Shake your money makers
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An increasingly competitive market fuelled by a bumper year and soaring US-pegged salaries is pumping up the pressure on law firms to increase partnership profits. Abigail Townsend reports on how to improve the bottom line.
The bottom line of any business is profit. It is the reason people go into business and maintaining and improving it is the reason people stay there.
Likewise in law, partnership profitability has always been an important part of running a firm. But in today's highly competitive and changing legal market, there is increasing pressure on partners to constantly improve the bottom line.
David Temporal, partner and head of the London office of consultancy practice Altman Weil, says firms cannot afford to rest on their laurels despite recent reports of strong profits across the market.
"We have seen rising profits from firms over the past few years because of a bumper market. But I do not think there needs to be a serious downturn, just the froth coming off the market [for firms to suffer]."
Giles Murphy, a partner at accountancy firm Smith & Williamson, says: "In the wake of mergers and global expansion by leading law firms, cement between partners may be strained. Procedures and systems should therefore be reviewed to ensure firm performance is maintained and enhanced."
Another major factor affecting profits is non-partner salaries. This year has seen assistant salaries rise dramatically as firms try to compete with US pay rates.
In February, SJ Berwin boosted salaries for newly-qualified assistants by up to 25 per cent to £45,000. Ashurst Morris Crisp soon followed, raising its rates for newly-qualifieds from £35,000 to £42,000.
One senior City lawyer sums up the issues surrounding salaries. "The difficulty is that your fee earners are your most expensive liability as well as your best asset," he says.
As Eversheds chairman Keith James points out, they can only be paid for by very specific economics. "Either it comes out of the partners [profits] or comes out of increasing charges or increasing productivity. It has to be one of those three things," says James.
Most are resigned to the fact that salaries must increase. Therefore achieving maximum partner profits is essential if firms are to recruit and retain the best graduates and lawyers.
Allen & Overy managing partner John Rink says: "Almost certainly this is true of all firms and the biggest item of expenditure is salaries. But of course you have to pay competitive salaries and you have to look at means of becoming more efficient to fund that."
A Slaughter & May insider says: "You cannot afford to pay below the market rate, it is just not an option. It is not fair and you will not have anyone new joining you. It will depend on market conditions where that falls as a cost, but it is not something you can spend any time debating."
The other big factor affecting profitability and its management is size. Firms are getting bigger and there are now only a handful of one office firms left. Most have adopted the strategy of nationwide or international coverage.
London-based Macfarlanes has 54 partners, considerably less than many of its City rivals, but senior partner Robert Sutton argues that old ways of management are inappropriate.
He says: "When you are a partnership of 10 it is not difficult to get all the partners round the table and say 'we have got to make decisions'. When you have 54 you cannot do that, there are too many people.
"In a firm of this size you can still achieve the benefits of good management without losing the intangible benefits of a sense of all for one and one for all. But it is hard when you are in a firm of several thousand people."
Freshfields now has a total of 1,200 legal staff and 298 partners after its merger with Deringer Tessin Herrmann & Sedemund last year.
Chief executive Alan Peck concedes that nowadays, controlling partnership profitability has got everything to do with size.
Peck says: "It is very difficult to get everyone involved in decisions.
"There is a recognition that as firms get larger they have to delegate. There is an acceptance of that but there is a longing for consensus government."
Rink says: "This business has been run extremely efficiently for many years but the bigger you get and the more international you get the less you can run yourselves like a small partnership. You need strong central management but that cannot work unless you maintain the confidence of the partnership."
One way of achieving this, argues James, is by creating accessible channels of information.
With 13 offices across the country and 370 partners out of a total of 1,535 fee earners, effective communication is something Eversheds has had to address, particularly in light of its poor profitability for equity partners compared with other firms in The Lawyer 100 survey in August last year (see box, right).
James says: "The most important thing is to have good financial information available promptly for every aspect of the business. In our case that means that all those involved with management will know in days the financial aspects of the business. You can then measure the good and bad and you can identify the problems and tackle them."
To address changing management needs more firms are concentrating on providing staff with specific training.
Temporal says: "[Management] is part and parcel now of doing legal work. Partners have to be able to supervise and manage not only the work but the people who are working for them. A key aspect of profitability is management.
"There is scope for more training, raising awareness, helping partners develop new skills as well as traditional ones. It is a complex mix that drives profitability."
Freshfields runs courses for its senior lawyers both internally and at the London Business School.
And it is not just the City big boys who are increasing the amount of non-legal training on offer.
James says: "We run management courses within the firm for all aspiring and new partners. We run separate courses for all heads of departments and also send partners on external courses.
"If you expect people to manage then all must have the appropriate training. It certainly pays dividends although not all partners want to become managers and you have to be aware of that."
One management technique is to invite non-lawyers from industry into the firm to deal with the daily needs of the business. The lawyers can then get on with practising law - a sound idea in theory and one that is gaining credence. Eversheds, for example, has a finance director with no legal training who was recruited from industry.
But because of the very nature of law firms - the employees are also the owners - many are still sceptical as to whether outsiders can fit in.
One industry insider says: "Unless the person actually understands professional firms they will get it all wrong. If you grow up in a firm you know the business from the grass roots up. Lawyers are intelligent people and can pick [management skills] up. A lot of outsiders coming in just do not understand that partners actually own the business."
And as one senior City lawyer says: "Lawyers do not respect non-lawyers mainly because they are just not of the calibre."
Firms are also different in that they are more flexible than public companies. As one magic circle lawyer says: "We would accept that we do not maximise profit and it is one of the virtues of partnership that we chose not to do it. We do not have a duty to shareholders but it means you can help partners."
