The Future of the Large Law Firm: Growth, Mergers, and Inequality

By last count, there are now 29 U.S. law firms with at least 1,000 lawyers.[1]  In a few weeks, this number should rise to 32, primarily as the result of mergers.[2] My prediction is that this number will climb to well over 50 by the end of this decade. Still, two inconsistent trends are peaking at the same time: (1) large firms are growing in size, but (2) growth in the number of equity partners at these firms has stalled (and may even have declined). According to the annual survey by the National Law Journal, the number of attorneys in the 500 largest U.S. firms has grown only modestly (2.5% in 2018, after only 1% in 2017). Conversely, growth in number of partners in these firms has stalled. That same NLJ 500 survey shows that the number of partners rose by only 1% in 2018, and this number was inflated by a 3.8% growth in the number of non-equity partners.[3] In short, the number of equity partners probably declined as the result of both law firm mergers and “de-equitization” programs at some firms.[4]

What explains this linked pattern of firm growth, but equity partner shrinkage or stagnation? This column will argue that firm growth is coming at the price of an internal re-organization within the firm that implies significantly greater inequality among the partners. In turn, this promises demoralization, departures, and ultimately the likelihood of litigation.

Growth in size has clearly come through mergers and the lateral acquisitions of partners. Over the last three years, Altman Weil reports that the number of law firm mergers increased from 85 in 2016, to 102 in 2017, and to 106 in 2018. Although 2019 started modestly in terms of mergers, it ended with a double bang, as Drinker, Biddle & Reath and Faegre Baker Daniels announced a “merger of equals” that will produce a 1,300 lawyer firm, and Pepper Hamilton LLP and Troutman Sanders LLP announced their intent to merge, which will produce a slightly smaller, but still 1,000-plus lawyer firm. Both mergers will produce new Top 50 firms, and both involve the same pattern: a growing firm is acquiring an East Coast platform by merging with an older firm that has encountered problems.[5] Still, the biggest merger news of 2019 was a transaction that did not happen. O’Melveny & Myers and Allen & Overy had announced that they were planning a merger, but called it off because of “macro-economic uncertainties” (which may be shorthand for Brexit).[6] This would have been the largest such law firm merger to date. Although its cancellation reminds us that it is difficult to marry mature firms, it also demonstrates that some strong forces are driving this merger market if successful firms are willing to consider such a disruptive change.

Why do law firms merge? It is much simpler to hire a team of “star” partners from another firm, acquiring hopefully a $30 million book of business by guaranteeing $10 million a year (for some period) to the highest-billing star. The distinctive fact about law firm acquisitions is that the acquirer can buy a profitable division from the target firm without paying anything to the target firm. This is because “star” lawyers are like free agents in the NFL or NBA; the employer does not own its most valuable assets (its partners). If so, why merge and acquire a mix of assets (some not so attractive) when you can just buy the prized assets? Academics have pondered this question, but not yet produced any consensus answer.[7]

Still, to the extent large law firms are growing, growth is coming not from internal expansion, but from acquisitions. The clearest indication of this transition may be Kirkland & Ellis, which grew by 310 lawyers in 2018, thereby accounting by itself for 7.4% of the entire growth of the NLJ 500 in 2018.[8] But, as later discussed, Kirkland has led all firms in making lateral acquisitions of individual partners or groups of partners. It also leads all other firms in having 560 non-equity partners.[9] This is a new and distinctive business model that appears to be working for them (and is being copied by others).

This column will examine in quick succession: (1) how the old order is changing; (2) the forces that appear to be driving law-firm mergers; (3) why some firms have remained aloof and distant from this process; and (4) the hidden impact on equality within the firm. Law firms once thought of themselves as a “band of brothers” — tight-knit, loyal, and supportive. Those characteristics may be the real casualty in this transition. Here, one statistic stands out: In 2000, 78% of law partners held an equity interest in their firm, but by 2018, this percentage had fallen to 56%.[10] Today, the percentage of equity partners may have already fallen below 50% of all partners. The NLJ 500 Survey shows that the median firm as of the end of 2018 had 339 lawyers, of which 91 were equity partners and 152 were associates. That leaves a balance of 96 lawyers who were neither equity partners nor associates and probably should be called non-equity partners. Predictably, this decline in equity partners will continue and, in the foreseeable future, large law firms may have only a third or so of their partners being equity partners. With the rise of the non-equity partner and the rise of the “mega-firm,” the “band of brothers” model for law firms is quickly dying. As later discussed, those most adversely affect by this transition will likely be female attorneys.

