It's no secret that major law firms are attractive anchor tenants for Class-A office properties. What too often is a secret is how to gauge the level of risk that they present as tenants.
Recent history shows that even established firms can fail. Pennie & Edmonds in New York; Hill & Barlow in Boston; Arter & Hadden in Cleveland; Altheimer & Gray in Chicago; Brobeck, Pfleger & Harrison in San Francisco; Bogle & Gates in Seattle — each of these went under with little or no warning, leaving a property owner waiting in line with other creditors, trying to recoup lost rental income.
Law firms are different from other businesses. First, law firms are notoriously private institutions. Property owners do not have access to the wealth of financial and operational data they have when considering other tenants. And they must learn how to filter what data they do have.
For example, average income per partner and other such data available in annual listings from various publications may not necessarily be standardized, audited information. That data is usually submitted voluntarily by the firms listed, or may even have been gathered from third-party sources.
Second, property owners, lenders or investors should understand that a law firm's financial condition is inherently fragile. Unlike many other businesses, which have a safety net of retained earnings to carry them through downturns, most law firms pay out virtually all profits to their partners each year. Further, many firms depend on a handful of key partners to generate a large percentage of business.
Art of due diligence
Because data concerning law firms is difficult to procure and analyze, many property developers, lenders or acquirers hire specialists to conduct due diligence on law firms. “Law firm consultants have credibility in the legal community,” says Greg Van Schaack, a senior vice president with Hines Interests, which recently developed three Class-A office properties anchored by large law firms in downtown Chicago. “They not only can gather accurate data, but also can sit down with a firm's managing partner to gain insight into the firm's strategy and direction.”
An experienced consultant will look at key ratios for a macro view of the firm's health. Net income as a percentage of revenue, rent expense as a percentage of revenue and the ratio of support staff to professional staff all are key benchmarks that the consultant can measure against current industry averages.
Trends also provide key insights into a firm's health. The firm's annual revenues and revenues per lawyer are key measures, as is the firm's debt. If revenues per lawyer are dropping while debt is increasing, the firm may be borrowing to artificially maintain partner earnings — a potentially dangerous move.
What is the firm doing to maintain or improve its profitability? Is the firm improving its cash flow by reducing the average age of its receivables? A firm can't collect fees that it hasn't billed. Is work-in-process — services performed but not yet billed — trending up or down? An upward trajectory points to inefficient billing practices.
A firm's retirement obligations are another key concern. Significant unfunded pension obligations can be a danger sign, particularly if much of the unfunded obligation is owed to partners nearing retirement.
Other red flags
Nor are financial issues the only risks. What is the firm's strategy? If the firm specializes in a particular area, how is it positioned to address business cycles? Are the firm's clients concentrated in one or a few industries? Is the firm growing organically or through mergers? Merging the cultures of two firms can be tricky, while rapid growth also may mean an increase in debt. Are the firm's compensation practices aligned with its strategy, or is the firm at risk of having key rainmakers lured away by competing firms?
“No single metric quantifies law firm risk,” emphasizes Todd Lundy, a managing director with RSM McGladrey and a long-time consultant to the legal community. “The key is to integrate the broad range of potential risks into a cohesive picture that allows all parties to effectively manage risk.”
A third-party report gives a clearer picture of the long-term strength of a large law firm as an anchor tenant and provides an increased level of comfort for investors and lenders evaluating properties.
Andre Lerman is a managing director with RSM McGladrey in Chicago and has consulted with major law firms nationwide.