Mind the gap: financial results reveal magic circle split

Notwithstanding that this year’s decline was a ­manageable 7 per cent, the headline figure does not tell the full story, either for ­Linklaters or its magic circle competitors.

Linklaters managing partner Simon Davies has long expressed his desire for the firm to operate on a near all-equity footing. The move towards that target has stepped up over the past year, at the obvious expense of PEP, which has now ­fallen by more than 15 per cent from a 2007-08 high of £1.44m. But with overall partner headcount falling over the same period after the New World restructuring project, all-equity ­partners now make 91.3 per cent of the total partnership.

The figures beg the question of whether PEP, long held by many as the defining factor of law firms’ respective performances as well as a carrot to be dangled in front of prospective lateral hires, has had its day.

Having seen his firm’s PEP numbers shoot up by 27 per cent, Clifford Chance managing partner David Childs identifies a number of factors to look at when assessing performance.

“We use a dashboard of metrics to review performance, including ­revenue, PEP, RPL [revenue per lawyer] and RPP ­[revenue per partner], and other important measures, such as client retention, client wins and so on,” he says.

Aside from turnover, in every other comparator a split in the magic circle seems to have emerged, with Freshfields Bruckhaus Deringer and Linklaters pulling clear of their rivals and Allen & Overy (A&O) putting some clear water between it and Clifford Chance.

It may not be coincidental that Freshfields and ­Linklaters are the ones with only a small rump of salaried partners.

Davies says his firm’s move to an all-equity partnership is a “long-term strategy” and one that has not changed simply because of the damage it can do to the PEP figure.
“If profit’s flat, PEP falls,” he explains. “What we’re more focused on is the aggregate profit [of the firm], which has been ­stable.”

At Clifford Chance the model is very different. The firm’s PEP figure suffered a 34 per cent decline between 2007-08 and 2008-09 before the widely anticipated bounce in the last ­financial year.

Childs accepts that this markedly improved performance during a period when revenue has continued to fall can only be ­produced by taking an aggressive approach to costs - including partnership costs.

“PEP’s driven by a combination of revenue, costs and how far the equity is spread,” he says. “Bearing in mind there was no revenue increase, the improvement in PEP was delivered thanks to a reduction in our cost base by around 10 per cent and a decrease in the size of the equity pool.”

The past 12 months has seen partner headcount drop by 77, with more than half of those, 41, coming from the equity. ­Statistically, this means that, while ­profit is being spread less widely, the expense of paying some 36 salaried partners has also been taken out of the equation.

Of the four magic circle firms Clifford Chance has by far the widest equity to non-equity ratio, with around a third of its ­partners not sharing in its profits. It is a structure that Childs says “is the right sort of balance”.

While Freshfields has introduced a small number of salaried partners over the past three years, it is still the closest to an all-equity model of the top four firms.

Joint senior partner ­Konstantin Mettenheimer believes that keeping the partnership as close to all-equity as possible is about maintaining top-end work. But he still places importance on the headline PEP figure.

“It’s a very crude measure,” he says, “but it’s ­meaningful, because it says something about the quality of the business.

“You can look at lots of things, but ultimately this is about what people take home, so if you want a happy partnership it’s vital.”

A&O, meanwhile, has reduced its equity partner ranks by 17 over the past year, in line with a 10 per cent hike in PEP. However, the overall ratio is virtually identical to 2006-07, suggesting it too has been a steadily run practice through the recession.

Managing partner Wim Dejonghe says the firm is “not driven by ratios or PEP figures”.

“Numbers of partners or equity partners isn’t a goal for us,” he adds. “What we look at is what the clients need.”

And Dejonghe is not alone in thinking PEP is an anachronistic measure of success.

“PEP’s largely an artificial statistic,” says Mark Jones, who heads Addleshaw Goddard’s professional services practice consultancy. “It can be ’managed’ by reference to the proportion of ­partners who are equity or non-equity in a firm.”

Jones adds that the ­partnership structure a firm adopts “isn’t a question of right or wrong. It’s more a question of matching an appropriate structure to the culture and ethos of the firm. Some believe in the power and benefits of ­having an all-equity partnership and others believe in keeping a tight hold of the equity.”

While PEP is not necessarily a clear indicator of performance, a comparison of the relative turnover ­figures for the top four firms may not provide any more clues to true performance. The mercurial performance of Clifford Chance over the last three years has seen it drop from the top of the tree in pure revenue terms down to third place last year and back to the summit this time round.

As one magic circle management-level partner puts it: “You can always create turnover. The hard thing is to create quality turnover.”

But with Freshfields and Linklaters still leading the way in terms of PEP, while now also operating with the largest proportions of ­equity partners, a two-tiered magic circle is now in operation.

“It’s not just a coincidence,” says Mettenheimer. “The magic circle’s still the magic circle, but a split’s developing. It’s about the strategic alignment of the business and its ability to control costs.”

It won’t make happy reading for those being left behind, but the days of ­judging the magic circle on a level playing field could well be over.