Below are two beliefs I carried with me for many years.

  1. In all human endeavors, incentives exert a powerful effect on behavior
  2. Within the legal industry, the billable hour is the primary impediment to innovation and efficiency

efficiencyengines2Belief 1 still stands. But belief 2, which I viewed as a corollary of 1, recently fell like an oak tree. This shift in worldview happened during my research for Efficiency Engines, a story on rise of legal managed services.  During visits to several managed service facilities, I witnessed quantum leaps in legal productivity for relatively sophisticated legal work.  And in each case, the work was priced and sold by the hour.

The biggest value of visiting an innovator is the possibility of learning something that disconfirms one’s own belief system.  A character in a John le Carre novel once quipped,  “A desk is a dangerous place from which to view the world.” That’s good advice for those seeking to understand today’s legal industry.

A better theory

After the fall of belief 2, I needed a theory on innovation and efficiency that incorporated my new learning. Here is what I came up with:

The billable hour can be harnessed as a powerful tool for innovation and efficiency.  This can be accomplished by: (a) selling work with a clearly stated budget, (b) paying your workforce by the hour, and mostly crucially (c) managing quality and the risk of cost overruns through world-class project management and process improvement.  A service provider who reaches scale and establishes a brand based on both quality and price can lock-in a profitable business with a long-term competitive advantage.

In a nutshell, this is the business logic of the legal managed service model.  The private equity/venture capital crowd have found it sufficiently compelling to fund it with hundreds of millions of dollars.

This post (010) situates the managed service model within a more fundamental theory of professional service firms.  It also explains how the managed service model is successfully pulling on the levers of diffusion theory, particularly compatibility, to accelerate its growth. Cf. Post 008 (adoption more likely if innovation is compatible with existing practices and norms). Post 010 then offers a few thoughts on the adoption of managed service methods, which is something separate from the managed service business model. Regardless of who wins and who loses, the methodology pioneered by managed service providers represents an innovation that is diffusing throughout the legal industry.

Balancing three goals inside two markets

The fundamentals of the professional service business model are explained in David Maister’s Managing the Professional Service Firm (1993) (chapter 1).  As shown in the diagram below, firms operate in two markets: clients and talent. For the owners of the firm, profitability is certainly the ultimate goal. Yet, this outcome is entirely derivative of (a) providing outstanding service to clients (market 1), and (b) offering high-quality career opportunities to a talented workforce (market 2).  Thus, under Maister’s theory, the professional services firm is always balancing three goals in the context of two markets.

maistermarkets2

Although this model looks simple, it’s easy to get wrong.  Firms that fail to understand their own cost structure are at risk of substituting revenues for profits.  As recently observed by Bruce MacEwen, this is why so many firms overpay for lateral partners.  See Opinion: It’s time to re-think the price war on talent.  Likewise, in the client marketplace, the growth of national and international businesses has reduced the importance of client relationships based on geography and increased the importance of best-in-class talent in specialized areas. On some level, law firms know this because they have jettisoned the “general service” descriptions that were so common 20 years ago.  However, there remains considerable internal resistance to closing down out-of-scope practice areas and offices. Cf. Henderson, “How to Take Market Share,” American Lawyer (Oct. 2015) (discussing ruthless focus needed to become market leader based on quality).

Perhaps its obvious that the client marketplace has become differentiated. Yet, differentiation is also occurring in the legal talent market — a point I did not fully grasp until the belief 2 oak tree fell.  Beyond preferences based on practice area, some lawyers are drawn to BigLaw for reasons of money and prestige.  But other lawyers — with the same level of intellect and pedigree — are looking for a different type of work environment.

In the course of writing Efficiency Engines, I asked Jane Allen, Founder and Board Member of Counsel on Call, how the company selected its talent.  Jane described a behavioral interview process that focused on a profile very different than a BigLaw rainmaker:

  • Loves the technical aspects of law
  • Wants to be part of a team
  • Does not need to be in charge
  • Is comfortable learning new technology
  • Places a high value on work-life balance

In a large law firm, a lawyer who fits the above profile would likely be diverted to an “off-track” position. Yet, in a managed service firm, these same lawyers are the core building blocks of the business.

