Global Elite and Slaughter and May

Investing in a global business is a gamble, but the figures in the firstever The Lawyer UK 200 Annual Report prove that it has paid off for the magic circle.

All four saw their average profit per equity partner (PEP) figures leap skywards last year, making it the first year in which all four broke the £1m barrier.

But this has been no get-rich-quick scheme. The years 2003 and 2004 were rotten for the magic circle, with the silver circle firms and the classier end of the mid-tier making the profit gains. Since then, all four have seen marked rises in turnover, net profit and PEP. But a more detailed analysis shows that each firm has achieved these goals differently.

Linklaters has increased its revenue by 55.7 per cent in five years, easily the best top-line performance in the magic circle. It is also the most consistent. “A disproportionate rise has come in Asia and the US,” says managing partner Tony Angel.

Allen & Overy (A&O) is second, with a revenue rise of 37 per cent in the same period. But it has been far less consistent, with much of that revenue coming in the past year.

All four firms held remarkably steady on qualified lawyer headcount. The biggest growth came from Linklaters, which pushed its revenue up with the help of a headcount increase of 9.85 per cent. A&O did it on a rise of 5.6 per cent. According to figures published by The Lawyer over the period, Clifford Chance actually decreased its headcount by 8.5 per cent, although the firm claims its own figures show the reduction was 6.3 per cent.

Headcount figures are notoriously vague at the best of times, although they do point to differing models. Freshfields Bruckhaus Deringer’s headcount figures should also be read with care. The statistics may show 474 partners on the books, but more than 60 of them were going through the exit door that year, so the revenue per lawyer (RPL) figure is slightly depressed as a result (although it has a much bigger effect on the revenue per partner figure).

Overseas jurisdictions are still essentially dilutive, with London still the most lucrative market. Take Clifford Chance: its global margin is 33 per cent, but in London it is 43 per cent. And the US? 25 per cent. The firm’s managing partner David Childs, however, argues that the size of the profit margin is not a reliable indicator of an arguably more important statistic – profit per unit. “What I look at is how much partners at the bottom of the lockstep [on 40 points] are earning and how much partners at the top [on 100 points] are earning,” he says. “The margin in any particular jurisdiction depends on how many partners there are at various points on the lockstep, so you could have a smaller margin and still be highly profitable.”

Nevertheless, over the past year it is those firms that generated the highest proportion of their revenue from London that should see disproportionately better performances. And this is where A&O scored big last year.

At Clifford Chance 37 per cent of its partners are in London; at Linklaters the figure is 38 per cent. Freshfields has traditionally had a relatively high number of London partners (currently 48 per cent), but that is not taking the mass partner exits into account.

In any case, Freshfields’ enormous cohort of German partners does not dilute overall profit because of its premium-billing M&A-focused model. The model can be characterised thus: the higher revenue in London and the higher margins in Germany mean the two practices essentially end up in the same place.

Over at A&O some 45 per cent of the partners are in London and they generate more than 52 per cent of the firm’s revenue; barely a shift from 2003, when London generated 56 per cent of global turnover.

In a sense A&O is much closer in model to Ashurst than Linklaters. It will have to continue to increase its headcount globally if it wants to keep up with the other three. Key jurisdictions such as France, Germany, Italy and Spain are notably underweight in comparison, and it is further behind on its global footprint. In order to catch up it may have to invest further.

All of the magic circle firms claim to have seen revenue increases across the board, but A&O’s massive turnover rise followed two relatively weak years and was propelled by the London office, where last year its corporate department had a stormer. Half of the extra turnover of £151m last year was generated out of the London office. All that proportionally larger chunk of extra revenue being billed at premium London rates meant much more also went to the bottom line. When the recovery came, it came big, and it came in London.

“The corporate story is a really big factor. We’ve got our act together on the corporate side and we’ve tried to position ourselves for that,” says A&O managing partner David Morley.

The firm’s total turnover rose by £151m to £887m. Net profit increased by £125m to £395m. A&O converted 82.8 per cent of that turnover rise into pure profit, the highest score in the magic circle. The increase propelled its margin from 36.7 per cent to 44.5 per cent, higher even than Linklaters’.

“The extent to which increased revenue becomes increased profit depends on how the revenue increases,” argues Freshfields chief executive Ted Burke. “If it’s because of higher revenue per lawyer then a lot of that increase will flow to the bottom line. If it’s because of increasing your gearing and headcount, then it won’t.”

Linklaters’ Angel agrees, saying: “The easiest way of not increasing your costs is when you haven’t been working at capacity, because you don’t have to take on more people or increase your premises. If you’re not working flat out one year then it’s much easier to turn it into profit the next. Whereas if you’re working very efficiently it gets more difficult because the only way you can grow is to take on more premises and people.”

Using this analysis it would seem that, after two mediocre years, A&O simply had more capacity in the system that it could utilise. And yet, despite moves such as Clifford Chance’s ferocious attack on costs, including its eye-catching India offshoring initiative, there are no quick fixes for the magic circle. “You’d hope to get more efficient, but it gets tougher,” admits Angel, “particularly when your employment costs are rising rapidly.” In other words, you can identify and deal with the more bloated parts of the business as one-off solutions, but it is all about growing the top line. And if you are in a mature market such as London, global growth is therefore vital for any sort of forward movement.

London’s more remunerative environment also means that these firms have to think of creative ways of managing the equity. “You manage it by having a higher proportion of national [non-equity] partners in other jurisdictions, or slightly higher gearing, or bringing in the country factor,” says Angel. “You adjust the levers to get it right.”

