A recent examination of major law firm failures showed how expansion and revenue gains can sometimes mask the struggles of law firms saddled by massive debt. Eventually, the debt load becomes too heavy, choking off growth and hastening collapse.

But industry watchers say law firms have become less reliant on bank debt over the past decade, as they explore other funding options. Often, that means raising capital from partners, or turning to other, less common sources.

Michael McKenney, managing director of Citi Private Bank's Law Firm Group, said "a deleveraging" has occurred at law firms since the Great Recession, when firm leaders started to reconsider how they funded operations and growth.

"The debt load carried by firms today is quite a bit different from the debt load that was carried by firms in 2008 and 2009," McKenney said, looking at a sample of 60 law firms in the Am Law 100, which does not include any firms that completed significant mergers or acquisitions in the past 10 years.

Among that sample, he said, bank debt per equity partner was $94,000 at the end of 2008. At the end of 2018, bank debt per equity partner was $57,000 at the same 60 firms.

But on the flip side, McKenney said, capital contributions per equity partner have jumped, from $330,000 in 2008 to $549,000 in 2018. The increase is due in part to law firms' success in recent years, he noted, as capital contributions are often taken as a percentage of a partner's earnings.

It's also not as risky as bank debt, McKenney said, because "the only way a call occurs on partner capital is if a partner leaves the partnership. Firms have become much more deliberate about how they respond when a partner leaves the firm."

Of course, under certain circumstances partners are taking on a good bit of risk, as shown by one recent example. At LeClairRyan, which announced its plans to close in August, sources said there were at least 50 partners who gave the firm up to $100,000 for an initial capital contribution and will likely never be repaid.

Legal industry consultant Brad Hildebrandt also noted that law firm lending banks include lending to individual partners, including funds for their initial capital contributions, but that has long been the case.

As McKenney noted, part of the shift toward partner contributions has been driven by overall strength in the economy in more recent years.

"Because profits have been pretty strong in the last three years, firms have been in a good position to call in capital from their partners," Hildebrandt said.

Meanwhile, some firms are holding back from distributing the fruits of a good year, using that as another source of capital, McKenney said. He said undistributed income represented about 11% of law firms' total assets in 2008. That has doubled to 22% in the decade since, he said.

On the whole law firms' changing attitudes surrounding debt is a good sign, McKenney said.

"In my view, firms have significantly improved their balance sheets. It leaves them more resilient in the event of a downturn than they were last time around," he said.

|

Lessons Learned

The recession was followed by half a dozen high-profile law firm collapses within just four years. In the aftermath, it became clear that some were carrying tens of millions of dollars of bank debt.

"Every time there's a major dissolution, people get nervous about debt because the banks tend to be tough about loan repayment," said Hildebrandt, who has been a trustee on a number of law firm dissolutions. Law firms willing to take on more debt are far fewer in number than they once were, he said.

"When you have a cataclysmic event like a financial crisis, there obviously were lessons learned," said Jay Benegal, a senior vice president and legal industry specialist at Citizens Commercial Banking.

Change is sometimes difficult to come by in the law firm environment, where decision-makers must get buy-in from numerous partner stakeholders, he said. But something like a recession can be an "impetus for change."

In recent years, that change has been a move away from borrowing. Law firms even use debt-free status as a way to attract lateral hires, Benegal noted. Bank debt has become "something firms think about after they've exhausted all their other options of satisfying their capital needs," Benegal said.

McKenney said some law firms found themselves in a bind during the Great Recession because of their reliance on demand lines of credit, or uncommitted credit. Under those agreements, lenders were able to call for repayment or refuse to lend further. More firms have shifted toward committed credit, McKenney said.

And, as Citi's numbers show, they're looking to other sources of capital, including partner contributions and undistributed income, he said.

Those options also include, simply enough, making a more continual year-round push for collections to keep cash flowing in the door, Benegal said. He said law firms have also become more open to selling their receivables, turning to litigation funding entities to make those deals, though they have not wanted to openly advertise that they're doing so.

Still, McKenney said he hasn't seen a great increase in selling receivables among law firms, and he would estimate that only a handful of Am Law 100 firms will be completing those transactions at year-end. He also cautioned that selling receivables one year may handicap firms in the next year, unless they know of other upcoming events that will fill the gap.

In general, McKenney said, firms are "much more favorably positioned" now than they were before the Great Recession.

"Firms are more profitable now than they were in the last recession," he said, and they're "much more thoughtful" about sources of capital.

At the same time, he cautioned that the fallout of any downturn still comes down to "a question of demand," and firms that see their hours drop are going to experience stress. With regard to lessons learned from the last recession, he said firm leaders must make transparency a priority and, when this happens, be "open and candid" with partners about the firm's performance.

"When I think about the law firm failures that occurred during the recession and post-recession, a lot of those failures occur because partners start to leave and it starts to spiral," he said. "In many of those firms, leadership was holding information very tightly, very closely. And, when the status of the firm became known, there's a flight."

|

Read More

Warning Signs: How Big Law's Greatest Failures Unfolded