EPP v PEP: The truth is in there

PEP figures are increasingly being dismissed as a barometer of a firm’s success, with earnings per partner regarded as a truer reflection of financial performance

You are a partner in a top 100 firm that has just posted an average profit per equity partner (PEP) that is significantly up on last year. Are you celebrating? Maybe. Although if you are a salaried partner at DWF, Ward Hadaway or Howard Kennedy you might be drinking Becks instead of Bollinger.

Each of these firms posted double-digit increases in PEP last year. DWF’s PEP was up by 12 per cent, from £332,000 to £373,000, while Ward Hadaway cracked the £400,000 PEP figure for the first time. And Howard Kennedy? PEP soared last year, up by a third, with equity partners on average receiving £630,000.

The operative word there is ‘equity’. These are three of the firms with the widest disparity of any in the top 100 between the number of equity and non-equity partners. Howard Kennedy’s strong PEP performance was aided by the fact that just 17 of the firm’s 75-member partnership are full equity.

Two years ago The Lawyer introduced a new indicator to measure a firm’s financial success: average earnings per partner (EPP). The idea was simple. Everybody in the market knows that a bunch of firms has been going through hoops to make their PEP figures look good, with de-equitisations, managed exits and a plethora of partner-related titles.

The result? A firm might have a couple of hundred partners, but in reality only a handful were sharing fully in the profit (although it should be pointed out, the risk as well), which means that, although PEP at legions of firms across the country might be up by more than 10 per cent on last year, only a handful of partners at these firms are benefiting fully.

The Lawyer’s groundbreaking EPP figure blew away the smoke from this particular game for the first time in 2005. It revealed just how tightly held the equity was at a sample 30 firms. The following year we broke ground again by making the EPP v PEP comparison for every firm in the top 100.

This year, in the inaugural The Lawyer UK 200 Annual Report, which is published next month, we will track how the performance of those 100 firms has changed during what has been a record year for the vast majority of firms.

A better comparator
Thanks to The Lawyer’s new online rolling unveiling of this year’s results (in the Top of the Peps blog), the market is already familiar with the headline PEP results of most firms. It is well known that last year for the first time the magic circle firms all posted PEPs in excess of £1m. But how do these firms compare on EPP?Of the four, only Freshfields Bruckhaus Deringer, which was all-equity until the end of the 2006-07 financial year, and Linklaters remain above the £1m per partner figure. Slaughter and May, that perennial oddity, is the only other firm in the top 100 to post a PEP and EPP of more than £1m.

Slaughters senior partner Tim Clark endorsed The Lawyer’s level playing field approach to profit, saying: “The profit per partner approach, equity or otherwise, that The Lawyer introduced is a better comparator, since it shows the rate of profit by ownership and is less susceptible to distortion through the firm’s approach continued #+ continuedto its equity than the PEP comparator.”

Linklaters and Allen & Overy (A&O) take the third and fourth places respectively in the EPP table, while Clifford Chance drops to ninth, one above superboutique Sacker & Partners, itself a new entry into this year’s top 100 and one that posted a record PEP of £874,000 (Sackers’ EPP is a respectable £507,000).

Elsewhere in the market the EPP research throws out some choice nuggets that highlight the financial re-engineering prevalent in the market in recent years, such as the number of equity partners at Cobbetts. This figure has dropped by a staggering 60 per cent since 2005, from 83 down to 33 for the most recent financial year. The total number of partners also fell, from 139 in 2005-06 to 110 in 2006-07, meaning that just 30 per cent of Cobbetts’ partners are full equity.

What effect, then, does this have on PEP? In 2005 Cobbetts’ PEP was hardly market-busting at just £190,000. Last year it did manage to break through £200,000 to reach £240,000. But its EPP, the average remuneration for all of its 110 partners? Just £165,000.

Cobbetts’ relatively low net profit (it has a profit margin of just 24 per cent) means that the differential between its PEP and EPP figures is by no means the most dramatic among the top 100, however. For that you will need to wait for The Lawyer UK 200’s publication on 3 September.

Looking beyond PEP
Does any of this matter? Certainly there has been a backlash recently against the use of PEP alone as a measure of a firm’s success. Most famously, A&O senior partner Guy Beringer wrote earlier this year that it was wrong to focus on PEP, calling it “a dangerous and undesirable metric for the legal profession to follow”.

At the other end of the turnover scale, the managing partner of Scottish mid-sized firm Macroberts Michael Murphy claimed in the firm’s inaugural annual review this year that “lawyers have become obsessed with a self-indulgent preening of their financial stats, the main culprit being the ubiquitous and oft-quoted profit per equity partner”.

The real issue at stake here, however, is simple: retention. It does not take a genius to figure out that if a proportionately tiny group of partners is creaming off the profit earned by ranks of assistants and non-equity partners working all hours, then some of them are not going to stick around long. Which explains why increasingly a share of the profit is being passed on in performance-related bonuses.

A&O managing partner David Morley says: “The best measure of financial health, and the one we focus on internally, is profit per point, not profit per partner, whether equity or otherwise. Our London associate bonuses are linked to profit per point, not profit per partner. “Financial metrics alone are only one indicator of success. Without losing focus on financial performance, tomorrow’s law firm will need to expand its view of success and redefine it in terms of sustainable positive impact on its clients, its people and society as a whole.”

Clifford Chance managing partner David Childs agrees. “There’s no single number that will adequately measure the success of a firm,” he says. “You also need to look at growth, the quality of clients, a range of factors.

“Financially we do look at PEP, but also the top of the lockstep. Lawyers working day after day, hour after hour want to know that what they’re earning is not way out of line compared with their peers at other firms.”

And the trend for tight equity?”That model is unsustainable unless the firm’s genuinely offering a route through to equity,” says Childs. “If it’s not then partners will just leave.”

Over the past few years the firm that, fairly or not, has been most closely associated with having a tight equity is DLA Piper. Last year the firm expanded its equity, yet it still represented just 31 per cent of the total partnership.

The firm’s chief executive Nigel Knowles denies that the equity at his firm is a closed shop.

“There is a genuine route. We promoted 18 partners into the equity this year. We have a business model based on the fact that we’re a multijurisdictional firm. That business model works for us and we feel under no pressure whatsoever to change it,” he says.

Knowles’ point about the internationalisation of the legal market goes to the heart of the matter, at least for firms with significant overseas operations. DLA Piper, for example, has a Georgian operation where fee rates are 40 per cent those of London’s. “If we compared the PEP of that office to a top City firm, it would appear disastrous,” says Knowles, “but we have a fabulous business there.”

Moreover, DLA Piper’s PEP of £715,000 includes the equity partners in Georgia. If the firm gave a PEP just for London, it would be significantly higher. A point worth making in light of Linklaters’ published £1.29m PEP, which on closer inspection only applies to ‘partners on full entitlement’. Factor in Linklaters’ (primarily overseas) partners on ‘reduced entitlement’, and the firm’s PEP drops to a measly £1.15m.

Freshfields, of course, has had plenty to deal with this year close to home without the added complication of overseas partners. But the firm’s chief executive Ted Burke agrees with Knowles that the overseas growth of firms makes the all-equity partnership virtually redundant. “For larger, internationally-faced firms it’s very, very difficult because of the differences in pricing across various jurisdictions,” he says.

As ever, it is all in the detail. Incidentally, Howard Kennedy has no overseas offices. n