Profit Distribution, an eternal discussion
Updated: Sep 21, 2020
On 10 September, Thursday last week, at 8:15pm (CET) my inbox bleeped with breaking news: “Elite Wall Street Firm Davis Polk Moves to Modified Lockstep Pay”. Within hours I got a request from a Law360 reporter to comment on Davis Polk’s announcement. (you can find the subsequent article here). It is quite surprising how much media frenzy emerged from such a simple message. Some commentators even went as far as declaring the ‘Lockstep model’ dead. For me, I certainly am not one of them.
Basically there are two main systems for profit distribution among law firms. One is merit based and thus a partner’s profit share is closely tied to that partner’s individual commercial performance. The other system is based on seniority. The best known example of the latter is the so called ‘Lockstep’ system where partners progress over several years on a ladder with the profit share increasing by a fixed percentage at each step.
Both principal profit distribution models have their own distinct advantages and disadvantages. The merit based model allows for much more spread between the best performing partner an the one at the bottom. Commercial success is immediately rewarded and star partners remain happy. One of the principal disadvantages of a merit based system is that cooperation between partners does not come naturally. That is why most ‘eat what you kill’ law firms have adopted complex ‘origination credits’ systems that create a direct financial incentive for partners to cooperate. Since a merit based systems allows for a much wider bandwidth, it also allows for much greater variation in quality and reputation between partners and practices.
So if ‘eat what you kill’ is not the holy grail, perhaps the ‘lockstep’ is? One clear advantage of the seniority based model is that there is no need to introduce complex financial incentives to have partners cooperate on matters and clients. Since personal performance is not determining an individual partner’s profit share, there is no hurdle to work on another partner’s matter. Typically in a ‘lockstep’ model there is more pressure on all partners meeting the same quality standards both legally and commercially. That is one of the reasons that traditionally the elite firms have (had) a lockstep model. So why did Davis Polk break rank?
Money, money, money (Abba)
The business of law is first and foremost peoples’ business. Being an outstanding lawyer is less about technical academic skills, than it is about human skills. This is different from other academic professions such as in mathematics, physics and chemistry, where technical skills are far more important than personal skills. Being a lawyer is not so much about excellent knowledge of the law, but about strategy, negotiation skills, empathy, creativity and more. For many areas of specialization a lawyer's knowledge of ‘best market practice’ is more valuable than detailed knowledge of the law. Not every lawyer, regardless how smart, has the talent to become a legal superstar. The qualities needed are quite rare.
The legal world is not unlike the world of professional sports, where the team that manages to sign-on the best talent will likely become the winning team. Just look at how much some professional athletes make to understand the monetary value of extraordinary talent. Law firms have since long recognized this and there is a lively transfer market for lawyers. Just among the 200 largest law firms in the US, more than 3000 partners swap firm every year. Like in sports, talent is lured with vast sums of money to join another firm. Changing the compensations system to allow for disproportional rewards for the legal ‘superstars’ is often seen as a remedy against partners leaving or a prerequisite for persuading stars to join. These days there is a lively market and professional brokers are making a lot of money.
Guess what: it is not about the money
We have done detailed research and found that ‘making more money’ is rarely the prime driver for a partner to decide to join a new firm. Data shows that partners only start to be open to exploring a potential switch once they have started to lose faith in the strategy of their present firm or when they are experiencing personal issues with other partners. Lateral movers typically ‘move away from’ rather than ‘being attracted to’ (except in those rare instances when someone is offered the opportunity to move several tiers up and become partner at a firm that has much more prestige in the market).
If this is the case, where does the profit distribution system come into play? Before we dive into this, it is worth highlighting that two-thirds of all lateral partner moves ends in disappointment within two years. Disappointment either for the firm if the new partner fails to live up to the promise and/or for the partner who feels lonely and frustrated.
In the premier league of law, partners make a lot of money. Enough to own a second home with a heated pool. Earning more money on such levels does not have much added value. Looking at the table below*, you can see that there are only five firms that reportedly have a higher PEP than Davis Polk. Three of those are more or less in the same bracket and only Wachtell and Kirkland make over 10% more and my guess would be that this is exactly where the pain originated. Typically Davis Polk partners would consider Kirkland partners to be their peers and equal. PEP is seen as a yard-stick to measure against (a ‘pissing contest’). The thought of someone just as good as yourself to earn ‘considerably’ more can become unbearable and will invoke criticism on the management of the firm. This in turn can lead to dissatisfaction with the management and the strategy, leading to top-performers opening up to opportunities outside the firm (out of the top-6 Davis Polk also has the lower profit margin, which could corroborate any internal criticism; if Davis Polk would have had a 56% profit margin, their PEP would have been $5,054,000 and thus almost the same as Kirkland's)
As it comes to vulnerability against predators, do not solely focus on your partners. Take a close look at the most talented of the generation below. You might not want to lose today’s partner, you most certainly do not want to lose tomorrow's partner either. Cherish the talent, keep your talented associates happy. Both financially, development wise and future career path. More on this in a future article.
Update 16-09-2020: since publishing this article, Davis Polk and Milbank have announced their associates will receive a “special one-time bonus” ranging from $7.500 to $40.000, to be paid out by next month. Milbank is also giving top performers an additional bonus that is equal to 50% of their respective class bonus.
*source AML-all rights reserved