Nothing not to like: diversity and law firm profitability (238)

Diversity is indeed associated with higher law firm profits.  To accept this fact, the profession needs to understand why.

Figure 1 above reports expected changes in average partner compensation at different levels of racial diversity among attorneys in large law firms.  These results come from an “all else equal” model that accounts for differences in a multitude of other relevant factors, such as geography, leverage, and firm prestige.

The key takeaway? Within the large firm market, firms with higher shares of Asian, Black, Hispanic, and Multiracial attorneys (“diverse attorneys”) are paying their partners higher average levels of compensation—at about a $260K premium for the firms with the highest diverse representation.

We’ve written about this “diversity dividend” in prior posts, see, e.g., Post 074, yet the foundations for this result remain murky.  Why are more diverse firms more successful, all else equal? This post explores what we believe are some of the most likely explanations, one of which is the diversity of cognition which is influenced by the diversity of identity.

There are multiple reasons to improve diversity within your law firm.

People have different opinions about the investments being made in improving workplace diversity. Many of the motivations have nothing to do with money, but statistics show that money can be one more motivator.

Some people advocate for improving diversity in the workplace to redress past wrongs or because it is the right thing to do.  Others view initiatives within firms, such as DEI and cultural improvement, as hindrances to productivity, as it gives attorneys yet one more task to manage between them and client work.  Another group is suffering from “diversity fatigue” because, compared to all the noise being made about the need to increase DEI, diversity within law firms continues to move at a snail’s pace.

Yet, how often does the internal dialogue on diversity coincide with the focus on higher profits?  This is somewhat surprising because, over the course of any given year, there are literally hundreds of large and small meetings convened for the explicit purpose of improving the firm’s financial performance.

Granted, lawyers are not experts at statistical models.  And it’s only been within the last few years that the requisite data has been available to evaluate the impact of diversity (and many other strategic factors) on law firm performance. 

But from a statistical perspective, there is no longer much doubt:  More diverse AmLaw 200 firms enjoy higher average partner compensation.

Statistical models can explain how a law firm’s attorney composition is related to average partner compensation.

In a long-running project, one of us (Parker) has regularly analyzed data on the largest 200 law firms’ average partner compensation.

Much of the underlying data have been pulled from ALM Legal Compass, including calculations of average partner compensation, which is referred to as “CAP” (Average Compensation, All Partners) in the annual league tables.  Per ALM, CAP is “the net operating income plus compensation to non-equity partners, divided by the number of equity and non-equity partners, and then rounded to the nearest $1,000.”

The reason to use CAP, rather than Profits Per Equity Partner (PPP), is that it provides a uniform measure of profitability spread over all lawyers in the firm who enjoy the title “partner.”  This is relevant because “partners” want and need the title to generate business for the firm. In effect, CAP measures the size of the profit pie relative to the number of partners, with each firm deciding how the profit gets allocated, including among those in the equity and nonequity tiers. Because allocating the profit pie can be very contentious, partners ought to be interested in levers and policies that are likely to grow the pie.

Incorporating 2020 fiscal year data, and covering twenty years in total (N = 3,600 firm-years), the latest results confirm longstanding evidence on how structural factors like headcount, geography, and race/ethnicity representation correlate with average partner compensation.

Below are the “firm factors” and “macro factors” used to predict differences in average partner compensation. 

Model results are illustrated in Figure 2. All factors are scaled such that their quantitative connections to compensation, or “factor weights,” are comparable.

At firms with relatively higher shares of diverse attorneys, partners are more highly compensated.   Our lead graphic (Figure 1) shows the practical importance of the positive association under “all else equal” conditions. Across the range of diverse representation %s observed in the data, expectations about partner compensation change from about $660K at the low end to $920K at the high end, a $260K+ per partner swing.

This diversity dividend persists even after model adjustments for the factors that include leverage, firm size, HQ Market differences, fiscal years, a COVID-19 shock, and firm-specific effects (to capture unmeasured aspects of firm differences, like prestige, reputation, and so on).

What are some other measurable characteristics of diverse firms?

Additionally, a supporting analysis shows that more diverse firms appear to have higher-rated cultures. See Post 095.  Using FY2018 diversity representation and Glassdoor ratings from large law firms in 2018, we observed a small yet statistically meaningful connection between diversity representation and culture ratings. Firms with high culture scores are those with about 4% more diverse attorneys on average.  (For a PDF summary of this analysis to share within your firm, see Law Firm Profitability Analysis (Parker Analytics, June 2021)).

To triangulate the findings between diversity, culture, and firm performance, we note that another analysis by LawVision performed in 2019 using Vault rankings of law firm culture and AmLaw 200 data showed that firms with top-ranked cultures grew headcount, leverage, and top and bottom lines at a faster clip than firms that were not ranked highly for their cultures.

Quod erat demonstrandum: There is a correlation between more diversity and higher-rated cultures, and higher-rated cultures have experienced faster growth in headcount, and top and bottom lines.

Correlation is not causation. What causes the higher profitability?

In the year 2021, a growing chorus of high-profile general counsel and industry groups is clamoring for more diversity in law firms.  In effect, the request is for law firms to do something that, by all accounts, will make them more profitable. Thus, we struggle to understand why any law firm leader or partner would be reluctant to comply.