When Angel talks of ‘the country factor’, he is referring to the system that operates in several of Linklaters’ former merger partners that have now also been incorporated into the body of the firm, notably Germany, where equity points are worth around 80 per cent. These partners on reduced entitlement account for 34 per cent of the total partnership, and their average remuneration is £875,000.

Clifford Chance has introduced the concept of a lower equity ladder for less economically robust jurisdictions, notably in Central and Eastern Europe. Freshfields’ decision to introduce non-equity partners was in part propelled by the economics of running a practice in Asia. A&O also runs lower ladders for smaller jurisdictions.

All firms have had to deal with a 10 per cent uplift in costs this year because of higher salaries. But an analysis of each firm’s cost base over the past five years yields an interesting set of stories. Clifford Chance’s cost base has risen by £202m, or 34 per cent, in the five years since 2003, from £594m to £796m. (Again, lower, at just above 20 per cent.)

Its best performance was in 2005, when the cost base actually fell by 6.8 per cent to £666m from £715m, but that was when the firm divested itself of its West Coast practice.

The US factor is one that distinguishes Clifford Chance from the rest of the global elite and is central to any discussion of costs within the global firm. The years after the merger with Rogers & Wells saw the US business slowly shrink in headcount and revenue; the US turned over £240m in 2002, nearly a quarter of the firm’s entire billings. In 2007 it turned over £167m, or 14 per cent of the entire revenue. But it is not all about the US at Clifford Chance. As Childs put it, the reduction in size was “a combination of some managing of headcount down during the last business recession, together with the contraction that occurred in north America”.

Attention at Clifford Chance is now firmly on increasing the top line, as evidenced by the firm’s recent decision to go all-out for growth in the US through a sustained campaign of lateral hiring.

In the past five years Clifford Chance’s revenue has increased by £216m alongside a cost base increase of £202m. The firm’s management has been remarkably efficient in increasing profit within that time (see five-year table). Consequently, the margin has improved over the period, from 29 per cent to 33 per cent.

Although Childs has taken at least £40m of costs out of the business (and that figure does not even include the Indian offshoring deal), the past two years have also seen a flurry of office moves in Europe. This is all expensive stuff. Small wonder, then, that there was an emphasis on a leaner workforce, particularly in relation to non-fee-earning roles (some 300 were phased out in 2006). In this context, taking at least £40m costs out of the business does not seem like managerial chestthumping; it was absolutely necessary in order to keep pace with its competitors.

Linklaters’ costs have risen even more steeply in five years, by 50 per cent, from £419m to £631m. This rise does not even take into account its biggest leap in costs, which came in 2002 following its Continental mergers. That year revenue shot up by 25 per cent, but the cost of taking on an additional 164 partners in less remunerative jurisdictions meant that PEP plunged by 18.8 per cent, from £800,000 in 2001 to £650,000. It was the 2002 set of results that kicked off much internal soul-searching, culminating in its massive restructure.

“There’s no question that the biggest increase has been salary costs,” says Angel. “It accounts for the overwhelming bulk of the increase every year. We made a very big investment in IT between 2002 and 2003 when we put in SAP. But otherwise IT and premises costs have been pretty well controlled.”

Freshfields’ cost base was always going to be much lower than the rest of the magic circle’s because its model relies on much lower gearing. This applies particularly to Germany, where the leverage is nearer 2:1. Its costs have remained relatively stable over the past five years. As Freshfields finance director Laurence Milsted puts it: “Managing the costs over this period has been about different things at different times. It’s included outsourcing of certain services for both cost and service-level reasons and the use of shared service centres in the multi-office German/Austrian region to get better efficiency.”

But there is an elephant in the room: the £55m restructuring of the partnership. The costs table must be read in conjunction with this.

On these figures, that £55m has not been added to the cost base. Earlier this year Milsted told The Lawyer (4 June) that the PEP was an “accurate reflection” of the profit the business has produced, which had then been split between the partners that produced it.

But because Freshfields has had to pay certain partners an additional share of profit by way of exit-related compensation, £1.04m is not necessarily what partners have taken home.

Freshfields has paid the partners that have left their profit shares, plus any additional payments, out of profit as a below-the-line cost. As The Lawyer noted in the 4 June issue, this is a perfectly fair accounting treatment and one that allowed it to post a PEP last year of more than £1m. In the year that all three of its chief rivals did the same, it was important Freshfields matched their performances.

And A&O? Its rivals will be gnashing its teeth at the way it appears to have kept their costs so low. In five years A&O’s cost base has risen by only 8.4 per cent, according to the figures in its accounts. The past 12 months saw the biggest rise of just more than 10 per cent as the firm absorbed its extra salary costs, while the move to Spitalfields was funded entirely out of retained profit.

“Our support staff numbers are 3 per cent lower than they were five years ago,” says Morley. “Essentially the cost base is smaller than it was five years ago, but revenue generation capability has become higher. We’ve put a tremendous effort into streamlining all around the world; not with headline-catching staff sackings, but we’ve been pretty careful about taking on headcount. I’m a great believer in the Japanese concept of kaizen – small but continuous improvement.”

Indeed, the revolution in the magic circle is permanent. As Freshfields’ Burke put it: “With banks and businesses really focused on London, it’s just as well we’re getting our act together. US firms are going to be coming over in droves and we could have been really vulnerable.”