Return to 2004: Financial flashback

We all know that ;the world is getting smaller. But by how much? Three of the big four magic circle firms have all confirmed reductions in headcount. All firms are now retrenching to the size they were in 2004.

Since January Clifford Chance, ­Linklaters and most recently Allen & Overy (A&O) have begun to publish details of their schemes.

A&O is cutting 47 partners and 200 fee-earners, around half of whom will come from the firm’s cost-heavy London office. The total redundancy programme will equate to 9 per cent of its total staff and will reduce A&O’s partnership to 427 – almost exactly the same size as in 2006.

Indeed, a look at partner numbers at magic circle firms in the past five years tells a tale. At two firms, Clifford Chance and Freshfields, partner numbers are now lower than they were in 2004. With Clifford Chance those partner numbers are about to dip further. If Linklaters does in the end cut 70 partners, then it too will be back to 2004’s level. A&O’s ­partner reduction could even be ­optimistic.

To axe partners is the immediate reaction to the recession, but it also exhibits long-term strategic ­thinking. Take Linklaters’ aptly named ‘New World’ strategy, as revealed by The.Lawyer.com (23 January). Not all the details have yet emerged, but it is clear that managing partner Simon Davies has been considering the move for a while.

“New World is a wide-ranging strategic response to the changes in the financial markets,” he told The Lawyer after the details of his plans were revealed on 2 February. “An ­element of that is the need to match the headcount of the firm to actual demand. It’s vital for us to ensure that the firm’s in the right shape to meet the challenges of this new ­market.”

The business models of A&O and Clifford Chance are not broken, but their practice profiles mean they have been particularly exposed to the slump in demand. Both firms have nearly 100 partners working in their finance and debt capital markets teams, as has Linklaters. Freshfields has just 34.

A&O managing partner Wim Dejonghe says that the drop in work, particularly since the New Year, has been across the board, across all offices and all practices. But certain areas have been more hard-hit.

“Real estate markets, M&A and as a consequence tax work. Tax work is about planning profits – if there’s no profit there’s no tax work,” explains Dejonghe. “Global loans, leveraged finance, acquisition finance – there’s no other work in those markets. We don’t see any signs that that will pick up soon.”

While the scale of the cuts at ­Clifford Chance and Linklaters have yet to be decided, in the case of the former (and yet to be revealed by the latter), if they follow A&O in making partner cuts in the same proportions as their associate redundancies, then they will also scale back their ­partnerships to around 2004’s size. But will that be enough?

“Everyone is thinking about what sort of world we’re going to live in and how we need to adjust to that,” says another magic circle partner.

“We don’t know how long or how brutal this downturn will be,” ­comments Jomati consultant and former Clifford Chance managing partner Tony Williams. “We know it’s affecting the whole world, but we don’t know what normal work levels will be. We don’t think they’ll be ’07 levels. Will they even be ’04 levels?”

Growth for growth’s sake has now definitively been ditched; the big four firms’ sizes are unsustainable in the current market. This will cause strain on the traditional law firm model itself, which has been reliant on a constant flow of promotions into the partnership. In the coming two years the business case for partnership appointments will be tougher, but in the long run there will have to be even more active management of ;partnership ;numbers ;by ­performance-related reviews.

Of course, Freshfields made the most dramatic change of all when it coined the size and shape phrase to describe its own partnership restructuring between 2004 and 2006. More than 100 partners left the firm, leaving Freshfields with a partnership of 422. It now has fewer partners than it did in 2004, when it had 516.

“We tried to do it fast and we did it during the good times because people could find jobs then,” reflects a ­Freshfields partner. “We didn’t know how brutal it would be, but what we did know is that there would be a downturn at some stage.”

The Freshfields experience shows how far other magic circle firms have to go in reducing partner numbers (we do not include Slaughter and May in this analysis because it uses an entirely different model, is considerably smaller and is not as subject to the same global pressures as the big four).
Freshfields’ partner numbers are much lower than its peers’, but total lawyer numbers are similar, meaning it relies strongly on leverage – although less so in Germany, which is more partner-heavy in accordance with local norms.

Cutting costs

An analysis of the big four firms’ cost bases since 2004 tells an interesting story.

Partnership sizes may be heading back to 2004 levels, but operating costs will still be at 2009 levels – ­exacerbated by currency fluctuations and the value of sterling. Clifford Chance is the only firm that has ­managed to reduce total costs at some point in the five-year period, when total costs dropped from £712.5m in 2004 to £667.22m in 2005. Clifford Chance also has a much higher ­proportion of non-equity partners than at other magic circle firms, and a large proportion of their remuneration is treated as a cost, which is ­reflected in its higher overall figure last year of £863.85m.

“It’s a people business, so almost all of the costs are driven by people,” says A&O senior partner David ­Morley. “That’s indirectly and ­directly, because accommodation is driven by people as well.”

For every single firm in this group, the cost per lawyer (CPL) has increased. Figures provided to The Lawyer by A&O show that since 2004 CPL has increased by 20 per cent. A caveat: CPL is notoriously ­difficult to benchmark, as methods of ;showing ;headcount ;vary ­enormously, depending on whether you take a year-end number or an average headcount throughout the year, not to mention the issue of part-time workers. A&O’s figures are taken from its LLP accounts, but are illustrative of the general trend ­experienced by all four firms.

As might be expected, the largest leap for A&O was between the 2007 and 2008 financial years at the height of the boom. Total operating costs leapt by £81.6m, an increase of 16 per cent in a single year. The firm has also made a major HQ move to London’s Spitalfields.

“Obviously we’ve been in a boom market for a number of years and our costs have increased in line with the market pressures on salaries and the opening of new offices,” Morley says.” But we’ve also kept costs under constant review and believe we have managed to keep them under control.

“We’ve saved about £21m over the past three years through renegotiating price agreements with several of our global equipment and services suppliers and changes to our IT ­purchasing agreements. We’ve also kept support staff numbers flat over the period. Our lawyer to support staff ratio has dropped from 0.94 three years ago to 0.82 now. That means we have 340 fewer support staff than we would have done if the ratio had remained at 0.94, resulting in a reduction in staff costs of £13m per annum.”

PEP talk

There has been plenty of discussion – much of it on TheLawyer.com concerining firms’ motives for the redundancies and whether these redundancies are predicated on ­keeping profit per equity partner (PEP) as high as possible. The profits culture is so ingrained within magic circle firms that it is part of their market positioning. It is clear that PEP will fall – but just how far? If PEP fell back to 2004 levels, Freshfields would record £675,000, Linklaters £674,000, A&O £609,000 and ­Clifford Chance £562,000.

And can magic circle firms ­continue their elite brands with lowered PEPs?
That may require a cultural ­revolution.

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