Costs in translation

This year’s double-digit PEP increases suggest a return to form, but The Lawyer’s analysis of law firm costs tells a different story

As lessons go, they don’t come much starker: the demise of Halliwells last month illustrates perfectly the importance of keeping your costs under control.

As The Lawyer reported last week, the North West firm went into administration after claiming its “high property costs… adversely impacted [its] finances”.

BDO partner Colin Ives sums up the costs reality facing all law firms. “The two big ones, when it comes to cost savings, are redundancies and discretionary spend. There’s not a lot you can do about property.” Halliwells could probably confirm that.

Ives’s point about cutting costs is underlined by Denton Wilde Sapte managing partner Howard Morris, who admits: “The only costs you can take out in a short time are people, and every firm has taken headcount out, whether or not they’ve been upfront about it.”

The highest-profile examples of UK firms that have embarked on widespread redundancy programmes recently are Clifford Chance, ­Linklaters and Allen & Overy (A&O), all of which implemented large-scale programmes during the 2008-09 financial year to combat the collapse of their transactional core business.

The highly leveraged business model used by these firms was ­predicated on having the dealflow to keep four or more associates per equity partner busy. “If that dealflow stops, the ­profits can turn on a sixpence,” says one City managing partner.

For years, the financial reporting season for UK law firms has been characterised by an obsession not with costs but with average profit per equity partner (PEP). Notably, back in those pre-2008 days, when PEP magically continued going up for most, the metric had become shorthand for success.

More recently, as PEP started heading in a different direction, firms have been noticeably less keen on trumpeting their results. At the same time there has been a growing realisation that PEP is a number that can be manipulated fairly easily to achieve the positive PR result firms want, primarily by chopping back on the number of equity partners.

Neither Clifford Chance nor ­Linklaters have reported their 2009-10 results so far, but A&O reported its results last week. The magic circle firm posted a 10 per cent increase in average PEP to £1.1m off a four per cent reduction in turnover. The total number of equity partners dropped from 372 to 355.

Clearly, A&O’s cost-cutting measures have paid dividends.

Watching the costs

To find out just how successful the UK’s leading firms have been at growing profit via stripping out costs, The Lawyer took a sample of the firms that have reported so far this year.

Our calculation was simple. We subtracted this year’s net profit from total turnover to give us the amount that firms spent on salaries, property, professional indemnity insurance and other costs. We then compared last year’s figure with the previous year’s. We also checked the growth or otherwise of equity partner numbers over the past three years.

Morris’s firm is one of a handful that have posted unexpectedly high rises in PEP. Although its equity ­partner number grew by one, ­Dentons cut costs last year by £7.9m.

Dentons posted a hefty double-digit rise in PEP of 22 per cent. Smaller rival Speechly Bircham’s was up 29 per cent, although the firm’s costs, largely a result of its 2009 merger with Campbell Hooper, rose by 6 per cent to £42.4m.

The exemplar of Morris’ comment about slashing headcount is ­Eversheds, where the impact of its 735 redundancies can be seen in the firm’s 28 per cent rise in PEP. As for costs, Eversheds cut its bill by £20.7m, or seven per cent, while the number of equity partners dropped by 14 to 136.

According to Eversheds chief ­executive Bryan Hughes, his was one of the first firms to recognise the severity of the economic downturn on the legal profession and to take the necessary measures subse­quently taken by others.”We did have to take some hard decisions in especially volatile market conditions, but clients were fundamentally changing as they sought to manage their businesses and risks, and our view was that we had to change too – in many ways faster and more aggressively than our competitors,” says Hughes.

“Our recent financial results show we are seeing the benefits of these actions and are more confident about the future than we have been for some time,” he explains.

A flexible approachIn this context the market’s expectation is likely to be that most firms’ costs will have gone down last year. In fact, as The Lawyer’s research shows, several rose. Why?

“If costs are going up it could be an indication that the firm reacted late with redundancies and had to continue paying salaries,” confirms Ives. “But it’s also true that some firms have invested during the downturn.”

Take Watson Farley & Williams. The firm’s total costs rose £6m last year, despite what managing ­partner Michael Greville describes as ­having a “bit of a drive on costs, ­targeting everything”.

The reason for the increase? Expansion plus the impact of currency ­valuations. The firm added 24 fee-earners during the year and opened in Madrid in November, incurring a recruitment fee and set-up costs.

“I don’t feel our costs have spiralled out of control,” insists Greville. “We came in ahead of budget on both profit and fee income by about the same amount, so that indicates our costs were also on budget.”

Greville highlighted the impact on Watson Farley’s costs due to ­currency changes in its Singapore and Bangkok offices, which bill in Singapore dollars and Thai baht. The firm also bills in US dollars in Singapore while the costs are all incurred in Singapore dollars. “The 4 per cent depreciation in sterling will also have had an effect on our costs not offset by income,” adds Greville. “Then there is just the general costs inflation of the business growing.”

Other firms have taken a more innovative approach to combating costs than simply slashing headcount. Norton Rose in particular blazed a trail for part-time or flexible ­working, reducing the salary bill significantly as a result. “Flex was central to our cost-cutting programme,” says the firm’s chief executive, Peter Martyr. “We didn’t make anyone redundant and in fact grew lawyer numbers by 40.”

