Partnership: Prepare for more failures

Why are the advising classes so bad at advising themselves? The travails at Manches, now merged with Penningtons, illustrate a vulnerability in partnership structures.

Ominously, the issue of financial instability and failure to manage business risks is now deemed so acute that the Solicitors Regulation Authority has taken powers to regulate firms, not just individuals. The authority is certainly no Cassandra, which suggests preparation for more failures.

An element of the reported difficulties at Manches appears to have been that money set aside to pay partners’ tax liability was used as working capital. This is hardly the sort of prudent planning an average family would apply to it finances. Ironically, it was considered prudent to retain the partners personal tax within the practice rather than giving it to the partners to retain in their own bank account.

The partnership model has, in fact, been put under immense strain by the Legal Services Act 2011. The Act has created a confusion between ownership and management within firms. This is causing many to lose their way.

The fundamental problem is that law firms work on a business model that sees partners divvying up all the profits with little set aside for a rainy day, let alone the storms of recent years.

Yet who can blame them? The UK tax regime positively encourages such rashness. Partners pay tax irrespective of whether the money is distributed so they might as well bank it. Yes, some firms have started using a hybrid Limited Liability Partnership and company structure to keep profits in the business. But planned measures to cut tax avoidance in partnerships may have an impact here.

A real issue is expectation. Partner profit shares have remained generally constant for many years, with lifestyles to match. Persuading people that the economy has changed and a traditional business model is like Monty Python’s parrot – deceased – can be hard.

There is another reason to think again about how profits are dispersed.  Law firms firms have relied on partnership bank loans to pay for acquisitions and property. But banks are now more wary of partnerships and expect partners not to take out all the profit but to play a greater role in the financing of the practice.

External finance outside banks remains rare and is normally only available for specific client projects or transactions. This means that external finance to deal with a cash flow crisis, even if available, will be expensive.

A further complication is that firms are often a gerontocracy, with an ageing partner group and little thought given to succession, which includes buying out the retiring partners’ profit shares. These are invariably, of course, the same partners reluctant to see a fall in their current drawings to provide working capital for the future.

There are steps that can be taken to keep a partnership viable and financially limber. Client facing partners cannot just leave understanding the mechanics of their firm to its management board. They are all in it together, to adopt a familiar Government mantra. If a professional services firm faces financial challenges all partners suffer and the SRA expects all partners to understand the financial risks. Furthermore, recent evidence shows that strong teams and partners will jump ship early if financial problems are on the horizon.

In practical terms it comes down to planning. Firms need to prepare realistic cash flow projections and stress test them with external advisers. An outside pair of eyes sees things more clearly sometimes than insiders caught in the fever of group think and optimism. A five year plan should be created that maps out retirement plans for partners and how the capital will be replaced.

The management team in law firms needs to discuss frankly with all partners how the business will be financed in the future and profits shared.

None of this is advice of fiendish cunning, just common sense in a world where constant innovation and change is becoming standard. The professional services need rather more professional self-service.

Fiona Hotston Moore, senior corporate partner, Reeves