I. The Old Order Crumbleth

For probably a century or longer, large law firms (which used to be rare) followed a business model known to many as the “Cravath System.” Its key elements were:

  • The firm would recruit young lawyers from the best schools based principally on their law school record;
  • After a probationary period (extending from 7 to 10 years), a few (and usually a very few) would be made partner, and the rest would be expected to find work elsewhere — up or out.
  • Partners would not be hired laterally, no matter how great their ability or book of business;
  • To maintain equality and democracy within the firm, compensation of partners would be in lockstep, without regard to the revenues generated by the partner.[11]

Academic theorists have sought to generalize this “up or out” pattern into a more formal model. The best known of these models, developed by professors Marc S. Galanter and Thomas M. Palay, is the “tournament of champions model.”[12] It assumes that the firm implicitly promises to award partnerships to the winners of this competition as a means of incentivizing the firm’s associates to work harder. This author has always been skeptical of this model because it is a supply-driven model (rather than a demand-driven one), and there is little hard evidence that firms truly live up to this implicit contract. But the rise in non-equity partners and the decline in equity partnerships substantially refutes this model. Although non-equity partners can eventually become equity partners, the “tournament” has now been stretched out for a generation, and that will not incentivize many.

The even greater vulnerability of the Cravath System is its lockstep compensation system, which exposed it to other firms that used an “eat-what-you-kill” system of compensation (or a “merit-based” system, to be less pejorative) that enables such predator firms to entice away those partners who generated well above the average revenues per partner for that firm. In effect, an aggressive firm could “cherry pick” the most successful partners from a firm that relied on lockstep compensation. This raiding has been happening for well over a decade, but it was only a serious threat to the top tier firm if an equivalent firm would adopt this strategy and apply it on a significant scale. Over the last two years, this has happened — and recurrently. For example, “star” partners have recently left Cravath for Paul Weiss and Kirkland & Ellis, reportedly for compensation of up to $10 million a year for a guaranteed period. But the real shocker in 2019 was Freshfields Bruckhaus Deringer’s hiring of a team of M&A partners (and associates) from Cleary, Gottlieb (which also used a lockstep compensation model).[13] Freshfields, a member of the U.K’s “magic circle,” is clearly a top flight firm (as are Paul Weiss and K&E), but it was hiring a whole team — and in effect buying a book of business. When Cleary terminated abruptly the partners so hired, the hard feelings were clear. With the possible exception of Cravath and one or two others, it seems doubtful that an inflexible system of lockstep compensation will survive much longer.

II. What Best Explains Robust Merger Activity?

When business corporations merge, the dominant rationale is usually hoped for synergies and/or increased market share. Particularly in consolidating industries, increased market share tends to imply higher prices and profits. But this goal cannot explain law firm mergers. Synergies, while conceivable, are rare when two firms of equal size enter into an alleged merger of equals, and gains in market share are trivial, given the highly competitive and fragmented nature of the legal market. Once, the goal may have been economies of scale, but these are usually fully realized at levels well below 400 lawyers. By that level, a large law firm can afford the best IT system it needs and can hire all the professional marketing and public relations staff it wants.

So what does better explain high merger activity among law firms? Two plausible answers are globalization and the need of a struggling firm to find a savior. Large corporate clients may want a law firm that can advance their interests on every continent and has politically savvy lawyers in every world capital. The world’s largest law firm is Dentons, now with approximately 11,000 lawyers; each year it makes several acquisitions of law firms around the globe, often in far flung regions, such as New Zealand and Peru (as well as in the U.S.). In the U.S. Dentons has indicated that it would like to open an office in each of the U.S.’s 20 largest markets. The rhetoric that it and other firms use to describe their strategy is that they want to offer “one stop shopping” to their clients — in effect, a firm that can advise them on political access and local custom around the world.

Viewed in terms of theory, this is a strategy of seeking to realize not economies of scale, but economies of scope. Of course, the client could seek to find the best counsel in each of these localities, but clients probably find it difficult to evaluate counsel (particularly foreign counsel) and may believe that a recognized law firm will have expert counsel in all its offices.

Of course, the alternative strategy is for a top tier firm to open its own offices across a broad terrain. In the 1990s, firms such as Skadden Arps and Jones Day did this across the U.S., opening branches in many cities. This also is an attempt to realize economics of scope (but without making acquisitions). Branching may, however, be a much harder strategy to employ overseas where the U.S firm has little knowledge of local law, custom, or even the language. Nonetheless, the Magic Circle firms have successfully expanded in this fashion for 20 years, combining some acquisitions with much use of their own lawyers to expand internationally.

