2018 Legal Executive Forum: Shining a Light on Law Firm Profitability
This blog post was authored by Heather Fox, manager with Thomson Reuters Communications Team, and it originally appeared in Thomson Reuters Legal Current, which can be found here.
The 2018 Legal Executive Forum kicked off with a presentation by Dr. Evan Parker, who explored the use of statistical models to illuminate a law firm’s profitability drivers and differentiators. Parker, managing director of Analytics & Research, LawyerMetrix, provided specific examples for how his company uses data science to help its clients set their “profitability agenda.”
He framed his session with two goals in mind:
- To consider how we can think more productively about law firm profitability in order to address some of the complex problems that law firms are facing;
- Leverage “rigor and analytics” in an effort to bring new perspective to law firm management and performance and to set a “profitability agenda”
Parker, a former political scientist, began his talk with a challenge to attendees to consider how media strongly influences what its readers think about and, by extension, how the annual release of top-level law firm rankings tends to dominate the collective consciousness of the legal profession.
While he acknowledged the rightful place of such rankings in legal industry metrics, Parker explained that the risk is when they are reduced to a heuristic, as in: “Am Law 100 good; Am Law 200 disappointing.”
It was from this position that he asked, “Is that really the way you want to be thinking about law firm strategy or financial performance?”
As Parker explained it, traditional metrics such as gross revenue which underpin the Am Law 100, don’t tell the whole tale. To illustrate, he displayed an initial grid of the Am Law 100 firms, and then in a series of successive slides, revealed which firms were eliminated when measured for the Top 100 based on additional financial performance measures, including: revenue per lawyer, profits per partner, average partner compensation and five-year growth against each of those metrics. In the end, only 41 firms within the Am Law 100 met the revised criteria, while 10 Am Law 200 firms did.
“Why are these firms on the list at all? It’s the answer to that question that’s actually going to help you think about how to thrive in a tough market,” he said.
Parker focuses on profitability within law firms because when a firm’s management wraps its head around that measure, it heads to greater overall business and organizational understanding. As a conduit, the discipline of data science enables firms to analyze the sort of factors that explain why some are more profitable than others.
Parker suggests the following systematic approach to understanding profits: first, isolating the effects of specific characteristics of law firms using a statistical model, and second, make statements about their importance as informed by the data models.
He suggested three specific questions when setting the profit agenda:
- Economic sensitivities: Are firm financials affected by the macro-economy?
- Law firm strategies: What strategies differentiate more vs. less profitable firms?
- From Thinking to Action: What strategies are feasible (at one’s firm)?
For starters, economic sensitivities refer to the idea of looking at how a firm’s financials are impacted by the macro-economy, which can help a firm anticipate the impact of a shift in the external environment. For example, when analyzing average partner compensation against the annual percentage change in real GDP from 1998-2017, LawyerMetrix analysis of 130 firms demonstrated a positive connection to economic performance for both Am Law 100 and Am Law 200 firms, with Am Law 100 even more sensitive to such conditions. Equipped with such knowledge, Parker suggested that firm management may wish to more closely monitor economic forecasts.
“You might think about a law firm like a portfolio—different pieces will be sensitive to different areas of the economy and knowing what those are gives a manager great opportunity.”
Law firm strategies
In this realm, LawyerMetrix built a model to measure profitability differentiators that have a strategic component, with the goal to identify reasons why some firms have higher partner compensation. The model was based on three years of financial data from Am Law 200 firms, and included these predictors: practice areas; firm size; geography; focus (which refers to concentration in practice area, geography, and industries); diversity and unobservables (such as leadership, talent, culture for which there aren’t quantifiable measures).
As a key takeaway, Parker said their analysis determined that 85 percent of the variation in firm profitability was a direct result of those inputs to the model. Based on these “all else equal” comparisons, the top predictors of profitability were geographic concentration (i.e. having a lot of attorneys in a single office) and diversity/race/ethnicity (i.e. a higher percentage share). Practice area concentration also ranked within the top five, while lateral hiring didn’t prove to be a key differentiating factor.
“We can now see how these things connect together across the Am Law 200 which can provide a robust understanding,” he said.
The model also predicts the change in average partner compensation in either direction of the average for any given factor. “You can begin to play these sorts of scenarios out in your mind,” he said.
To close, Parker laid out a roadmap: come up with a list of the metrics that have proven to matter and consider where one’s firm can create change on those given dimensions. Or in other words, move from thought to action:
List and rank order the viable strategic paths at your firm.
- Identify firms that currently have this strategic profile.
- Generate firm-specific predictions using a statistical model.
For more from the 2018 Legal Executive Forum, including a recap of a talk on law firm-client relationships, visit the LEI Blog.