Hedging Your Bet: Dealing with the Risks of Dominance

Among lessons learned by law firms from the recession is the danger of having too much of their revenue dependent upon a few dominant practice areas.  Firms with large transactional, real estate, environmental, bankruptcy and other cyclical practices find that factors beyond their control can cause peaks and valleys in the demand for their services.  But the price some firms pay to hedge against changes in demand may be greater than the risk from which they are attempting to protect themselves.

Uncontrollable economic or political forces have a significant effect on some legal practice areas.   While those forces are, in large measure, cyclical, the timing of downturns is generally unpredictable.  The most obvious cyclical force is an economic recession that decreases the demand for legal services, typically because it disrupts industries that law firms serve.  The two most recent recessions, affecting the technology sector in 2002 and the real estate and banking sectors in 2008-2009 are examples of how industry problems cascade to impact the entire economy.

A more subtle cyclical impact on legal practices is related to political factors that may be entirely unrelated to the economy.  Political cycles are based on government policies, international affairs, natural disasters and a variety of factors that impact the demand for antitrust, environmental, energy, white-collar crime, government investigations and a host of regulatory practices.  But, because political cycles tend to be more isolated to specialized practices they tend to have less of an impact on entire law firms or the legal industry as a whole.

Traditionally law firms have taken the cyclical nature of the practice of law for granted as an economic fact of life.  This is largely because general practice firms enjoy a natural hedge through their balanced practice areas.  Certain practices are by their nature counter cyclical.  Bankruptcy, Labor and Employment and Government related practices tend to flourish when economically cyclical practices face a downturn.  Other practices like Health Care, Insurance and Intellectual Property are effectively non-cyclical because demand for practice services is relatively inelastic to the economy.

The combination of counter cyclical and non-cyclical practices made law firms pretty well bullet proof – or so they thought.  Then came the most recent recession and firms were called upon to lay off associates and staff, deeply cut overhead costs and really address underperforming partners, in order to minimize catastrophic hits to profitability levels.  The result is that firms, particularly boutiques and multi-specialty firms (as opposed for full-service firms), are, for the first time, actively looking at purposely hedging against economic and political cycles.

In large measure this is like diversifying an investment portfolio.  Being fully invested in equities puts the investor’s capital at risk in a cyclical down

turn.  However, bonds, which are less elastic to the economy, earn smaller returns in strong economic periods.  The loss of earnings is the price of the hedge against capital loss and, the greater the hedge, the higher the cost in terms of lost earnings.

There are two things that law firms should be consider when looking at practice diversification.  First, firms should be careful not to over react to the past couple of years.   As the chart below shows, the past recession represents an abnormal decrease in gross domestic product, the indicator that most closely tracks to changes in spending for legal services.  While, the past is, of course, not a predictor of future economic growth, it is clear that economic downturns come in cycles that are typically at least six or seven years apart.  But perhaps most importantly, creating diversification in a law firm is not necessarily a zero sum game.  Creating practice hedges does not require that a firm reduce profitable practices that flourish during economic growth cycles.

Perhaps the best advice for firms that were badly stung during the recession is not to be so careful in building hedges against cyclical downturns that they miss profitable growth opportunities in their practice areas of strength.  To protect against any economic downturn means perpetually underachieving the firm’s profit potential.  The secret is creating a risk awareness that balances risk with potential rewards.