III. Why Do the Best Firms Hold Back?

Dentons may be the largest firm in the world, but no one to my knowledge has characterized it as the best. The largest U.S. firm is Baker McKenzie, and, while respected, it never appears near the top of the various lists of the most elite U.S. firms. Correspondingly, this author would be shocked if a Sullivan & Cromwell merged with another firm. Why? Not only would its strong culture not mesh well with another firm, but it would believe it was diluting its quality. Indeed, none of the most elite U.S. firms have yet merged (although some do make regular lateral acquisitions of partners).

Clearly, there are outliers. Cravath and Wachtell remain basically one office firms, and so does Slaughter and May in London. They believe they can attract the best clients based on a reputation that they can communicate internationally without having to open costly local offices (or risk dilution of quality). Who is right? Time will tell.

IV. What Are The Costs of Law Firm Mergers?

Here is a hypothesis: those firms that are expanding the most (either internationally or domestically) have higher ratios of non-equity partners. Conversely, the most elite U.S. law firms generally have no (or few) non-equity partners.[14] Of course, this is partially a cultural phenomenon, as most of the major New York law firms simply do not have non-equity partners (although they may use the term “of counsel” for some associates who have been promoted to a sub-partner status).

The use of non-equity partners is a means of leveraging the firm, retaining more profit for the firm’s residual equity owners, who receive the earnings generated by the non-equity partners over their salaries. In effect, the top of the pyramid is declining to share the residual returns with the middle. Should we care that law firms are using more leverage — in effect, giving up on the ideal of a “band of brothers” in favor of a small team of highly motivated entrepreneurs? Arguably, this is similar to what private equity firms (such as Kohlberg Kravis Roberts) have long done.

How should we evaluate this transition — desirable or undesirable? As usual, the answer depends on whose ox is gored. The clearest loser in this transition to “mega-firms” with few general partners may be the female attorney. Looking at the statistics recently compiled by the ABA’s Commission on Women, one finds that women received 50% of the JDs recently awarded in the U.S., and they constitute approximately 46% of all associates in law firms. Further, they constitute 22.7% of partners, but only 19% of equity partners.[15] Disproportionately, they are thus becoming non-equity partners.

Is that discriminatory? Conceivably, there are women who might prefer to be a non-equity partner (and make less) if it gave them more time to undertake family and child-rearing responsibilities that still fall disproportionately on them. But that description does not fit all women, and those that are not happy with this system seem likely to eventually file sex discrimination class actions.

Conclusion

Law firms are splitting the pie differently than in the past. One explanation for this re-allocation is that to purchase “star” partners in the lateral acquisitions marketplace, firms need to economize on costs elsewhere and so have turned to non-equity partners to provide lower cost labor — in effect, spear carriers to service their “stars.” Revealingly, at the same time as Freshfields was poaching “stars” from Cleary, press reports show that it had just de-equitized its U.K. and European offices by ousting or downgrading its less profitable finance partners.[16] It is an unavoidable fact of life that costs must be cut somewhere.

Still, the bigger point is that a transition may be in progress from the old “Cravath model” to a new “Kirkland & Ellis model” for law firm organization. Staffed with a record number of non-equity partners (560 as of early 2019) that overwhelmingly outnumber its equity partners, K&E is a paradigm of efficiency and inequality. To other firms, it is a constant threat because, once it identifies a target of opportunity, it can outbid most other firms. Thus, much like the Death Star in Star Wars, it can potentially stalk the legal heavens, wreaking havoc on its rivals.

But can the model persist? Some doubt its efficiency, believing that non-equity partners have too little incentive to work hard.[17] This is certainly what tenure usually does in academia. Further, to the extent that the success of this model is fueled by the earnings of its non-equity partners, there is always the prospect of a revolt (or at least defections) by this army of galley slaves. No prediction is here made that a Spartacus will arise to lead a rebellion by very well-paid galley slaves. But the K&E model has internal strains that may cause it to encounter both legal and organizational problems.

One key such strain involves the status of women and minority lawyers within it. Some believe that the use of non-equity partners is a sly stratagem that enables conservative law firms to appease and mollify critics by creating new female and minority partners (without significantly re-allocating the partnership’s profits). Clearly, minorities tend to be made non-equity partners.[18] Claims of discrimination, however, probably require more evidence (which this author has not seen) and, as an explanation, it is unlikely to apply uniformly to all firms.

In any event, law firm growth is increasingly connected to an internal redesign within the firm that implies greater inequality. With greater inequality may also come resentment, demoralization, and ultimately litigation. What voluntary steps could law firms take to mitigate these problems? That is the question this author will delay for a later column.

