely known in advance and require little senior involvement. These projects are run most efficiently with high leverage ratios.

In practice, most projects do not fall neatly into one of the three categories sketched out above. Nevertheless, Maister's logic also applies to law firms: different types of legal work can require different leverage ratios. For instance, litigation and M&A cases are typically associated with high leverage ratios, because the bulk of the legal work does not require close supervision, as in Maister's procedure projects. In M&A projects, for example, associates might comb through large data rooms without seeing their partner for days in a row.

The German offices of Hogan Lovells and Skadden Arps are among the law firms with the highest leverage ratios, and both are traditionally strong in corporate law. Tax and public law cases, by contrast, are some of the service lines where firms often operate at leverage ratios as low as one associate per partner. Clients in these service lines often demand a holistic yet also detailed view of the case, as well as of their other activities, which impedes task sharing among too many individuals. Hence, partners can delegate less of the legwork to associates, as in Maister's brain and grey hair projects.

Redeker Sellner Dahs has a strong public law practice and, alongside a number of other German boutiques,
takes pride in its low leverage ratio of around one.

Streamlining leverage

The variety of leverage ratios across service lines poses an interesting challenge to diversified law firms: if you
are active in different legal fields, each
of which has its own optimal leverage
ratio, which overall leverage ratio is the optimal one?

One deceptively straightforward approach that many firms pursue is to use different leverage ratios for different service lines. This approach may work, but only if the service lines are quite clearly delineated from one another and each practice area has its own set of clients, limiting the need for information and knowledge exchange between different practice areas. Essentially, the firm lets each practice area operate on its own account, similar to strategic business units found in other sectors.

The problem with this approach is that it defies the purpose of diversification to begin with. If there is no sharing between the practice areas, why have the combinations of different practice areas in the first place? If each practice area follows a different leverage ratio without restricting coordination and exchange between them (such as to maintain a 'one firm' approach and culture), then the firm may end up with problems of inequality that it is ill equipped to handle.

Internal compensation differentials may become too large and associates' exposure to clients and senior professionals may become unequally distributed, thus leading to envy and distrust. Therefore, in order to overcome the challenges of managing diversified service portfolio, the firm should structure itself in a way that the leverage ratios are as similar to each other as possible.

Further, changes in the business mix can lead to a large gap between the required and the actual leverage and, in turn, to staffing problems. For example, a law firm which moves from a mixed approach to a higher share of procedural projects may well find its partners performing relatively low-value tasks because not enough associates are available to do the job.

Conversely, if the same law firm acquires an unusually high number of brain projects, associates are swamped with complex tasks usually performed by partners, which is not desirable either. If the firm is focused on either brain or procedural projects to start with, it would be in a better position to cope with changes in the business mix.

Organisational implications

Therefore, to build a successful diversified law firm, you need to restrict the urge to enter into business areas that may let your leverage ratio in individual units get out of hand. Our statistical research shows that firms suffer a performance disadvantage if they operate with overly large variations in leverage ratios among service lines. Effectively, the practice areas whose nature requires a low leverage ratio puts a cap on those other practice areas that, in theory, could work with a larger leverage ratio, and vice versa.

Our research implies that law firms should carefully consider the organisational implications of diversification. It appears to be easier to diversify into legal practice areas that require similar leverage ratios as the ones that a firm has already. When diversifying into a practice area that poses very different organisational requirements, the firm might be better off running it as a separate business unit.

Growth (especially through diversification) requires high managerial attention and carries the risk of letting the core businesses get out of hand. Diversified law firms thus require a much larger degree of deliberate management than is the case in smaller, less diversified law firms.

Small law firms work largely on the basis of experience: time has told which organisational practices work and which ones don't and, if a firm takes a wrong choice (such as to over- or under-leverage its senior capabilities), market feedback mechanisms are bound to kick in fairly quickly. Large, diversified firms are much more shielded from the potential severity of such sanctioning mechanisms. However, harsh as it may be, market feedback ultimately serves a positive purpose.

Law firms that wish to grow should not overstretch their capabilities. In other words, it is advisable for a law firm to grow with an eye on its managerial constraints. One of the earliest growth theorists - Edith Penrose - suggested that the chief constraint on the growth of firms is a shortage of the managerial capabilities required to manage such growth.³ There is no reason why this lesson should not hold for law firms too.

Professor Amit Karna is an associate professor at the Indian Institute of Management Ahmedabad
(www.iimahd.ernet.in). Professor Ansgar Richter is chair of management at the University of Liverpool Management School (www.liv.ac.uk/management). Monika Schommer is a doctoral student at EBS University (www.ebs.edu) and consultant at Boston Consulting Group.

The University of Liverpool Management School is offering a series of evening roundtable sessions in London on the challenges facing professional service firms. For more information, please contact Ansgar Richter (a.richter@liverpool.ac.uk).

Endnotes

1. See 'Strategic structure', Ansgar Richter, Managing Partner, Dec 2013/Jan 2014, Vol. 16 Issue 4

2. See Managing the Professional Service Firm, David Maister, Free Press, 1993

3. See The Theory of the Growth of the Firm, Edith Penrose, Blackwell, 1959