How Did You Do in Northern California in 2000?

Nobody likes to be the weatherman when the forecast is for wind-driven freezing rain, and far be it from me to aspire to that dour post. 

But based on some indicators such as the Hildebrandt/Citigroup Private Bank March 2007 Client Advisory, which reports that "the compound annual growth rates (“CAGRs”) of revenue and profits per equity partner for the 2001-2005 period were 9.8 percent and 10.6 percent, respectively," it's only fair to ask how long these tail winds and this sunny environment can prevail.

It's time, in other words, to mention the dreaded "R" word: Recession. 

[Time out for a Favorite Economist Moment: Alfred Kahn, the NYU-educated Cornell Professor of economics who headed the late Civil Aviation Board under the Carter Administration, and who we have to thank—seriously—for airline deregulation, was called to testify before Congress at one point during his tenure and, anticipating that the Senators would stray afield from questions about the airline industry to questions about the parlous state of the OPEC-shocked, stagflating economy at the time, President Carter firmly instructed Kahn that "Under no circumstances can you say that we're in a recession."  When the inevitable question arose on the Hill, Kahn replied calmly that "I have been instructed not to say that we're experiencing a recession.  So I'll tell you that we're experiencing a banana."]

Which brings us back to the word I have not been enjoined from using. First, another extract from the Hildebrandt/Citigroup report:

"Looking ahead to 2007, we believe that law firm revenues will come close to reaching 2006 levels but that net income will be squeezed by increasing costs.  Although firms will continue to manage their expense budgets carefully, we believe that growing pressures for discounts, coupled with increases in “big ticket” expense items (including compensation costs), are likely to limit both revenue growth and improvements in profitability."

Now, as innumerable jokes have it, economists/the Dow Jones/the Fed have predicted 12 of the last 5 recessions, so I'm not about to advance a prediction, but I do know that cyclicality is still a characteristic of even our 21st-Century economy. [A reader now tells me the most credible source of the 12-for-5 quote is Paul Samuelson, whose tireless revisions of Economics instructed generations of Econ. 101 students.] This raises the question: What, if anything, is to be done to prepare for the inevitable?

The good news is that law firms have high variable and low fixed costs.  The bad news is that your assets are elevator assets?  Yes, but in bad times that's a blessing in disguise.   It can be, and will be if the time comes, terribly painful from a human, and humane, perspective to unload idle people, but such would be the imperatives of the market, especially if your competitors are doing the same. Understand:  I take no satisfaction whatsoever in this.  But I point it out as reality, and as the ineluctable responsibility of those of you who get paid the bucks to be in charge.

Short, indeed, of overly ambitious lease obligations or (quelle horreur!) outsized debt obligations, there's little reason a law firm should be fatally imperiled by a recession.

Still, don't there remain smart and not-smart ways to prepare?

Yes, but don't take my word for it. McKinsey has released a study this month of how, during good times, you can prepare your firm to not only survive, but to thrive following the upturn after the next recession.  As usual, McKinsey's data is exhaustive:  This time, they looked at 1,300 US companies across a broad range of industries and looked at how they fared during and after the 2000—2001 recession, identifying those who emerged with gains in industry leadership. 

And yes, while some of their findings, which are focused on industrial companies and banks, don't relate directly to the peculiar economics of law firms, we as a profession are built to reason by analogy, so let's proceed.

The key findings support the intuitively correct notion that the more flexibility your firm has going into the bad times, the more svelte your operations, the more diverse your offerings, the healthier you will emerge.

So how do we translate this industrial/bank-land advice into law firm land?

Lesson #1 is that balance sheet strength matters.  We've all seen this in the bloody post-dot-com experience of many firms in Northern California.  Those with large liabilities—Brobeck's lease obligations being the most notorious—had a tough time.  Those with lower debt obligations lived to tell the tale. 

But balance sheet strength is not just what lets you survive:  It's what enables you to thrive.  One phenomenon of a recession is that previously-valuable assets can get cheap, as distressed sellers multiply.  If you have the wherewithal to pick them up at a local minimum price, why wouldn't you?   The flip side of this, of course, is that you don't want to be a "distressed seller."  If you've larded up, you may fit just that description.

#2, "operational flexibility," with the focus on "SG&A" expenses (selling, general, and administrative), has  a slightly different tale to tell.  In a law firm, the rough equivalent of SG&A is non-lawyer-related staff and associated overhead.  These costs are notoriously difficult to cut in the short run, unless you're already prepared. Ways to prepare include:

• outsourcing; and
• using a higher ratio of temps, contract workers, and part-timers to full-time full-benefits people.

The problem is that to prepare the groundwork in this fashion means you are substituting people whose primary allegiance lies outside your firm for people whose primary allegiance is (one can hope) to your firm.  A compromise that accommodates both goals of flexibility and loyalty may be to examine some lower-cost geographic regions within your firm's overall national or international footprint, and putting more "SG&A" expenses there.

#3, adjusting your mix of product and service offerings, may be the easiest for law firms to achieve.  If we're any good, we adapt to the economy and our clients' changing demands organically and continuously:  We just have to be more intense, focused, and relentless about it when times are tough.

How do you prepare for this?  Ideally, you want to have a geographically and substantively diversified practice before the downturn.   Then you will be able to see which clients with what precise legal needs are still spending—indeed, they could be spending even more.

Faithful readers of "Adam Smith, Esq." know that I'm a proponent of firms' placing an array of small, smart strategic bets rather than pushing out one or two enormous piles of chips into the center of the table.  (Northern California in the late 1990's, again, an historic phenomenon I will be eternally grateful to for its educational value.)

Two examples, both taken from the 2000-2001 downturn:

• Starbucks reacted not by discounting but by adding more services, such as Wi-Fi, the Starbucks card, and new products.  Result:  Same store sales growth continued virtually unabated.
• Verizon, like the rest of the telecom industry, was facing ever-declining revenue per minute of call:  From 27.5 cents in 1999 to 11 cents in 2003 (a 60% decrease in four years!). Nevertheless, they readjusted their services towards broadband, cellphone's, and value-added services, and their average revenue per subscriber (1999 index = 100) went from 100 in 1999 to 108 in 2003, while the industry finished that period at 100.

Am I forecasting a recession?   Harry Truman famously fumed that he needed someone to find him a "one-handed economist," exasperated with on the one hand, on the other hand prognostications.  And I myself have often found truth in the crack that if you laid all the economists in the world end to end, they wouldn't reach a conclusion.

But actually, I am decisively not forecasting a recession.  Still, we all know one lies in store sooner or later.  Will your firm be ready?