Joseph Schumpeter famously proclaimed that capitalism works through "creative destruction," as its institutions are periodically torn apart and reshaped. See Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (1942). We last saw such a wave of destruction in the 1980s-1990s, when takeovers downsized and pruned the conglomerate. Large law firms are also very capitalistic institutions and may be about to face a similar wave of change and disruption.

Two seemingly inconsistent trends now characterize the environment of the largest U.S. law firms: First, law firm mergers are peaking, but, second, the number of equity partners is either stagnating or has actually declined. According to the latest annual survey of the 500 largest firms by the National Law Journal, the number of attorneys in the 500 largest U.S. law firms is growing only modestly (2.5% in 2018, after only 1% in 2017). But growth in number of partners in these firms has stalled. The most recent NLJ survey shows that the number of partners rose by only 1% in 2018, and this number was inflated by a 3.8% growth in the number of non-equity partners. In short, the number of equity partners probably declined as the result of both law firm mergers and "de-equitization" programs at some firms.

Yet, the very largest firms continue to grow by mergers and acquisitions. Over the last three years, Altman Weil reports that the number of law firm mergers increased from 85 in 2016, to 102 in 2017, and to 106 in 2018. Although 2019 started modestly, it ended with a double bang, as Drinker, Biddle & Reath and Faegre Baker Daniels announced a "merger of equals" that will produce a 1,300 lawyer firm, and Pepper Hamilton and Troutman Sanders announced an intent to merge that will produce a 1,000 plus lawyer firm. Both mergers will produce new Top 50 firms, but both also reveal the same pattern: a firm that wanted to expand its reach is taking over a more troubled firm that has lost partners or revenue.

Still, the biggest merger news of 2019 was a transaction that did not happen. O'Melveny & Myers and Allen & Overy had announced that they were planning a transaction, but called it off because of "macro-economic uncertainties" (which may be shorthand for Brexit). This would have been the largest such law firm merger to date. Although its cancellation reminds us that it is difficult to marry mature, healthy firms, it also demonstrates that some strong forces are driving this merger market if successful firms are willing to consider such a disruptive change.

If one firm shows the full dimensions of this transition, it is probably Kirkland & Ellis, which grew by 310 lawyers in 2018, thereby accounting by itself for 7.4% of the entire growth of the NLJ 500 in 2018. As later discussed, Kirkland seems to have led all firms in making lateral acquisitions of individual partners or groups of partners. It also leads other firms in having the largest number of non-equity partners (560 according to the Wall Street Journal, a number that dwarfs that of its equity partners). Its internal structure reflects a new, but problematic, business model that appears to be working for it (and is being copied by others).

This column will examine in quick succession: (1) how the old order is changing; (2) the forces that appear to be driving law firm mergers; (3) why some firms have remained aloof and distant from this process; and (4) the hidden impact on equality within the firm. Law firms once thought of themselves as "bands of brothers"—tight-knit, loyal, and supportive. Those characteristics may be the real casualty in this transition. Here, one statistic stands out: According to the Wall Street Journal, in 2000, 78% of law partners held an equity interest in their firm, but by 2018, this percentage had fallen to 56%. Today, the percentage of equity partners may have fallen below 50% of all partners. For example, the NLJ 500 Survey shows that the median firm in its survey had 339 lawyers as of the end of 2018, and 91 were equity partners and 152 were associates. That leaves a balance of 96 lawyers who were neither equity partners nor associates and probably should be called non-equity partners. Predictably, this decline will continue and, in the foreseeably near future, large law firms may have only a much smaller percentage (maybe one third) composed of equity partners. With the rise of the non-equity partner and the rise of the "mega-firm", the "band of brothers" model for law firms is quickly dying. As later discussed, those most adversely affect by this transition will likely be female lawyers.

The Old Order Crumbleth

For probably a century or longer, large law firms (which used to be rare) followed a business model known to many as the "Cravath System." Its key elements were:

(1) The firm would recruit young lawyers from the best schools based principally on their law school record;

(2) After a probationary period (extending from 7 to 10 years), a few (and usually a very few) would be made partner, and the rest would be expected to find work elsewhere—in effect, an "up or out" pattern was mandated;

(3) Partners would not be hired laterally, no matter how great their ability or book of business;

(4) To maintain equality and democracy within the firm, compensation of partners would be in lockstep, without regard to the revenues generated by the partner.

