Enlightened tradition

I am intrigued by what the future historian will make of the economic and commercial change we are currently experiencing. Will this be another ‘world turned upside down’ moment, or just a blip in the continuum? Over the past couple of days, I have read a few commentaries suggesting that law firms at least are facing real upheaval. They also start to indicate what the way out might look like.

First, a couple of last month’s posts from Bruce MacEwen. It is trite to point out that the supply side of law firm economics is notoriously fickle: Bruce links the problem to change on the demand side.

Imagine for a moment you are in charge of designing the balance sheet of one of these firms (or any sophisticated law firm regardless of location and absolute size).  As you examine what role debt should play, perhaps the first question that should come to mind is “what assets do we have on the other side of the ledger, against those hypothetical liabilities?”  And the answer is:  Elevator assets.  That’s it, folks.  Your firm’s primary and only meaningful asset is its talent:  Its human capital, a/k/a its people.

And on the other side of the ledger?

What about accounts receivable, a pledgeable asset since the Peruzzi and Medici families in medieval Tuscany, if not before?  Normally, a law firm’s accounts receivable are a highly reliable credit—one with something approaching the creditworthiness of the firm’s clients themselves.  But consider:

• Discounts and writeoffs are more widespread than at any time since I entered the practice;
• Realization is systemically lower than at any time in memory (by “systemically” I mean industry-wide, not firm-specific);
• And, most importantly, if a firm’s partners and/or clients begin to lose confidence in the firm, receivables decline in value abruptly and often irretrievably.

In sum:

Fundamentally, building long-term debt on to the balance sheet of an enterprise whose only material assets are readily marketable and freely mobile human beings is to repeat the classic mistake of the institutions at the core of virtually every post-World War II financial crisis in the United States: It’s to create a timing mismatch.

That is to say, firms doing this are securing long duration liabilities with short duration assets. Should anything imperil the value of the short-term assets, the roof can cave in before you can evacuate the building.

How can law firms protect themselves against this problem? In a later post, Bruce hints at the traditional way they have done this — by trying not to scare the troops.

Imagine a firm that allocates its talent, investment, and management focus consistently every year, making incremental changes but following the same “steady as she goes” broad pattern year after year.  Imagine another firm that consistently evaluates the performance of practice areas and offices over time and adjusts the allocation of lawyers and other resources based on relative market opportunities (be they expanding or shrinking).

Which would you guess is going to perform better over some suitably extended timeframe?

And which model do you think most law firms actually resemble?

The answer is that most law firms favour the ‘steady as you go’ approach, which is also the one in which performance is more muted. This reflects research done by McKinsey into successful strategy in corporate America.

McKinsey sums up the results this way:

• Companies that reallocated more resources—the top third of our sample, shifting an average of 56 percent of capital across business units over the entire 15-year period—earned, on average, 30 percent higher total returns to shareholders (TRS) annually than companies in the bottom third of the sample. This result was surprisingly consistent across all sectors of the economy. It seems that when companies disproportionately invest in value-creating businesses, they generate a mutually reinforcing cycle of growth and further investment options.
• Consistent and incremental reallocation levels diminished the variance of returns over the long term.
• A company in the top third of reallocators was, on average, 13 percent more likely to avoid acquisition or bankruptcy than low reallocators.
• Over an average six-year tenure, chief executives who reallocated less than their peers did in the first three years on the job were significantly more likely than their more active peers to be removed in years four through six.

In other words, not only did “high capital reallocators” generate superior growth and returns, they did so (a) with lower volatility and risk, including lower risk of bankruptcy or acquisition; and (b) with less managerial turnover.

Bruce suggests that this process of constant review of profitable and unprofitable activities is something that law firms need to start to emulate. Unfortunately, that process will affect the firm’s position in the market for lawyers. It therefore needs to be matched with real attractiveness in the firm itself. Businesses like Google or Apple routinely drop products or service lines if they aren’t working out. Inevitably this will induce a sense of volatility (and nervousness) in their people: will I still have a job tomorrow? But Apple and Google are still places where people really want to work. The law firm that can create the same sense of positive nervous energy must surely have a winning ticket.

So what might that winning ticket look like? Two unrelated posts elsewhere provide some clues.

First, Robyn Bolton of Innosight, writing in an HBR blog post:

Here’s a quick quiz for you. Is it easier to get

A: 1% of a huge, established market?
or
B: 100% of a completely new one?

If you work for Apple, you might have picked B. But too often when companies embark on innovation projects, they pick A: that is, they start by believing that nothing could be easier than to capture a small chunk of a very big, existing market.

But to unleash the power of innovation to capture big markets, what matters is not how big any existing market is but how many people are wrestling with some problem that no current offering really solves, what we here at Innosight call the “important and unsatisfied jobs” of consumers — and non-consumers. When sizing an innovation opportunity, what you should be looking for are jobs what are widely held and currently poorly served, not lots of people who haven’t bought your own products yet.

I suspect that many firms concentrate too much on one or both of (a) their own internal issues or (b) resolving the problems that clients bring to them. Robyn shows how this can go wrong by examining what happened when Kellogg first tried to enter the Indian market.

Kellogg invested $65 million in establishing an operational and marketing presence to launch Corn Flakes, Wheat Flakes, and its “innovation” — Basmati Rice Flakes — throughout the country. “Our only rivals,” declared the managing director of Kellogg India, “are traditional Indian foods like idlis and vadas.”

Things didn’t turn out quite as planned.

How is it possible that Kellogg could envision building a $3 billion business in India, invest $65 million in the first year alone, and end up, 16 years later, with only $70 million in annual revenues? And how can other business leaders avoid making similar mistakes?

Kellogg’s mistake (admittedly easier to see in hindsight) was that it had taken a far too simplistic approach to identifying its “huge” market, merely looking for people who might want its products.

Essentially, the cereal company failed to understand that Indians culture favoured warm breakfasts, so a cereal served with cold milk was unlikely to be more than a niche product. They also struggled with pricing: starting from a base that was 33% higher than the domestic competitors. Better insight into the needs of Indian consumers might have led Kellogg to create versions of traditional foods that could be stored and prepared more easily.

Law firms could therefore improve their product by really getting to the heart of what their clients need to achieve — not the explicit needs, such as getting this deal done or settling this litigation, but the more important unspoken ones. What is the client’s market like? What pressures are there on profitability, costs, income, competition, regulation? What would help the business to meet those pressures?

Alongside this focus on the product (what the firm does), there is also a need to look at delivery (how it does what it does). This is something that Ron Friedmann examines in his most recent post.

Only a few firms will continue to win business on the strength of their name. The rest must provide clients with better service delivery to keep and win business. That means understanding client expectations and changing how how lawyers practice and the firm operates, for example, with alternative fee arrangements, process improvement, project management, KM, technology, new approaches to resource allocation, a better approach to staff support, value-add services (e.g., private content), and tailored business intelligence.

Ron’s post summarises three items from elsewhere, all of which point in the same direction: “firms must change how they deliver services.”

Let’s go back to where we started: the problem of elevator assets. Bruce MacEwen lists 26 law firms that are located within a 7 minutes walk of each other in New York. The point he makes is that this proximity could make movement between the firms a trivial matter. But that is only true (putting aside constants like the hiring process) if each of those 26 firms is practically indistinguishable — whether to its lawyers or to its clients. As soon as one firm stands out (as Google or Apple do in their markets), joining or leaving that firm is a much more significant step. The fear that constant change and improvement may bring could actually make the firm more attractive to join and more difficult to leave voluntarily.