Using the billable hour to balance the legal talent market

The managed service model is tapping into the large segment of the legal talent market that wants work conditions very different from BigLaw.  At the top of the list is work-life balance.  In addition to a professional wage, a collegial work environment, and freedom from business development pressures, lawyers in the managed service sector can refuse work outside the bounds of a 40-hour workweek (or, in some cases, pre-negotiated shorter weeks).  Further, if the managed service firm needs additional hours, the lawyers are paid for their time. These constraints force managed service providers to build remarkably tight systems for project management and process improvement.

In large law firms, the incentives run in the opposite direction.  Once the firm locks in its labor costs in the form of high guaranteed salaries to associates, it benefits financially from hours that are billed during nights and weekends. Work that is unplanned, unpredictable and urgent is often the most profitable.  It is any wonder that firms would be reluctant to invest in technology and systems that would make client work more transparent and thus more manageable?  Some legal work will always be unplanned, unpredictable and urgent. But not all legal work. Clients are slowly figuring this out.

In all three of the managed service facilities I visited (Counsel on Call, United Lex, and Axiom Law), I encountered the same thing: lawyers who enjoyed working in a team-based environment where efficiency and innovation were valued.  Indeed, being part of a continuous improvement process appeared to be a key component of their job satisfaction. They enjoyed the challenge of exceeding their clients’ expectations. In turn, their employers benefited through higher volume that included a built-in profit margin.  Note the careful balancing of Maister’s three goals.

Leveraging cultural compatibility

One of the reasons that the legal managed service market is growing at 15-20% per year is that most managed service providers have packaged their offerings in a way that is culturally compatible for legal department clients.  As noted in Legal Evolution’s foundational posts, particularly Post 008, compatibility is an important driver of innovation diffusion.  When an innovation is highly compatible with a social system’s existing practices and norms, adopters can obtain the benefits while staying within their comfort zone.

In the managed service model, there are two major touchstones of compatibility.  First, the work is still being done or supervised by lawyers with large firm experience and strong academic qualifications — lawyers just like the in-house buyer. Second, and perhaps most crucially, the work is sold in billable hour units, which is the only system of measurement that all lawyers understand.  Pricing by the hour invites a direct cost and quality comparison with law firm associates, which casts the managed service provider in a very favorable light.

It near impossible to overemphasize the importance of cultural compatibility.  I have witnessed other highly innovative legal services providers who have refused to share the amount of lawyer effort needed to produce their outstanding work product. Instead, they hold to a pricing model based on terabytes of data or overall scope of work.  Most in-house lawyers lack the time and interest to get into the weeds of a cost and quality comparison.  An easier sell is pedigreed lawyers working by the hour in a process-driven environment.  Cf. Post 008 (discussing crucial importance of relying on the buyer’s rather than the innovator’s perspective).

NewLaw is not as new as we think

Managed service companies like Counsel on Call, Axiom, UnitedLex, Pangea3, and Elevate are often put into the NewLaw bucket.  I don’t dispute the categorization, except to point out that it’s our awareness of alternative models that is new, not the companies themselves.  Axiom and Counsel on Call both launched in 2000. Pangea3 was founded in 2004 and sold to Thomson Reuters in 2010.  UnitedLex opened in 2006.  Although Elevate is a relative newcomer (opening in 2011), its CEO, Liam Brown, founded another NewLaw company, Integreon, in 2001. Further, he began in the NewLaw space nearly 20 years ago, starting Conscium in 1998, which pioneered virtual deal rooms for lawyers and investment bankers.

Sally_crab_labelWhy does “new” takes so long in law?  Like the Galapagos Islands at the time of Charles Darwin’s landing, the legal sector operates in peculiar and isolated ecosystem that bears only a distant resemblance to the economic mainland. Under the ethics rules, lawyers can’t co-venture with professionals from other disciplines. If you can’t co-venture, opportunities to share knowledge, know-how, and perspective are inadequate for the challenges being faced. As noted in Post 008, this dramatically slows the diffusion of innovations within the legal social system.

Yet, let’s not confuse slow change with no change.  Very few lawyers appreciate the amount of outside investor money that has arrayed itself to profit from the inefficiencies of law firms. These capitalists are waiting longer than usual for their desired return (7-10 years are the usual outer limits for PE and VC investors).  However, they are also learning more about the legal industry and normalizing their involvement in the legal supply chain.

