Pretend Your Firm Is an Investment Bank

Analogies are imperfect (that's why they're called analogies), but here's an interesting thought experiment tying together the wild rides investment banks have had on Wall Street during the past few weeks and the potential impact of the Legal Services Act in the UK, permitting law firms to go public and to take on public investors.

James Surowiecki, writing in the current New Yorker, talks knowingly about the repercussions of being a public company.

And he was writing before the most recent downward acrobatics occasioned by Congress' incomprehensible, profoundly irresponsible, self-serving, and altogether shocking rejection of the Treasury's rescue plan. Here at Adam Smith, Esq., we don't editorialize, but numerous analyses of the votes have shown that those congressional representatives facing contested elections voted overwhelmingly against while those with safe seats voted overwhelmingly in favor. You are at liberty to draw your own conclusions, but the word "courage" ought to be a part of your reflections.

Back to the repercussions of being public. Here's the intro:

Before the government stepped in last week, the bodies of financial institutions--Lehman Brothers, Merrill Lynch, and A.I.G., with Washington Mutual and even Morgan Stanley threatening to be next--were piling up so fast it seemed possible that Wall Street might simply cease to exist. The list of blunders that led to the carnage is by now familiar: firms succumbed to the frenzy of the housing bubble; relied on dubious mathematical models to manage risk; and leveraged bad bets with suicidal amounts of borrowed money. But the impact of these mistakes was made worse by a seemingly harmless decision that these companies made many years ago: the decision to go public. Doing so put the firms at the mercy of the stock market, and last week that mercy evaporated.

Once upon a time, investment banks were private firms, structured as partnerships, and relying on the capital provided by the partners in order to run their operations.

Sound familiar?

It only gets more so (interpolated text mine):

For Wall Street firms, going public was a deal with the devil, because it meant exposing themselves to what was, in effect, a minute-by-minute referendum, in the form of the stock price, on the health of their operations. This was fine as long as things were going well--the higher the stock price, the richer everyone got--but, once things started to go bad, that market referendum started to look like a vote of no confidence. And that made the problems that the companies were already facing much, much worse.

That's because the entire edifice of Wall Street is built on confidence. Investment banks [law firms] rely on short-term debt [people] to run their businesses, and their businesses consist of activities--trading, dealmaking, money management--that depend on people's faith in their ability to honor their obligations [continue to perform at impeccable levels]. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse [the firm will lose top talent], they become less willing to lend or to trade, and more likely to demand their money back [take business away]. The perception of weakness exacerbates the reality of weakness. And although there are myriad measures of a company's health, nothing looks scarier than a stock price that's heading toward zero.

About now you may be arguing that the "stock price" of a law firm should reflect more than the inchoate and indefinable notion of "confidence" in its ongoing power as a magnet for talent, that, after all, the firm has serious clients and a genuine accomplishments and a powerful partnership and a strong pipeline of associates and robust and reinforcing systems of professional development, recruitment, knowledge management, business development, and so forth.

Nice try.

The problem is that if the "stock price" of a law firm drops, it might well signal a drop in confidence in the firm's ongoing viability, whereas the drop in the stock price of most corporations which aren't entirely dependent on confidence per se signals only a drop in expectations for their near-term performance, not an existential questioning of their reason for being.

Thus concludes the article:

The downward spiral can be stunningly fast and near-impossible to escape. Lehman's assets were not significantly more toxic last Monday, when the company filed for bankruptcy protection, than they had been a week earlier. And, technically speaking, the bank may not even have run out of money, since it had access to an emergency liquidity line from the Federal Reserve. What Lehman did run out of was credibility. It couldn't remain a going concern because creditors and customers no longer trusted it. Why would they, when its stock price had fallen nearly eighty per cent in the previous week? The less faith the market had in the possibility of Lehman's survival, the more remote that possibility became.

This doesn't mean that stock prices don't reflect reality--Lehman's business really was in bad shape--or that Lehman would have survived had it been private. But being publicly traded makes it harder to take the long view and survive market storms. [...]

Considering that Wall Street firms spend all day dealing with the market, they have been slow to understand just how vulnerable they were to it. Companies like Lehman and, earlier, Bear Stearns saw going public as an excuse to take on more risk and act more recklessly, when in fact becoming a public company makes caution more important, since the margin for error is smaller, and the punishment for failure swifter. Now that the government has acted, Wall Street (or what remains of it) may yet be able to regain investors' confidence. But long-term survival really depends on remembering the fundamental truth about playing with other people's money: it's a lot of fun until they suddenly decide to ask for it back.

Am I counseling, then, against considering the possibility of going public or taking on material amounts of outside investment? No, I'm only counseling against doing so without considering the long-run repercussions of having to deal with (a) transparency and disclosure that outside investors will demand; and (b) the possibility--and the repercussions--of their yanking their money.

You have tools to fight the reality that being publicly traded makes you "vulnerable" and that it punishes reckless behavior more swiftly. For example?

One thing investors always favor is a stable revenue stream over a variable one. They prefer subscriptions to events, wealth management programs to brokerage commissions, leases to sales, and, in general, ongoing relationships to opportunistic and expedient windfalls.

Let's assume that going public is not within your sights at the moment: What do the preferences of investors have to tell you? Here are a few thoughts:

• Lateral partner acquisitions for revenue bumps are a losing game. This is buying market share, and what you buy is for sale to the highest bidder.
• Lateral partner acquisitions for increasing your firm's capabilities hold, to the contrary, potential promise. Skadden, for example, doesn't even ask lateral partners about their books of business; they only care about what potential partners can add to the firm's capability.
• Thinking of merging? Same analytics apply. Would it add capability or merely revenue?
• Or, approach it from the perspective of client relations: It's amply proven that the more practice groups within your firm a client utilizes, the more loyal that client is. Loyal clients provide more stable revenue streams than one-off clients. So cross-marketing is not just a nice thing, it could be vital to your long-run stability.
• Finally, don't permit partners (senior or otherwise) to hoard clients. Insist that they expose the clients broadly to other members of the team, making the client a client of the firm rather than the individual.

The vast majority of large, profitable, and growing US and global corporations are, of course, publicly held. So there must be something to that model.

But investment banks, and law firms, may be different. Pay attention.