Every lawyer who has tried to deflect a scientific study is familiar with the old saw “correlation is not causation.”  Perhaps lawyers would warm to the statistical relationship between diversity and profit if they better understood the most likely causal mechanisms.

We think the most likely explanation for the persistent relationship between diversity and higher CAP is the benefits that flow from the diversity of cognition.

Because of the broader social dialogue on diversity and inclusion, we tend to think of diversity in terms of identity traits such as race, gender, sexual orientation, age, and physical abilities.  But there is also diversity of cognition which includes the information, education, feelings, and life experiences we have that shape how we view the world, how we think, and how we anticipate and solve problems.

Further, these two types of diversity overlap.  This is because our race, gender, sexual orientation, age, and physical abilities affect how we interact with the world and the information we receive. 

One of the leading researchers on diversity in the workplace, Katherine Phillips of Columbia Business School, writes:

It seems obvious that a group of people with diverse individual expertise would be better than a homogeneous group at solving complex, non-routine problems. It is less obvious that social [identity] diversity should work in the same way—yet the science shows that it does. This is not only because people with different backgrounds bring new information. Simply interacting with individuals who are different forces group members to prepare better, to anticipate alternative viewpoints and to expect that reaching consensus will take effort.

Phillips, “How Diversity Works,” Scientific American (Oct 2014) at 43.

Another leading social scientist studying the relationship between diversity and organizational and group performance is Scott Page, an economist at the University of Michigan. In his book, The Diversity Bonus: How Great Teams Pay Off in the Knowledge Economy (2017), Page pulls together overwhelming evidence that diversity of cognition consistently results in better solutions to complex problems.  Further, he makes the surprising point diversity of cognition is an old idea that we need to discover:

The idea that diverse ways of thinking can lead to deeper insights is not new. It can be found in the writings of Aristotle. [President] Lincoln himself applied a logic diversity when appointing his cabinet. He did not create an echo chamber of like-minded people. He chose a diverse cabinet, the famed team of rivals. He opted for diversity partly to build political consensus but primarily because he faced complex problems. He wrote in his December 1962 message to Congress, “The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew and act anew. We must disenthrall ourselves.”

The Diversity Bonus at 14.

When we embrace the idea of diversity of cognition, we begin to value the sliver of knowledge that each person brings to the table, especially those who are different from us.

To make this point, let’s consider for a moment the information we obtain through book learning. The total number of books published in the U.S. in 2019 exceeded four million (about 1.7 million of those were self-published).

Even if we all are like 17th-century multilingual polymath and poet John Milton, who supposedly read two books a day, Milton could have, at best, read about 43,000 books in his lifetime if he started at age seven. No one can read everything or have all the information. Furthermore, what we read is often related to our identities. We tend to read things we can relate to, written by people we follow, and that appeal to us.

Think about how AI feeds us recommendations for what we should consume based on our past consumption patterns. Similarity can breed unhelpful homogeneity.  Several years ago, publisher Steven Piersanti pointed out that “most books today are selling only to the authors’ and publishers’ communities.” See “The 10 Awful Truths About Book Publishing,” BK Connection, June 24, 2020.

We must take care to avoid creating teams that will reinforce confirmation bias and homogeneous thinking when trying to solve wicked problems, make predictions, uncover the truth, and innovate. Instead, we should assemble talent in ways that reduce the overlap of cognitive abilities to encourage unique insights for the task at hand.

In a recent opinion piece published on Knowledge@Wharton, David Komlos and David Benjamin, authors of Cracking Complexity: The Breakthrough Formula for Solving Just About Anything Fast (2019), shared some of the uncertainty regarding how to leverage diverse perspectives, particularly for the first time.

In practice, few leaders know how to configure teams with the specific diversity of talent required to resolve their top challenges; they aren’t clear on what qualifies as diverse in terms of “who” and “how many,” nor how to construct these teams. This is essential to mastering complexity.

Komolas & Benjamin, “How Highly Diverse Teams Can Help Untangle Complexity,” Sept. 5, 2019.

As Komolas and Benjamin note, one framework for identifying the unique qualities and information talent can bring to a team is “The Twelve Zones of Variety.”  The Twelve Zones, grouped by type of challenge, are summarized in the table below:

Different challenges require different zone and characteristic combinations.  The goal of every leader is to achieve “the necessary variety with a minimal number of people.”

Back to Law

Bringing the conversation back to law and financial performance, back in 2019, Legal Evolution published a summary of Randy Kiser’s work on lawyer decision-making in cases that result in a trial verdict. See Post 110.  One of the most surprising findings was that, on average, a male-female trial team outperformed a male-male trial team, winning more often and making fewer decision errors. For defendants, the average cost of these errors was a stunning $2.6 million average reduction in defendant liability.

Kiser’s results are statistically significant, which means that there is a very low probability that these results are the product of chance.  In this context, it seems foolish to fall back on the old saw that “correlation is not causation.” A more persuasive response is that  diversity of cognition really matters.

To summarize: identity diversity influences cognitive diversity. Partners at law firms with more racially diverse attorneys see higher average partner compensation. This higher financial performance may be due in part to how these firms embrace talent with diverse cognitive abilities, create highly-rated cultures, and meet client expectations around diversity.