Norton Rose posted a small decrease in turnover of around 2 per cent but increased its equity by almost 7 per cent. How? “We’ve been managing expenses,” adds Martyr. “You cut back on travel, make harder deals with suppliers, cut luxuries and spend less money on partner conferences. The real goal last year was to be flat.”

Pinsent Masons, which slashed £19m out of its costs last year, also did so with the help of a flex scheme. Indeed, managing partner David Ryan says the firm did everything it could to hold the whole team ­together – a decision that in effect meant very few layoffs.

The measures include a recruitment freeze, aside from some ­targeted investments; the redeployment of lawyers to busier parts of the business; the flexy scheme, prim­arily in corporate and property; the introduction of more sabbaticals and part-time working; more secondments to clients (“we made a virtue of this”, says Ryan); and the voluntary deferment of trainees and newly qualifieds’ start dates.

The response was almost entirely positive. “It became a cohesive effort across the firm to achieve the goal,” says Ryan. “There were good ­reasons for doing it. We believed it would put us in a strong position as we come out of the recession.”

Desperate measures

Not every firm has taken quite such a holistic approach, but every firm has been faced with similar market pressures as Ryan’s. What underlines the impact on PEP of the cost-cutting measures that firms have taken, however, is that these ­occasionally spectacular results have been achieved during a period that could hardly be described as ­booming, particularly for the core corporate and property groups that make up a significant amount
of turnover.

Take LG. The firm tops the list of the big PEP rebounders so far with an astonishing 63 per cent increase. As one legal market consultant put it: “It looks like LG put an awful lot of ­layoffs or costs into the previous year. That would make the year before very bad but it also means they got the bad news out the way early.”

Yet LG’s managing partner, Hugh Maule, said last month that LG’s return to form was partly the result of the “exceptional levels of activity” in its dispute resolution, finance, and corporate recovery and restructuring teams.

Certainly, LG hasn’t been immune to layoffs. The firm made 47 redundancies in total: 14 in September 2008 and 33 in February 2009. Maule confirms that the costs for these layoffs were almost entirely booked during the 2008-09 year. But that was far from being the only part of LG’s war on costs.

“Quite a lot of the positive effect for 2009-10 stemmed from the time when I took over as managing partner and we started looking at the cost base, right down to the nitty gritty,” says Maule. “For the most part we’d done it all by 1 May 2009, so the full benefit of the cost savings in late 2008 and pre 30 April 2009 was in place for our cost base in 2009-10.”

Maule describes the economic environment over the past two years as “an opportunity” that allowed his firm to “turn up the focus on ­everything” – from ­outsourcing contracts to flowers in meeting rooms.

“I did feel we were pretty ­ruthless,” admits Maule. “We wanted to look at it keenly. We think it was ­relatively early action which stood us in ­fabulous stead for 2009-10. Then with some parts of the business ­coming back there was a double-whammy effect.”

LG’s 81 per cent increase in net profit, helped by a reduction in ­equity partners from 45 to 41, also underlines how bad the firm’s ­previous year was.

Maule admits that however ­ruthless a firm may be, there is only so much it can do in cutting costs. “There’s a level below which you can’t go before you cease to function.”

Pinsents’ Ryan agrees: “Certainly there’s a limit. Our costs were ­substantially down, but at some point professional services firms need to find growth.”

Norton Rose’s Martyr is firmly in the camp that some of the results seen this year are a blip – the one-off result of cost cutting. He also agrees that there is a point at which firms can’t cut any more. “That’s exactly right, and I think that’s what you’re seeing happen,” confirms Martyr. “You’re seeing a blip.

Martyr also suggests that next year’s PEP increases are likely to be less spectacular, unless the markets rebound significantly. “It’s not impossible to reduce expenses if turnover is down. I guess it’s an imperative,” says Martyr. “The ­difficulty is getting profits up.”

Balancing act

As Norton Rose’s chief executive ­outlines, if a typical City firm wanted to keep its profits the same while keeping the same number of ­partners, but its turnover went down by 20 per cent, it would need to reduce expenses by around 30 per cent on the previous year. “If you then ­wanted to increase profits by 10 per cent, on the same basis, with the same number of partners and a 20 per cent reduction in turnover, you’d need to save a further 15 per cent,” adds ­Martyr. “That’s a lot of expense saving.

That would mean a pretty huge reduction in partners.”

Dentons’ Morris agrees with ­Martyr that there is a limit to the amount firms can cut, although not simply for financial reasons. ­”Partners say, ’I need to have critical mass to be credible to clients’, which means a certain number of lawyers, skills and so on, so they can say to clients with confidence, ’I can do your work’,” says Morris. “The traditional law firm shape is the pyramid – the leverage model. It’s great when the work’s there, but it kills you when the work dries up. This change may be permanent, which means law firms may never again get back to the level of profitability they once had.”

In other words, it’s going to be tough for firms to add to profit next year without adding to revenue.

“All the current pressure from clients is downward on pricing and there’s a shrinking universe of work,” adds Morris. “Margins are being squeezed and most firms have already done their efficiency savings.”

Or, to put it another way, don’t expect to see many 63 per cent PEP rises this time next year.