But the bottom line always will be the bottom line. As Peck puts it: "There is a slightly pious line, that I almost believe, that not many lawyers are in it for the money. But you must be the most profitable to attract and retain the right people."
Temporal believes firms no longer have any choice but to deal head-on with the fundamental economics of business.
"Utilisation, rates, the ability to realise the value of the work you charge, experience and so forth. Profitability is about managing the accountability between these dynamics. Managing profitability is a critical factor for success in a competitive market."
Eversheds v Macfarlanes
Gross fees: £177.5m
Fees per fee earner: £116,000
Profits per partner: £211,000
Top of equity: £340,000
Bottom of equity: £120,000
Number of partners: 335
Total fee earners: 1,535
Eversheds is one of only a few firms operating on a truly nationwide basis. It has 13 offices in, among other locations, Newcastle, Leeds, Manchester, Birmingham, Norwich, Reading and the City.
It currently does not have full profit sharing. Individual offices contribute a small percentage of profits to a central pool, otherwise office profits remain within that operation. But the firm is moving to 100 per cent profit sharing this summer.
Chairman Keith James says the partners are still negotiating the nuts and bolts of how this will be done.
But there has been speculation that achieving a balance between highly profitable offices such as Leeds and far smaller operations such as Norwich and keeping partners happy, will be extremely hard.
James is at pains to point out that profitability has been increasing despite the relatively low profits per partner at £211,000 in a firm of 335 partners.
"We look at our profit per equity as a key measure of the performance of the business. It has gone up almost 100 per cent in five years and that has been a target."
But even he concedes the future is not written in stone: "That will be hard to achieve in the future because of competition."
Gross fees: £43m
Fees per fee earner: £215,000
Profits per partner: £470,000
Top of equity: £580,000
Bottom of equity: £260,000
Number of partners: 50
Total fee earners: 200
Macfarlanes is a highly respected firm within the industry. One insider attempts to explain its success: "It has a good mix of high value and high margin work. It also tends to push up chargeable hours and has generally got its costs under control although it will spend money where it knows it adds value.
"It also has a group of motivated people within the firm, ambitious people who are prepared to work the hours."
Senior partner Robert Sutton says that keeping the partnership numbers steady is not an intentional mechanism to maintain profitability.
He adds: "We grow as the quality of the people and the needs of the clients demand it. We will not grow if it means sacrificing the quality. There is nothing magical about it."
The firm has worked on some high profile deals, the latest as adviser to Alchemy in its ill-fated bid for Rover. It won the account after the venture capitalist invited firms to pitch last year.
Macfarlanes does not operate a lockstep system. Sutton describes its method of sharing out the profits as a "transparent but subjective procedure". Partners are consulted and the money is shared out based on contributions made to the firm, not just on billed hours.
Ways to improve performance
Increase chargeable time
Each fee earner does an extra billable fee each week, say 4-5 pm each Friday.
Example: 1 hour @ £200 p/hr for 48 weeks
= £9,600 a year extra produced by each fee earner
= £1.92m a year extra income to firm with 200 fee earners
This extra income has no impact on costs, such as fee earners' salaries, as these are already being met. The additional billing therefore has a direct and immediate influence on profits and partner drawings. The effect of the above on a practice with £30m fee income prior to the changes would lead to a staggering increase in earnings of £19,200 per partner.
Tools to achieve this include: agree and set targets for chargeable hours (individual/departmental); monitor budgets, for example, are individuals on course to reach targets; include results in management accounts (such as budgeted figures v actual)
Improve management of work in progress (WIP) - work done but not yet billed
Aim to reduce money locked up in WIP by generating invoices more promptly, say 30 days earlier.
Example: Assume it takes an average of 97 days after the work to raise the invoice.
Therefore 30 days of WIP lock up = £2.5m
Overdraft borrowings = £5m
Improvement from new regime = £2.5m
Revised overdraft = £2.5m
Overdraft fees: 8 per cent interest on £2,500,000 = £200,000 pa overdraft costs
(previous overdraft fees on £5m = £400,000)
A saving of £200,000 between 100 partners = £2,000 each
Tools to achieve better management of WIP: agree and set lock-up targets (individual/departmental); agree and set billing targets; agree billing schedules.
Improve cash collection
Aim to speed up cash collection, for example 30 days earlier. As with WIP, prompt cash collection reduces need for overdraft.
Example: If cash collected 30 days earlier overdraft can be reduced by a further £2.5m, providing a further £2,000 per partner (see calculation above).
Prompt cash collection may also reduce bad debt provision.
Example: £30m pa fee income. Reduce bad debt provision by 1 per cent of total because of improved cash collection = £ 300,000 saving for the practice.
Assuming 100 partners = £3,000 per partner
Tools to achieve this: agree and set up lock-up targets; agree and set cash collection targets; set strict credit terms; get/invest more in improved credit control.
Positive side effects
The three examples above highlight how small changes can substantially improve profitability.
There are some important beneficial side effects: improved professionalism; improved staff morale - people proud of working for a professional firm; improved client relationships - most clients like their adviser to be 'up front'; improved bank relationships - easier to borrow if bank is confident of good management.
Summary for action
Any action should be in accordance with the firm's own culture, but consider the following key steps and remember communication throughout the firm is key.
review current position - open discussion
get partners and fee earners to 'buy into' new procedures
agree and set measurable targets/budgets
act on results
apply stick and carrot approach to encourage all involved to work more efficiently
care should be taken to ensure specific policies support the firm's culture
Source: The Smith & Williamson Group