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Gray Rule
October 2017 | VOLUME 18, NUMBER 4
Gray Rule
Market Restructuring and Lateral Partner-hiring
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Market Restructuring and Lateral Partner-hiringby William Henderson, Professor of Law and Stephen F. Burns chair on the legal profession at Indiana University Maurer School of Law, Bloomington, IN
Lateral partner-hiring has become a topic of strategic importance to law firms primarily because of flat overall market growth for nearly a decade. The challenge for law firm leaders is to ensure that the short-term perception of growth and dynamism that comes from lateral partner recruitment leads to stronger long-term economic results.

The first page of David Maister's authoritative book, Managing the Professional Service Firm, states that one of the most interesting discoveries of his consulting work is that "regardless of size, specific profession, or country of operation," the mission statements of virtually all professional services firms boil down to some variant of the following:

To deliver outstanding client service; to provide fulfilling careers and professional satisfaction for our people; and to achieve financial success so that we can reward ourselves and grow.

The commonality of the mission, Maister continues, "does not detract from its value. Simply put, every professional firm must satisfy these three goals of 'service, satisfaction, and success.'"

These three goals are depicted in the following diagram, which is adapted from Maister's classic book. In essence, a firm's financial success is a byproduct of how skillfully it operates in the markets for clients and talent. I harken back to Maister's fundamental principles because lateral partner-hiring is the one area of law firm strategy that simultaneously bears on both markets. If we hire the right lateral partners, then we can access valuable new client relationships.

Balancing Three Goals of Professional Service Firm

For several reasons, this logic is substantially right—at least in 2017. But success requires a law firm to adopt a realistic strategy based on accurate assessment of the market, and to recruit candidates that advance its strategic goals.

Lateral Hiring in a No-Growth Market

Lateral partner-hiring has become a topic of strategic importance to law firms—primarily because of flat overall market growth—for nearly decade. Lack of growth is very uncomfortable for law firms. Without it, there is a hard limit on the number of deserving associates that can be added to the partnership. Although partners are generally against promotions that dilute their partnership shares, they care about how a lack of promotions affects the lawyers they depend on to service their clients. Lack of growth is also problematic because it causes partners to question the firm's leadership. Thus, lateral partner-hiring is sometimes used defensively to foster a perception of growth and dynamism.

Law firm leaders must ensure that the short-term perception of growth and dynamism that comes from lateral partner recruitment leads to stronger long-term economic results. Yet that is only possible if law firm leaders understand the causes of the current no-growth environment. I would point to two key inflection points that are impacting client demand.

First, we are nearing the end of a 40-year transition from regional law firm "fiefdoms" to a national marketplace for legal services. Between 1978 and 2008, the average law firm in the NLJ 250 league tables grew from 102 to 535 total lawyers. More significantly, the average number of offices increased from 2.5 to 10.2. Essentially, firms moved into each other's backyards. When the concentration of restaurants increases in a geographic area, restaurateurs attempt to recapture their market power by becoming very good in a particular niche, or by making a commitment to value based on price, quality, and convenience. A similar dynamic now affects law firms. With competitors eyeing each other's client base, it's time to change or die.

The second inflection point, however, reveals how difficult change is for law firms. Over the last 20 years, the number of lawyers working in-house has tripled, increasing from 35,000 to more than 105,000. This growth rate is 7.5 times faster than lawyers working in private practice. Indeed, since 2008, employment of lawyers in law firms has grown more slowly than the number of lawyers working in government.

% Change in Number of Employed Lawyers by Practice Setting, 1997 to 2016

The implications of this second chart are striking. The number of U.S. lawyers working in-house is now roughly equivalent to the number of lawyers working in a domestic office of an AmLaw 200 law firm. Although it goes against conventional business wisdom, corporations are increasingly deciding to in-source a non-core function—at least when it comes to legal services. Why? Because the advantages of outsourcing, at least to law firms, are not sufficient to outweigh the costs. Why pay someone $400 per hour for 1,000 hours per year when you can make them a full-time employee at a reduced cost and obtain an additional 500 hours or so of in-house capacity?

How the Market is Restructuring

The market for legal services is in the process of a transformation that has no historical parallel. While modern society becomes more regulated and complex, gains in legal productivity are stagnant. Stated more concretely, traditional one-on-one consultative legal services are becoming relatively more expensive compared to other parts of the modern economy. To stay within budget, consumers of legal services are forced to look for substitutes. For corporations, this means bringing work in-house. For many ordinary citizens and small businesses, it means using LegalZoom, RocketLawyer, or another DIY solution rather than hiring a lawyer at all.

This market restructuring will not put law firms out of business (not all of them), but it does limit the number of law firm strategies that will produce economic growth and success. Below are three market restructuring trends, each of which is accelerated by lateral partner-hiring.

1. Best-in-Class Specialization

The annual ranking of law firms according to revenues and profits gives the illusion that all large law firms are in competition with each other. But that is never really the case. If a corporation hires a BigLaw lawyer, it is because it has a relatively complex problem that it cannot handle in-house due to issues of costs and/or quality.

When a law firm develops a reputation for providing best-in-class results in a particular area of law, it becomes the safe choice for risk-averse, in-house counsel. Economies of scope and scale enable a firm to pass along efficiencies and quality features to its clients while also locking in a substantial and highly defensible revenue stream. We see this strategy playing out in practice areas such as labor and employment, immigration, intellectual property, and specific areas of litigation.

Many lateral partners are drawn to these firms because they provide a better "fit" for their clients in terms of price and depth of talent. In the years to come, this will result in more national law firms with a boutique practice area focus.

2. Better Pricing, Practice Management, and Technology

Law firm partners with a long-term client relationship have a tremendous incumbent advantage. That advantage, however, does not provide permanent protection against internal cost pressures. Thus, in many cases, the most significant risk factor to continued work is the inability to respond effectively to requests for alternative pricing, better practice management, or technology that improves efficiency and transparency.

Unfortunately, this type of change is very complex and expensive to implement within law firms, particularly across multiple practice areas. Not surprisingly, most partners tend to resist it until their own clients start asking for it. Yet, when the moment comes, moving to a more advanced firm may be easier than navigating change at your own firm.

This dynamic explains why the overall pace of industry change is so slow. However, firms that are making marginally greater investments in pricing, practice management, and technology have an advantage in the lateral market. Further, these innovations tend to make client relationships more solid, particularly when combined with a national or global platform. Thus, in the long run, the number of outbound defections will also go down.

3. Continued Consolidation of Bet-the-Company Matters

Many lawyers believe that their firm has the potential to ascend the AmLaw league tables and effectively compete with the New York and global elite law firms for the most lucrative, price-insensitive work. I often hear the refrain, "We are just as good as they are."

However, ability is very difficult to measure. Thus, buyers of legal services fall back on perception. In large, bet-the-company transactions, and litigation where the CEO and board could be held responsible for a bad outcome, the safe choice is invariably limited to firms with the most sterling reputations. Firms in this elite group have the luxury of growing their own high quality partners while also hiring outstanding lateral talent. Unlike the rest of the market, these firms tend to be focused on legal expertise rather than the ability to port clients. Thus, in most cases, perception is likely tracking reality.

Vetting of Lateral Partners

Lateral partner-hiring is destined to become a major part of how the market for corporate legal services restructures itself. In addition to having the right strategy to attract the right candidates, firms need to take a cue from the corporate world and invest in evidence-based selection methods. This will increase the odds of identifying the right lateral partners at the right price. In the market we are now entering, the stakes are too high to continue doing it the old way.

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