It’s a sobering sign of what we’ve been reduced to when we’re praising firms for doing the obvious. This time it’s the pioneering technique of holding a little cash back to cover investment, working capital and future partner drawings, rather than doling it all out to equity partners almost as soon as it comes through the door.
Field Fisher Waterhouse (FFW) and Dentons are the latest proponents of the dark art of prudence – FFW confirming it would hold back its ‘special’ profit distribution in March, while Dentons has delayed some payments over the last 18 months from the 2011/12 financial year.
This will resonate with law firm managers considering that withholding profits is one of a suite of tools available to correct a listing vessel. Other weapons include hiked partner contributions (even increasingly for fixed-share partners). Such measures are designed to lock in partners and create some stability and accountability within partnerships, while ensuring that profits are used effectively as working capital.
These are increasingly necessary disciplines in an age when the transfer market for star partners can easily erode the ties that bind law firms, especially during tough economic times. And law’s a funny business. By most industry standards, major law firms are very stable institutions. Yet the curious dynamics of people businesses based on ‘cash-in, cash-out’ funding means that they can very easily become destabilised when the assets hit the elevators, cash flow suffers and liabilities expand.
The only really sticky issue for law firms is how the communicate a shift in funding policy
The good news for managing partners is that there are a range of straightforward techniques – aside from increasing the amount and retention of partner capital – that make law firms more institutionalised and less like hotels for individual partners. Carefully pitched restrictive covenants – while not a tool to be deployed crassly – have proved effective in this regard. Client relationship management programmes likewise have a strong track record at retaining clients when partners move (client mobility being a far bigger problem than partner mobility).
One school of thought suggests that withholding profits and raising capital requirements could make a firm unattractive to lateral recruits. There’s some logic to this, if a firm goes well above market norms. But conversely, a firm showing fiscal restraint is also attractive to potential recruits. And, in a consolidating legal market, firms with a healthier balance sheet make more attractive merger candidates, a point The Royal Bank of Scotland’s law firm banking head James Tsolakis makes.
In the US, there are similar signs of more financial discipline. According to data recently compiled by Citi Private Bank’s law firm group, paid-in capital as a percentage of net earnings went up from 21% to 26% between 2007 and 2011, a strategy largely based on cutting reliance on debt.
Tsolakis believes that UK law firms have followed a similar path, a stance he supports. ‘The old model of withdrawing all the profits is no longer fit for purpose,’ he says, adding: ‘Most top firms have no drawn debt and are financing the business with capital.’
The only really sticky issue for law firms is how they communicate a shift in funding policy. Here, the only advice can be to apply common sense, explain the rationale honestly and treat your partners like adults (or even owners). They’ll understand. The law firm model is largely as stable as you make it.
mark.mcateer@legalease.co.uk