But somewhere — perhaps in a legal galaxy far, far away — a young Luke Skywalker may arise to challenge this new empire. Organizing small boutique firms to defect from the empire, Skywalker could begin a guerilla war for independence. At the least, this could make an exciting movie.[19]

ENDNOTES

[1] See “The NLJ 500,” The American Lawyer, August 1, 2019, Vol. 41, No. 8, p.41.

[2] The Faegre/Drinker and the Troutman/Pepper Hamilton mergers discussed below will each exceed 1,000 lawyers (assuming they are consummated). The 30th firm on the NLJ 500 list was Davis, Polk and Wardwell with 982 lawyers at the close of 2018, and it may by now have also crossed the 1,000 threshold (or soon will).

[3] See “The NLJ 500,” supra note 1; see also Ryan Lovelace, “For Large Firms, Growth Gains Steam,” National Law Journal, July 1, 2019. The total number of lawyers in these 500 firms was 169,477; hence, we are discussing a significant proportion of the profession.

[4] De-equitization (or the demotion of an equity partner to a non-equity status) is now an increasingly common phenomenon. See George Benson, “De-equitization is the elephant in the room in Biglaw’s profit distribution,” May 3, 2018. https://remakinglawfirms.com

[5] Faegre Baker Daniels, LLP is a primarily Midwestern firm (with offices in Denver and Silicon Valley also) that extends its range to the East Coast by linking with Drinker Biddle. Drinker Biddle has experienced “significant departures” in recent years, according to press reports, and Faegre was the larger, more profitable firm. Similarly, Troutman Sander’s merger with Pepper Hamilton pairs a growing firm with one (Pepper) that has experienced falling revenues and headcount. Thus, one firm needed stability and the other mainly wanted access to the larger Northeast market. In short, as later stressed, both Faegre and Troutman were seeking economics of scope through extending their range.

[6] See Lovelace, supra note 3.

[7] For a concise overview (and data), see Bruce Aronson, “Elite Law Firm Mergers and Reputational Competition: Is Bigger Really Better?” 50 Vand. J. Transnational Law 763 (2007).

[8] Lovelace, supra note 3.

[9] See Sara Randazzo, “Being a Law Firm Partner Was Once a Job for Life — That Culture is All But Dead,” The Wall Street Journal, August 9, 2019. Other estimates place the percentage of non-equity partners in large firms at 42.2% as of 2017.

[10] Id.

[11] Because this author spent nearly six years at the Cravath firm (as an associate), he even will cite himself for these generalizations, even though the term “Cravath model” is widely used.

[12] See Marc S. Galanter & Thomas S. Palay, Tournament of Lawyers: The Transformation of the Big Law Firm (1991). As a generalization, “law and economics” scholars are inclined to posit an “implicit contract” on very thin evidence.

[13] See “Freshfields Nabs 4 Partners in Quest for Top U.S. M&A Practice,” Law360, November 12, 2019; see also Christie Simons, “Lockstep Model is Doomed, Says Recruiter Behind Cleary Rainmaker Move,” New York Law Journal, November 6, 2019.

[14] This is certainly true for most New York City “elite” firms, but Shearman & Sterling appears to have 26 non-equity partners versus 162 equity partners (as of 2017). See GEP Market Intelligence News Services, “De-equitization of Law Firm Partners on the Rise to Curb Costs,” June 24, 2017. The leader in the number of non-equity partners appears to be Kirkland & Ellis with 560 non-equity partners (a clear majority of its “partners”). This seems more than coincidentally related to its active pursuit of lateral acquisition partners at $10 million a year.

[15] See ABA Commission on Women, “A Current Glance at Women in the Law, April 2019.”

[16] See Kathryn Rubino, “Big Law Firm Gets Busy Shredding Finance Partners,” Above the Law, April 18, 2017. (discussing Freshfields’ termination or de-equitization of eight finance partners).

[17] Some law firm compensation experts report that non-equity partners work fewer hours than associates and are not fully utilized. See James D. Cotterman, “What Should Law Firms Do About Non-Equity Partnerships?” (Altman Weil Inc. 2017). Thus, there are rival stories as to whether non-equity partners are exploited or inefficiently subsidized.

[18] See Dylan Jackson, “Minority Partners Disproportionately Placed on Non-Equity Partnership Tier,” Law.com, October 8, 2019 (finding that majority of minority partners have been made only non-equity partners).

[19] If any movie producers read this column, I am available to play the role of Obi-Wan Kenobi in this film. Who could be better?

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.