Money Matters

Some of the findings from the PricewaterhouseCoopers Financial Management in Law Firms 2000 Survey have raised a few eyebrows. Mark Waddilove, David Snell, Alistair Rose and Denise Catterall lay bare the survey and its implications for the future

The results to come from the Financial Management in Law Firms 2000 Survey, conducted by PricewaterhouseCoopers (PWC) in association with The Lawyer, combined with historical trends, would appear to provide realistic benchmarks for law firms across the UK. There is sufficient data for all firms to compare their performances across a wide range of measures, and to highlight the overall operating trends of law firms.

The year past has been a successful and busy one for many firms. Following the high levels of activity in a number of corporate markets, 86 per cent of firms have this year reported an increase in fees billed per partner, with 50 per cent reporting that their fees had increased by more than 10 per cent. Increases were seen across all sizes of firm, although those reporting a decrease in fees billed per partner tended to be in the 15-partners-or-below category.

In terms of fees billed per partner, 11 per cent of firms achieved partner billings in excess of £1m. While the majority of these are larger firms, there is still a significant number with 10 or fewer partners achieving this level, clearly demonstrating that a growing number of smaller niche City practices are comfortably matching – and even exceeding – the levels reached by some larger firms. Lower down the range, 22 per cent of firms reported billings of between £501,000 and £750,000 per partner, a 6 per cent increase on last year's figure. Fifty-eight per cent of firms billed below £500,000 per partner, but unsurprisingly, all of these have 30 partners or less.

Concerning profitability, 74 per cent of firms reported an increase in profits per partner this year, compared with 69 per cent for 1999. This year, however, there is clear evidence that it is predominantly the larger firms, with 30 or more partners, that are undergoing this growth. Firms of 30 partners or less are generally finding it tougher to maintain levels of profitability, with a higher proportion of these reporting that their profits per partner had declined.

In terms of overall profitability, 22 per cent of firms reported a profit margin of over 30 per cent for 2000, although this is a marked reduction on previous years. In 1999, 26 per cent of firms reported margins at this level, and in 1998 this figure was 29 per cent. There are a number of factors depressing overall profitability percentages, the most significant being rapidly escalating staff costs, client fee pressures, the impact of panel cuts (particularly in the insurance sector), greater choice in the marketplace and intensified competition.

Broadly speaking, the results of the survey show that this has been a good financial year for many firms. This has been well documented in the legal press, with a number of larger City and regional firms publishing figures that show strong growth in fee levels and record partner profitability for the year to April 2000.

This record profitability per partner has in all likelihood been achieved through growth in fee income, while containing growth in equity partner numbers. The results, however, show clear evidence of reduced profit margins, and firms should be alerted to the adverse impact on profits per partner should a future downturn in the economy result in reduced fee income levels.

Increasing staff numbers and the upward pressure on salaries continue to be the main factors contributing to the pressure on firms' margins. Salary levels, particularly in London and the South East, took a strong upturn at the start of this calendar year, due partly to the impact of US law firms in the London market, but due also to pressure from industry, including the lure of start-up companies. The impact of this is particularly strong in the City, but is also being increasingly felt in the regional market.

The highest growth in numbers was among fee-earners, professional support staff and other support staff, with 71 per cent of firms reporting an increase in their fee-earner headcount, 50 per cent reporting an increase in their professional support staff, and 52 per cent reporting an increase in other support staff. Partner numbers also rose, although appointing fixed share partners is gaining in popularity – 40 per cent of firms reported an increase in fixed share partners, whereas 33 per cent of firms reported an increase in equity partner appointments, a drop from last year's figure of 42 per cent.

The growth levels reported in non-partner grades of staff has had a beneficial impact on the key staff ratio. Forty-four per cent of firms report that they are achieving a 1:4 ratio or better of partners to qualified staff, compared with last year's 30 per cent. However, there is still a worrying 35 per cent of firms that are reporting a ratio of 1:2 or less in this category.

Last year saw the initial impact of IT investment in improving the partner/fee-earner to secretarial ratio. This year has seen little change, though, with 51 per cent of firms still operating on a 1:1 basis.

Cash management continued to improve during 2000, with 60 per cent of firms reporting that their cash position had improved from last year. Firms with a cash position that had worsened or remained the same were predominantly in the 30-partners-or-less category.

The number of firms reporting that they have a documented business plan is broadly the same as last year, at 75 per cent. It is generally the smaller firms that continue to operate without a plan.

The time spent by partners on chargeable work has declined in 2000, possibly as a consequence of improved staffing ratios, enabling more work to be passed to qualified staff. Fifty-eight per cent of partners reported that chargeable work accounted for between 61 per cent and 100 per cent of their time, while 48 per cent spent between 61 per cent and 80 per cent of their time on chargeable work. In 1999, 57 per cent of partners achieved chargeable hours of between 61 per cent and 80 per cent of their total available time.

The 1999 results were a cause for some concern over the firms' focus on achieving short-term increases in chargeable hours, possibly at the expense of marketing and training. The increase in time available for partners on non-chargeable activities appears to have been used wisely, with 68 per cent of firms reporting that partners spend between 5 per cent and 15 per cent of their time on marketing. In 1999, this proportion was 59 per cent, with the bulk of partners in both years spending between 6 per cent and 10 per cent of their time in this area.