I first interviewed Mark Harris, founder and then CEO of Axiom Law, back in 2013.  At the time, I had the mindset that Harris was running a legal start-up.  But by then, Harris was 13 years in.  Axiom was less a start-up than an ultramarathon. (In late 2016, Harris became Axiom’s Executive Chairman, handing over the CEO reigns to Elena Donio, formerly President of Concur, a $1 billion business software company.)

The long game

During that 2013 interview, Harris laid out the long game analysis — the same analysis he was then using to sell services to Fortune 500 general counsel.

On a whiteboard, Harris drew a set of diagrams that segmented legal work into three groups: extraordinary events, experienced demand, and efficiency demand. In the past, corporate clients viewed virtually all legal work as risky and complex. Thus, they outsourced virtually everything to law firms. Over time, as in-house lawyers took over the role of buying legal services, they began unbundling legal work and insourcing some of it to themselves. This fueled the rapid growth of corporate legal departments. See Post 003 (showing the 20-year grow trajectory of in-house legal departments). In its early stages, this was pure labor arbitrage. Yet, as in-house lawyers develop more sophisticated sourcing strategies, Harris explained, the extraordinary events and experienced demand segments will shrink while the efficiency demand grows.  See diagrams below.

harrismarketsegments

A huge part of moving work from the top of the pyramid to the bottom is introducing systems and process that can partially supplant the clients’ deeply held faith in elite brands and credentials. This challenge is truly an ultramarathon, and only a handful of managed service providers are running it.  If Harris and his investors are correct, and they play the long game correctly, they will be among a relatively small number of competitors who divide up a large portion of the green triangle above.

How does this end?

One scenario is that extraordinary events work consolidates with a small number of firms that attract brain surgery-type talent. Think the Wall Street elite plus Latham, Kirkland, Gibson Dunn and a few others.   A tranche of complex and strategic work remains in-house. See Post 003 (reporting that more than 105,000 lawyers work in-house).  And a large portion of the remaining pyramid goes to large managed service providers who specialize in high-volume process work. These companies could go public or be owned by the BigFour accounting firms. Think Accenture. (See Efficiency Engines for how this is possible under the existing ethics rules.)

Yet, there are alternative scenarios that are likely to co-exist with the ambitions of the managed service sector. For example, it is likely that some US and UK law firms will emerge as global “general contractor” firms. They will earn a premium for their supply chain expertise, from captive LPOs to AI-enabled automation to high-stakes court room practice. Think Allen & Overy, Herbert Smith Freehills, Baker McKenzie, Hogan Lovells, and a few others.

In the labor & employment space, Littler Mendelson and Ogletree Deakins have already incorporated many managed service methods into their businesses. They tend to get ignored by the legal press because their profits per partner are lower than the rest of BigLaw.  Yet, managed service methods are the equivalent of a moat around the franchise. Would you rather have $2 million this year, or $500,000 per year for 20?  This isn’t a lottery hypothetical. It’s a strategy choice made by lawyers with large L&E practices.

Likewise, many elite US law firms have relatively large alternative staffing operations that are deployed in massive M&A deals and Big Game litigation. To protect their brands, these firms seldom publicly tout these capabilities. Yet, within the confines of a client pitch, the existence of these capabilities helps protect work at the top of the pyramid. In this context, bundling is likely more valuable to the client than fine gradients of cost and quality.  Although currently run primarily as support units for high-end work (at least for now), many of these operations are quite profitable based on their own P&Ls. Thus, in some segments of the market, the rich are only getting richer.

How does this end?  Obviously, the work methods of managed service providers are innovations that are diffusing throughout the legal industry.  Large scale disruption of the legal industry by managed service companies seems less likely that successful co-existence with law firms who adopt similar work methods. The buyers, after all, are mostly lawyers working in legal departments.  That said, a lot of law firms are far behind on the methods front.  It’s a difficult slough for law firm leaders because the required investments don’t produce higher profits this year or next. Instead, the payoff is long-term relevance and survival, a topic many senior partners put in the same category as global warming.

At some point, legal education will begin to grasp the import of managed service methods in helping law grads obtain high quality employment.  But that is a topic for another day.