Financing the future

Tensions between partners at different points on a lock-step can make long-term investment decisions problematic. Partners close to retirement may not see the personal pay-back of a sophisticated IT system, marketing initiative or new office, even if that project proves a strategic necessity for growing the business. Effective analysis and implementation plans will be essential.

By Nicola Davies, chief executive, Mourant Ltd

After 20 years working in a law firm that has seen its ownership structure evolve from a lock-step partnership to a limited liability company with an annual external valuation, it is interesting to reflect on how the different ownership and management structures adopted by professional-services firms impact on their willingness and ability to make capital investment for the long-term success of the business. This article aims to examine what the issues are for large and medium-sized law firms.

By any measure it appears that the majority of law firms are going through something of a purple patch at the moment. According to the Price Waterhouse Coopers Law Firms Survey 2006 profits have risen strongly – with 100 per cent of the top 25 respondents having increased profits per partner and 30 per cent having done so by more than 30 per cent. In a benign commercial environment and times of strong profits, there is a natural bullishness towards expansion and investing for the future. However, law firms have two particular difficulties in tackling the issue of capital investment:

Structural issues that discourage long-term investment in favour of short-term cash distributions;
In many cases, woefully inadequate mechanisms for making, implementing and monitoring capital-investment programmes.

The demise of lock-step

Over the years firms have sought to find the right way to attract partners into their business while maximising their all-important profit-per-partner statistics. Traditionally, professional-services firms established themselves as partnerships with a lock-step mechanism, and despite the many criticisms that have been levelled at that type of structure, the majority of UK law firms today still operate as lock-step partnerships, albeit with an almost infinite range of variations and modifications to the ‘pure’ lock-step model. Lock-steps have also varied in length; ‘gateways’ have been introduced to ensure only star partners can progress to the higher levels of partnership; and all sorts of performance-based remuneration structures have been implemented to vary the way in which profits are shared between partners. Nevertheless, while a huge amount of intellectual capital has been expended in devising the best method to divide a law firm’s profits, relatively little attention has been paid to one very basic financial issue, which is the question of how to structure the business to facilitate capital investment for the long-term benefit of the firm.

There has always been a tension between the interests of retiring and continuing partners in a law firm. Around 30 years ago, however, when firms tended to be smaller and were typically based in a single location, the capital needs of the business weren’t that large. By far and away the largest cost the firm incurred was its salary bill, but other overheads tended to be relatively modest. It was the practice of all but the most enlightened of firms to arrive at the end of the financial year and distribute the vast majority of the profits to the partners, as there was relatively little need to retain anything other than basic working capital. A law firm partner could therefore expect to receive a generous income flow over his working lifetime, but little or no capital from the business when retiring or leaving. According to research conducted by Grant Thornton as far back as 2001 the overwhelming response of law firms of all sizes, right across the country, was that partners did not expect to receive a payment in respect of goodwill when they retire, and there is no reason to believe that the results would be significantly different if that research were updated today. Most firms repay a retiring partner’s capital over a fixed number of years post-retirement, but nothing more than that. Certainly it would be highly unusual for any exit capital payment to be a material element of the partner’s overall career remuneration, or a sum based on a proper valuation of the capital value of a business. Given the relatively modest capex requirements of businesses in the past, it is probably no great surprise that little attention was given to the issue.

The stakes are raised

The commercial environment in which firms are required to operate has changed significantly in the past 15 years or so. The dawn of the technological age has driven firms to make significant investments in infrastructure and IT; not only to open up new revenue streams or improve margins, but also to be able to offer a competitive service proposition and protect existing income streams. In the case of the bigger firms, sophisticated clients take for granted a certain level of technological capability and firms who fail to keep pace with developments will lose ground to their competitors in the medium term.

With technology has come globalisation. Some notable exceptions aside, such as Slaughter & May, most of the large commercial law firms wishing to compete in the fields of international finance have felt compelled to expand their geographical footprint, and these types of project come with a large price tag attached. As many firms have found to their cost, it can be many years before a new office starts to add anything at all to the bottom line of the business. By 2006 Allen & Overy had reputedly lost £70m in the preceding five-year period in getting its US practice established – a sum that is material even for a large magic-circle firm. There are many other examples of very significant capital investment being made by firms in pursuit of their long-term strategic aims.

So lawyers in the bigger firms now find themselves in a position where capital investment in the business is essential, not just to move the business forward strategically, but also to protect its existing position and revenue streams. The sums of money involved mean that the stakes are now getting much higher, and the days when firms could afford to have a casual approach to issues of investment are gone.

A delicate balance

In many cases, the basic structure of law firms has not kept pace with these changes, however, and as a consequence the businesses are forced into trying to balance a number of conflicting needs, but in particular:

The desire of partners to maximise cash earnings. This is because there is an in-built expectation of income levels based on a weight of history that profits are stripped out of a partnership each year, but also because of the need to be competitive in the annual ‘profits per equity partner’ (PEP) calculations. PEP statistics are used by many firms as the primary way of measuring themselves against competitors, and are focused on to an almost obsessive extent by the legal media. In times where one of the main preoccupations of law firms is the war for talent, having a high PEP figure is seen as crucial to the ability to hire and retain the best people;
The need to invest money for the long-term health of the business.