Time spent on administration, training, holidays and sickness has remained broadly the same.

If anyone knew the answer to this question, they would now be taking it easy on a tropical island paradise. However, measuring the correlation between the proportion of time spent by equity partners on various activities and the profitability of their firms, and taking the best results from each activity, a mock-up "partner of excellence" can be created, albeit lacking the human traits which are an essential part of partners' roles.

This is not to suggest that every partner should model themself against the following statistics – clearly, there will be partners who have a defined role within the firm as training, marketing, finance or staff partner, for example. However, what may be an interesting exercise is to compare the percentage of time spent by an average equity partner against the time spent by the "model" partner across each of the following activities:

The survey asked firms whether they saw their future growth being achieved through existing or new services. The response was that 84 per cent are relying on existing services to fuel growth, with only 12 per cent relying on new services, and 4 per cent a mix of both. Given that certain traditional legal services are becoming increasingly commoditised, particularly through the expansion of online delivery systems, it is surprising that more firms are not projecting growth from new services. In today's changing business environment, opportunities must exist for new service offerings, even more so when traditional corporate advisory services are becoming increasingly competitive, particularly for mid-tier firms. Perhaps firms are being too conservative in developing new products for an innovative business environment.

There has been surprising consistency over the past three years in the number of firms considering a merger as a means to achieve critical mass. This year, 33 per cent of firms are confident of achieving or consolidating critical mass through merger or acquisition, with 36 per cent reporting that a probable merger features in their plans. However, this year the proportion of larger firms considering a merger has increased significantly, with 63 per cent with more than 50 partners, and 80 per cent with more than 80 partners, examining this option. In general, around 33 per cent of smaller firms are contemplating mergers, although in the 11-15-partner range, only 15 per cent of firms believe that mergers will assist them in achieving or consolidating critical mass. Of those firms considering a merger, only 20 per cent are considering allying with a larger firm – the majority are seeking a firm of equivalent size or one which is smaller.

Regionally, 37 per cent of firms in London and the South East are seeking mergers. In the South West this increases to 58 per cent, and in Scotland it drops to 18 per cent.

The number of firms wishing to expand internationally is consistent with last year, with 20 per cent of Central London firms relying on the international market as a key growth area. Of the firms looking to the overseas markets to support their growth, only 12 per cent are considering setting up a new office, as opposed to last year's 17 per cent. This is not surprising, given that the experience of many firms has shown how expensive it is to set up a new office from scratch.

Merger is undoubtedly the most popular option, with 34 per cent of firms indicating that this is their preferred route into the international arena. Twenty-seven per cent of firms favoured the alliance route, while another 27 per cent – mainly firms with 30 partners or less – intend to service their international clients from their existing UK base.

The relative advantages and disadvantages of these different routes towards overseas business are a source of considerable debate. In recent years a number of firms have focused on alliances as their preferred option for servicing their international clients. However, the looseness of certain alliances, with firms switching between rival groups, has convinced some firms that the complexity of an international merger is worth undergoing in order to cement a relationship. This may well explain the almost 20 per cent increase in the number of firms considering a full merger with an overseas practice.

There has been an increase in the number of firms requiring partners to increase their fixed capital contribution. This year, 25 per cent of firms asked partners to contribute fixed capital, whereas for the last few years this figure has remained at around 20 per cent. It is likely that this increase has occurred in order to enable firms to fund their investment in IT.

Firms were asked to provide details of their financial structures, which revealed the following typical arrangements:

In the last year there has been a shift in the way that firms structure their finances, with only 8 per cent, as opposed to 13 per cent of firms in 1999, reporting that they use bank overdraft facilities. And banks are considerably more cautious of extending facilities to the legal sector, particularly where little or no real security against the facility is available.

More firms are also taking advantage of leasing arrangements, with 67 per cent reporting that leasing obligations represent between 1 per cent and 11 per cent of their total financing. This appears to be a popular approach in the South East, where 63 per cent of firms reported that more than 11 per cent of their total financing resource was provided by leasing arrangements. Given that IT remains a significant part of most firms' spend, this is a sensible approach, and one which is expected to continue.

Sixty-two per cent of firms use longer-term loans to finance fixed assets. However, 26 per cent are not using them to finance fixed asset purchases, the inference being that such loans are funding short-term working capital requirements.

Some partners take the view that the whole of any undrawn current account balance should be available for distribution to partners if requested. Occasionally, firms meet such requests, borrowing to finance such distributions if there is insufficient working capital within the firm. This is a dangerous course of action, as future cash flow is being sacrificed to meet profit distributions when the cash generated by these profits may have already been absorbed within the partnership. In practice, just as in the corporate world, a sensible balance should be struck between the distribution and the retention of profits to finance the partnership.

The level of funding by way of partners' fixed and current accounts continues to remain high, with most firms funding between 11 per cent and 50 per cent by way of fixed capital. Larger firms in particular have partners who borrow more capital personally, with almost 80 per cent of firms of 80-plus partners reporting that equity partners borrow upwards of 75 per cent of capital personally.

Mark Waddilove, David Snell, Alistair Rose and Denise Catterall are all members of the Professional Partnerships Advisory Group.