Academic theorists have sought to generalize this "up or out" pattern into a more formal model. The best known of these models, developed by Professors Marc S. Galanter and Thomas M. Palay, is the "tournament of champions model." See Marc S. Galanter and Thomas B. Palay, TOURNAMENT OF LAWYERS: The Transformation of the Big Law Firm (1991). This model assumes that the firm implicitly promises to award partnerships to the winners of its competition as a means of incentivizing the firm's associates to work harder. This author has always been skeptical of this model because it is a supply-driven model (rather than a demand-driven one), and there is little hard evidence that firms truly live up to this implicit contract (especially in economically bad times). But the rise in non-equity partners and the decline in equity partnerships substantially refutes this model. Although non-equity partners can eventually become equity partners, the "tournament" has now been stretched out for a generation, and that will not incentivize many.

The even greater vulnerability of the Cravath System is its lockstep compensation system, which exposed it to other firms that used an "eat-what-you-kill" system of compensation (or a "merit-based" system, to be less pejorative) that enabled such predator firms to entice away those partners who generated well above average revenues that were not reflected in their compensation. In effect, an aggressive firm could "cherry pick" the most successful partners from a firm that relied on lockstep compensation. This has been happening for well over a decade, but it was only a serious threat to the top tier firm if an equivalent firm would adopt this strategy and apply it on a significant scale. Over the last two years, this has happened—and recurrently. For example, "star" partners have recently left Cravath for Paul, Weiss and Kirkland & Ellis, reportedly for compensation of up to $10 million a year for a guaranteed period. But the real shocker in 2019 was Freshfields Bruckhaus Deringer's hiring of a team of M&A partners (and associates) from Cleary Gottlieb Steen & Hamilton (which also used a lockstep compensation model). Freshfields, a member of the U.K.'s "magic circle, is clearly a top flight firm (as are Cleary, Paul, Weiss and K&E), but Freshfields was hiring a whole team—and in effect buying a book of business. When Cleary terminated abruptly the partners so hired, the hard feelings were clear. With the possible exception of Cravath and maybe a few other off-line firms, it seems doubtful that an inflexible system of lockstep compensation will survive much longer at any major firm.

What Best Explains Robust Merger Activity?

When business corporations merge, the dominant rationale is usually hoped for synergies and/or increased market share. Particularly in consolidating industries, increased market share tends to imply higher prices and profits. But this goal cannot explain law firm mergers. Synergies, while conceivable, are rare when two firms of equal size enter into an alleged merger of equals, and gains in market share are trivial, given the highly competitive and fragmented nature of the legal market. Once, the goal may have been economies of scale, but these are usually fully realized at levels well below 400 lawyers. By that level, a large law firm can afford the best IT system it needs and can hire all the professional marketing and public relations staff it wants.

So what can better explain high merger activity among law firms? Why don't ambitious, expansion-oriented firms simply buy away "star" partners, rather than acquire the whole firm (all of whose components may not be as attractive)? One plausible answer is globalization. Large international corporate clients may want a law firm that can advance their interests on every continent and has politically savvy lawyers in every world capital. The world's largest law firm is Dentons with approximately 11,000 lawyers, and each year it makes several acquisitions of law firms around the globe, often in far flung regions, such as New Zealand, Africa, and South America (as well as in the United States). In the United States, Dentons has indicated that it plans to open an office in each of the United States's 20 largest markets and would like to be based ultimately in the 100 largest U.S. markets. The rhetoric that it and other firms use to describe their strategy is that they want to offer "one stop shopping" to their clients—in effect, a firm that can advise them on political access and local custom around the world.

On the domestic level, another plausible answer is that acquisitions may be an attempt to acquire a platform in an important market. Both the Faegre and Troutman firms have acquired bases in the Northeast, which were previously beyond their effective reach. Viewed in terms of theory, this is a strategy of seeking to realize not economies of scale, but economies of scope. To be sure, a client could seek to find on its own the best counsel in each of these localities, but clients probably find it difficult to evaluate counsel (particularly foreign counsel) and may believe that a recognized law firm will have expert counsel in all its offices.

Of course, the alternative strategy is for a top tier firm to open its own offices across a broad terrain. In the 1990s, firms such as Skadden, Arps and Jones Day did this across the United States, opening branches in many cities. This also is an attempt to realize economics of scope (but without making acquisitions). Branching may, however, be a much harder strategy to employ overseas where the U.S firm has little knowledge of local law, custom or even the language. Nonetheless, the Magic Circle firms have successfully expanded in this fashion for 20 years, combining some acquisitions with much use of their own lawyers to expand internationally.

Why Do the Best Firms Hold Back?

Dentons may be the largest firm in the world, but no one to my knowledge has characterized it as the best. The largest U.S. firm is Baker McKenzie, and, while respected, it never appears near the top of the various lists of the most elite U.S. firms. Correspondingly, this author would be shocked if a Sullivan & Cromwell merged with another firm. Why? Not only would its strong culture not mesh well with another firm, but it would believe it was diluting its quality. Indeed, none of the most elite U.S. firms have yet merged (although some do make regular lateral acquisitions of partners).

