Tuesday, December 12, 2023

Party rock in the [law firm] tonight

I read this article from the Financial Times full of details about what is going on at major law firms due to the boom in private equity, especially at Kirkland & Ellis, one of the largest of the biglaw firms: "Kirkland & Ellis: is it party over for the world’s most profitable law firm?"

To summarize, Kirkland & Ellis successfully rode the boom in private equity to become a top law firm. As private equity ballooned (the article says that private equity holdings have increased by $7.83tn, or 1,350%), Kirkland made itself available as the leading law firm to advise on that type of transaction. Kirkland also benefited from a major cultural difference compared to other law firms. Kirkland operates more like an aggressive private equity fund, rewarding bringing business to the firm more than seniority, which typically determines who's at the top:

Unlike other, stuffier firms, if you are good enough you rise through the ranks fast rather than waiting for existing partners to retire or die, he adds. “It’s run like a business and not like a club. A lot of law firms are run like clubs.” 

Another longtime partner says the promotion prospects are “one of the unique things about Kirkland . . . you don’t have to wait until you are 60. You can be rewarded really early on and it can give you a sense of energy.”

Kirkland was a kind of pioneer of the junior, non-equity partner status that has been a big driver of the success of its business. Law firms and other professional services companies initially began as partnerships, meaning that the profits of the firm were shared amongst the partners equally. Now, non-equity partners get the fancy title, the responsibilities, and the abilities to act as a partner to clients, but without the benefits. It is not like this has gone poorly for lawyers: "On Wall Street, Lawyers Make More Than Bankers Now." But it has shaved off some of the prestige of AmLaw 100 firms. 

Associates at law firms are generally expected to bill at least 2,000 hours per year. Partners get to relax, and focus on massaging client relationships. But it seems that at Kirkland, they figured out that if they give junior partners some status, they will work their way to the top, and bring in major revenue on their way. One partner they hired has a reputation for billing 3,000 hours a year1

One thing I learned is that it is totally okay for lawyers to co-invest on deals that they advise. This sounds ridiculous, if you were hiring an accountancy, it would be against the law for them to be conflicted in such a way. But lawyers aren't accountants, at times, they are their clients deepest confidante. Lawyers should be close to their customers, at least from the perspective of making money.

Another thing is that a law firm like Kirkland, because of its massive scale, can take advantage of information asymmetry to write contracts that benefit their clients. Lawyers who advise on deals define the terms of the deal that both parties will agree to. One side proposes a set of terms, they send it over, and the other side's lawyers give their counterproposal. It goes back and forth until they settle on something they like. But when you are a law firm, you don't propose your terms from scratch each time. You take the terms from your last successful deal, then send them into here. Matt Levine of Money Stuff said they take the terms from last time, make them more aggressive, and debate ensues. 

But for many terms in the contract, the main argument will be: “This term is market.”[5] “Market” means that it is the normal way that these sorts of deals are done by sophisticated parties with sophisticated lawyers. “Market” is a sort of efficient-market argument. It means “a lot of smart people have argued over this term from first principles, they have thought about what is fair and what is in everyone’s best interests, and their collective conclusion is that the provision should be written this way. So who are you to argue for something different?” If there have been 50 private equity leveraged buyouts in the last three years, and 48 of them had a cap on damages for non-performance, then that’s “market” and it is hard — not impossible, but hard — for the target to argue that there should be no damages cap.

But Levine and the FT article explain that when you are the market, you can decide what "market" is. Kirkland even has data scientists analyzing legal terms. Many deals are private, so as a third party you have no idea what the terms are. Kirkland can decide that some terms are "market," just kind of on their own:

It uses this data to get better terms for its own clients, making life difficult for less well-resourced investors such as public pension plans. “They have the largest market share,” says the head of private equity at a large US public pension plan. “They will pick a few terms each year and insist they are [the] market”, rolling them out across most of the private equity funds they advise.

It's great marketing for Kirkland. "Come to us, we advise such a large share of deals that we have shrouded information on what these deals look like to other parties, and we use that information to your advantage. Also, pay us more!" It sounds a bit immoral, but it is so far legal. 

Professional services is a very interesting place for information asymmetry to play a big role in market dynamics. Information asymmetry shows up in consumer-facing industries frequently. Healthcare insurance firms know significantly more about healthcare than insurance customers, and use that to their advantage. Used car dealers know a lot more about used cars than a used car buyer, and use that to their advantage. This is called the lemons problem, and it shows up in a lot of places. The effects on information asymmetry on the legal industry and on private equity don't seem to me like a perfect port of the lemons problem, but they are interesting. 

I think that some may look at the legal industry, and say that using your knowledge of deal terms to the advantage of your clients and the disadvantage of the other parties is bad for private markets and bad for the economy. Therefore, we must regulate legal advisory in order to tamp these adverse effects. Private equity probably won't do this, because they are not fans of regulation. But I think there is an argument to be made here. 

1 I read on the internet that about 90% of hours are billable. Counting vacation, 2,000 hours would be 47 hours a week. 3,000 hours is 70 hours a week.