A particular difficulty is that the appetite of a partner for long-term investment will depend very much on where he or she sits within the partnership and how long is left until retirement. It is relatively easy for a very junior partner in the lock-step to agree to sacrifice some income for the sake of long-term investment in a new office, a new jurisdiction, or new systems, as his contribution to the costs will be relatively small and the pay-back period in theory should be relatively long. The position of a partner who may be only a year or two from retirement is likely to be very different. He may be effectively being asked to make a fairly significant income sacrifice in his last few years of working, and never reap the long-term benefit. Having tensions between the top and bottom end of a lockstep around these sorts of question is neither healthy nor desirable, and can be the cause of real discontent. Add to this the fact that those at the senior end of the lock-step will, almost inevitably, hold more voting weight and occupy more of the senior-management positions, and the problem is increased further as the interests of those at the top and bottom of the lock-step diverge.

Nor is this an issue confined to those approaching the end of their careers. It is no longer the case that accepting a partnership with a firm means that partner spending his entire career with the organisation. Partner moves have become increasingly commonplace, and even relatively junior partners in a lock-step mechanism may have concerns about whether they will be with the business long enough to see the pay-back on the investment.

A better way?

So how can firms balance these conflicting forces? There are a number of different mechanisms that might be employed. One would be for partners to continue to receive a profit share for a period of years post-retirement, thus making it less likely they will be reluctant to sacrifice income in order to make a capital investment with a pay-back profile too far-distant for them to benefit from. The difficulty with this approach, however, is that there may be a number of undesirable dynamics having retired partners still drawing profits. Not only can they become a source of resentment for younger partners, but they may have a very different perspective on the business from those who still work in it – leading to unpredictable results on crucial votes. Furthermore, it is highly unlikely many firms would contemplate having a profit-tail arrangement with partners that may have left to join competitor firms. Therefore, although it may alleviate the problem of retirees to some extent, it does nothing to address the issue of short-termism on the part of younger partners.

An alternative, and far more radical approach, is to adopt a corporate structure, so that the remuneration of lawyers is split into the cash remuneration elements, plus their capital investment in the business in the form of shares. If partners who leave the business at any point in their career are confident they will receive a capital payment in respect of their proportion of the value of the business, then in theory they should be more inclined to take decisions that are in the long-term interests of the business. However, this approach requires a number of things to happen.

Crucially, the lawyers have to accept that cash remuneration will decline. A greater proportion of their overall wealth will be generated by capital growth on the shares. Acceptance of this is problematic, partly because of the desire to measure themselves against their peers in purely income terms, and partly because it requires the partners to have confidence in the long-term capital value of the business. They need to believe that the business is being properly managed and that investment decisions are being properly evaluated, implemented and monitored. The reality is that many, if not most, professional-services firms do not have the management structure, the discipline, or the systems to do this in any systematic way.

Spending just enough time to waste it

Professional-services firms in general, and law firms in particular, tend to focus on issues of technical excellence, recruitment and utilisation. Management of the cost base often comes a poor second, and proper evaluation and monitoring of investment spend a distant third.

The reality is that most firms have almost no idea how much hidden capital is being invested in their business in the form of time and effort as well as direct expenditure. Projects are started, but often not followed through properly as client demands get in the way. With the focus on utilisation and maximisation of profits, the result is that firms will often spend just enough time to waste it. How many firms have purchased expensive client-relationship-management systems – or other marketing initiatives – only to fail to reap the rewards of investment due to failures in implementation – such as the need for fee-earners to pay attention to properly using the system and not always to put it behind fee-earning? Unless firms can get to grips with these issues, and demonstrate investment decisions are being taken with a proper analysis of the likely return to the business and a detailed implementation plan, the partners or shareholders are unlikely to buy into a model that requires them to sacrifice income in return for long-term capital growth. This will require a root-and-branch review of how projects are managed; how objectives are set and measured; and by what criteria the business will judge the success or failure of a capital initiative.

Market pressures are driving firms to tackle these issues seriously for the first time. It is to be expected that the impact of the Clementi reforms will accelerate the process and bring additional, more complex dynamics into the equation. If, as we are led to believe, a significant number of law firms expect to raise money through stock-market flotations or venture capital, they will not only have to stop the practice of stripping the profits out each year, but will also need to be able to produce properly-costed capital-investment plans showing a measurable return in a short period of time to satisfy the relatively short-term horizons of external investors. Before jumping on the bandwagon of external investment, therefore, firms will need to do an honest appraisal of whether they have the ability or the appetite to follow such a route.

Nicola Davies is chief executive of Mourant Ltd and sits on the Managing Partner editorial board. She can be contacted at nicola.davies@mourant.com