Clearly, there are outliers. Cravath and Wachtell remain basically one office firms, and so does Slaughter and May in London. They believe they can attract the best clients based on a reputation that they can communicate internationally without having to open costly local offices (or risk dilution of quality). Who is right? Time will tell.

What Are the Hidden Costs of Law Firm Mergers?

Here is a hypothesis: Those firms that are expanding the most (either internationally or domestically) have higher ratios of non-equity partners. Conversely, the most elite U.S. law firms generally have no (or few) non-equity partners. Of course, this is partially a cultural phenomenon as the major New York law firms simply do not have non-equity partners (although they may use the term "of counsel" for some associates who have been promoted to a sub-partner status).

The use of non-equity partners is a means of leveraging the firm, retaining more profit for the firm's residual equity owners. In effect, the top of the pyramid is declining to share the residual returns with the middle. Should we care that law firms are using more leverage—in effect, giving up on the ideal of a "band of brothers" in favor of a small team of highly motivated entrepreneurs? Arguably, this is similar to what private equity firms (such as Kohlberg Kravis Roberts) have long done.

As usual, the answer depends on whose ox is gored. The clearest loser in this transition to "mega firms" with few general partners may be the female attorney: Looking at the statistics recently compiled by the ABA's Commission on Women, one finds that women received 50% of the JDs recently awarded in the U.S., and they constitute approximately 46% of all associates in law firms. Next, they constitute 22.7% of partners, but only 19% of equity partners. Disproportionately, they are thus becoming non-equity partners.

Is that discriminatory? Conceivably, there are women who might prefer to be a non-equity partner (and make less) if it gave them more time to undertake family and child-rearing responsibilities that still fall disproportionately on them. But that description does not fit all women, and those that are not happy with this system seem likely to eventually file sex discrimination class actions.

Conclusion

It is not just that law firms are splitting the pie differently than in the past; rather, we are witnessing a transition—for better or worse—from the old "Cravath model" to the new "K&E model," which runs not as a "band of brothers," but as a small team of entrepreneurs. How will these firms profit? There seem to be three potential sources of profit:

(1) Economies of Scope. Denton's focus on offering "one-stop shopping" illustrates this approach, as the client now has immediate access without search to qualified lawyers in every market it will conceivably enter or deal with. The law firm in effect certifies local lawyers as qualified;

(2) Gains from Arbitrage. If the acquiring firm can identify a partner elsewhere with a $25 million "book of business" who is only being paid $3 million under lockstep compensation, it can offer this partner $5 million per year and reap an easy gain. How much longer this will be possible depends on how wedded to the lockstep system "old school" firms are;

(3) Gains from Leveraging. If a firm employs 100 non-equity partners at an average salary of $600,000 (and incurs another $400,000 per year to service them through rent, staff and resources) and if these non-equity partners average billings of $3 million per year, there are obvious gains here—at least until the better non-equity partners depart.

Of course, there are also costs associated with this transition. First is the loss of the egalitarian ethos of a "band of brothers" (and sisters). Some believe that the use of non-equity partners was a sly stratagem that enabled conservative law firms to appease and mollify critics by creating new female and minority partners (without significantly re-allocating the partnership's profits). Recent surveys show that minority attorneys tend to be made non-equity partners. Is this discriminatory? Opinions may vary, but to show discrimination, more evidence is probably needed (which this author has not seen), and such a theory is unlikely to apply uniformly to all firms.

In any event, can this new model persist? Some compensation experts doubt it, arguing that non-equity partners are insufficiently motivated, tend to work less hours than associates, and are not even fully utilized by their firms. See James D. Cotterman, "What Should Law Firms Do About Non-Equity Partnerships?" (Altman-Weil Inc. 2017). One analogy seems obvious: The institution of tenure has not made academia more efficient, but rather shelters some egregious non-performers at every institution. Thus, there are rival stories here: Either non-equity partners are being exploited or they are being inefficiently subsidized.

Whichever theory is preferred, one conclusion holds true: Law firm growth is increasingly linked to an internal redesign within the firm that implies greater inequality. With greater inequality may also come resentment, demoralization and perhaps litigation. Even if a Schumpeterian wave of creative destruction is coming, there may be ways to channel or soften this wave. A future column will suggest voluntary measures that individual firms could undertake. Complicating matters even further, this wave of change may soon intersect with another: artificial intelligence may reduce the demand for lawyers (as fewer will be able to do more). Given these challenges, what should individual firms do? This column does not suggest that firms should merge (or not merge) or create non-equity partners (or not do so). Predictably and properly, firms will follow different paths and reach different decisions. But they need to think things through, assess where the profit potential truly lies, and be conscious of the fuller implications of their choices. Many will, but at some firms, these issues will be repressed, with the result that the blind will once again lead the blind.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia University Law School.