With turbulent economic times seemingly ahead, all companies and businesses have a reason to be on high alert - However, the legal industry and other professional services businesses have reason to be especially concerned. After all, the recessions in 1987, 2001 and 2008 historically led to devastating collapses of the world's top law firms.
Economic dislocation is always challenging, but partnerships and other non-public companies, of which law firms are a major component, have built-in structural weaknesses that make them particularly vulnerable to a “run on the bank” scenario.
Despite the COVID-19 pandemic and the 'Great Resignation' that followed as a socioeconomic ramification, it’s not a lack of work that causes partnership instability. Many firms are designed for balance in such a way that they are, if not recession proof, at least able to weather the storm.
Counter-cyclical practices, most notably bankruptcy and restructuring, are a feature of basically every large scale firm. When the transactional and securities market slows down, these practices heat up. Other types of legal work, such as litigation and labor & employment, have plenty of work once cutbacks take place.
But law practices are movable shops - There is no heavy equipment or prime location. Firms’ successes are not based on pre existing patents that can be monetized. Instead, law firms rise and fall on the intellectual capabilities of their partners.
The individual lawyers themselves, and their own proven legal acumen, is what keeps clients coming in and paying the bills.
One result of this skill-based income stream is that lawyers are constantly jumping ship, moving from one firm to another to get the best deal for their services. Every law firm spends a significant amount of time and money on the lateral marketplace and ensuring that they have a team of top attorneys.
Because this is the basis of a law firm’s value, and because the attorneys’ money comes directly from their own billing that is distributed in draws throughout the year, law firms do not have large cash reserves sitting around. Partners have to pay into the firm when they join or are promoted to partnership, but they too do not want money sitting around in long-term holdings.
The accounting model is therefore a simple, but potentially quite risky one.
Unlike public companies, who can go to the marketplace for cash, firms borrow from banks to cover when they're short. Most of the time, this is not a problem. But if the firm starts having bad quarters, or begins to lose big name partners, they may not have enough cash on hand. At that point, partners may start to see the writing on the wall and flee the firm, starting a death spiral.
We’ve seen this exact situation play out, with many firms, and senior partners who have the most money in and the most to lose — having the easiest time jumping ship — They are always on the lookout for signs that their own firms are not doing well.
Firms have taken steps since the 2008 collapse to avoid these problems. According to reports from Citi Private Bank Law Firm Group, the available credit for an average firm is now $135 Million, up from $70 million in 2007. They’ve also reduced their debt and more than doubled the capital buying in requirements for partners.
These are welcome steps for firms, but for younger partners and senior associates, the dangers are still evident. These attorneys will be the last to know of a lateral run from big name partners. And, especially if they’ve just bought-in, they are probably the ones who can least afford the price of a collapse. Many junior partners actually need to take out loans to pay-in for their chance to attain the rank of partner.
These attorneys have faced criticism for lacking loyalty and being willing to jump ship once a better deal comes along. But the history of firm collapses and the dangers of over-leveraged law firms, especially during a recession, should give any junior partner pause.
Now is the time to consider your options, before the bank run starts.